ADVANCE FINACIAL MANAGEMENT

SYLLABUS
UNIT 1: INVESTMENT DECISIONS AND RISK ANALYSIS

Risk Analysis - Types of Risks - Risk and Uncertainity – Techniques of Measuring Risks – Risks adjusted Discount
Rate Approach – Certainity Equivalent Approach – Sensitivity Analysis – Probability Approach – Standard
Deviation and Co-efficient of Variation – Decision Tree Analysis – Problems

UNIT 2 - COST OF CAPITAL

Meaning and Definition - Significance of Cost of Capital – Types of Capital - Computation of Cost of Capital —
Specific Cost – Cost of Preference Share Capital – Cost of Equity Share Capital – Weighted Average Cost of
Capital - Problems

UNIT 3 - CAPITAL STRUCTURE THEORIES

Introduction - Capital Structure — Capital Structures Theories - Net Income Approach — Net Operating Income
Approach — Traditional Approach – MM Approach - Problems

UNIT 4: DIVIDEND THEORIES

Introduction — Irrelevance Theory — MM Model. Relevance Theories – Walter Model - Gordon Model —
Problems on Dividend Theories.

UNIT 5: PLANNING AND FORECASTING OF WORKING CAPITAL

Concept of Working Capital - Determinants of Working Capital - Estimating Working Capital Needs —
Operating Cycle — Cash Management - Motives of Holding Cash - Cash Management Techniques —
Preparation of Cash Budget — Receivables Management — Preparation of Ageing Schedule and Debtors
Turnover Ratio — inventory Management Techniques — Problems on EOQ.

UNIT 6: CORPORATE VALUATION

DCF method, relative valuation method, net asset method, value based management.

SKILL DEVELOPMENT

1. Preparation of a small project report of a small business concern covering all components- (Finance,
Marketing, Production, Human Resources. General administration) (Any one component can be selected as a
title of the report)

2. Designing a capital structure for a Trading concern

3. Preparing a blue print on working capital of a small concern.

4. Prepare a chart on Modes of cash budget.

5. List out different modes of Dividend Policy.

6. List out the Companies which have declared dividends recently along with the rate of dividend.
 1. Investment Decisions and Risk
Analysis

INTRODUCTION

Risk analysis is capital budgeting a substantial degree of importance in the field of corporate finance. Risk
arises in project evaluation because the firm cannot predict the occurrence of possible future events with
certainty and hence, cannot make any correct forecast about the cash flows. The uncertain economic
conditions are the sources of uncertainty in the cash flows. For example, a company wants produce and
market a new product to their prospective customers. The demand is affected by the general economic
conditions. Demand may be very high if the country experiences higher economic growth.

RISK
Risk is the potential that a chosen action or activity including the choice of inaction will lead to a loss of an
undesirable outcome. The concept implies that a choice having an influence on the outcome exists or exist)

Risk Analysis

Risk analysis refers to the uncertainty of forecasted future cash flows streams, variance of portfolio/stock
returns, statistical analysis to determine the probability of a project’s success or failure and possible future
economic states. Risk analysts often work in tandem with forecasting professionals to minimize future
negative unforeseen effort.

NATURE OF RISK

Risk is the potential that a chosen action or activity including the choice of inaction which lead to a loss of an
undesirable outcome. Risk exists because of the inability of the decision maker to make perfect forecasts.

A large number of events influence forecasts. These events can be grouped in different ways. However, no
particular grouping of events will be useful for all purposes. The considerations categories into three types
such as:
i) General economic conditions

This category includes events which influence general level of business activity. The level of business activity
might be affected by such events as internal and external economic and political situations, monetary and
fiscal policies, social conditions etc.

ii) Industry factors

This category of events may affect all companies in an industry. For example, companies in an industry would
be affected by the industrial relations in the industry, by innovations, by change in material cost etc.

iii) Company factors

This category of events may affect only a company. The change in management, strike in the company a
natural disaster such as flood or fire may affect directly a particular company

IMPORTANCE OF RISK

In today’s world, managing corporate risks is a daunting task. The last few
decades have seen a substantial increase in the average rate as well as the volatility of inflation. The increased
uncertainty about inflation has been followed by greater volatility in interest rates, exchange rates and
commodity prices. Global competition has intensified in the wake of reduced tariff barriers.

Risk cannot be eliminated. However, it can be:

(i) Transferred to another party, who is willing to take risk, say by buying an insurance policy or entering into a
forward contract.

(ii) Reduced, by having good internal controls.

(iii) Avoided, by not entering into risky businesses.

(iv) Retained, to either avoid the cost of trying to reduce risk or in anticipation of higher profits by taking on
more risk.

(V) Shared, by following a middle path between retaining and transferring risk.

TYPES OF RISKS

The various types of risks are as follows:

i) Financial Risk

ii) Static and Dynamic Risk

iii) Fundamental and Particular Risk

iv) Pure and Speculative Risk

y) Exchange Rate Risk

vi) Business Risk

vii) Liquidity Risk

viii) Country Risk

ix) Market Risk

X) Credit Risk

xi) Operational Risk

i) Financial Risk

It is the risk borne by equity share holders due to a firm’s use of debt. If the company raises capital by
borrowing money, it must pay back this money at some future date plus the financing charges.

ii) Static and Dynamic Risks

Dynamic risks are those resulting from changes in the economy. Changes in the price level, consumer tastes,
income, output and technology may cause financial loss to members of economy.

Static risks involve those losses that would occur even if there were no changes in the economy. If they hold
consumer tastes, output, income and the level of technology constant, some individuals would still suffer
financial loss.

iii) Fundamental and Particular Risks

Fundamental risks involve losses that are impersonal in origin and consequence. They are group risks, caused
for the most part by economic, social and political phenomena, although they may also result from physical
occurrences. They affect large segments or even all of the population. Particular risks involve losses that arise
out of individual events and are felt by individuals rather than by the entire group. They may be static or
dynamic Unemployment, war, inflation, earthquakes and floods are all fundamental risks.

Particular risks are considered to be the individual’s own responsibility, inappropriate subjects for action by
society as a whole. They are dealt with by the individual through the use of insurance, loss prevention or some
other technique

iv) Speculative and Pure Risks

Speculative risk describes a situation in which there is a possibility of loss but also a possibility of gain.
Gambling is a good example of a Speculative risk.

Pure risk in contrast, is used to designate those situations that involve only the chance of loss or no loss. One
of the best examples of pure risk is the possibility of loss surrounding the ownership property.

Types of Pure Risk

Pure risks that exist for individuals and business firms can be classified under one of the following:

a) Personal risks: These consist of the possibility of loss of income or assets as a result of the loss of the ability
to earn income. In general, earning power is subject to four perils: (a) premature death (b) dependent old age
(c) sickness or disability and (d) unemployment.

b) Property risks: Anyone who owns property faces property risks simple because such possessions can be
destroyed or stolen. Property risks embrace two distinct types of loss: direct loss and indirect or
“consequential” loss. Direct loss is the simplest to understand: If a house is destroyed by fire, the owner loses
the value of the house.

c) Liability risks: The basic peril in the liability risk is the unintentional injury of other persons or damage to
their property through negligence or carelessness. However, liability may also result from intentional injuries
or damage.

d) Risks arising from failure of others: When another person agrees to perform a service for you, he or she
undertakes an obligation that you hope will be met. When the person’s failure to meet this obligation would
result in your financial loss, risk exists.

V) Exchange Rate Risk

This is particularly important for investors that have a large amount of overseas investment and wish to sell
and convert their profit to their home currency.

vi) Business Risk

The term business risk refers to the possibility of inadequate profits or even losses due to uncertainties e.g.,
changes in tastes, preferences of consumers, strikes, increased competition, change in government policy,
obsolesce etc. The uncertainty of income is caused by the nature of a company’s business measured by a ratio
of operating earnings.

vii) Liquidity Risk

The uncertainty introduced by the secondary market for a company to meet its future short term financial
obligations. When an investor purchases a security, they expect that at some future period they will be able to
sell this security at a profit and redeem this value as cash for consumption this is the liquidity of an Investment,
its ability to be redeemable for cash at a future date.

viii) Country Risk

This is also termed as political risk, because it is the risk of investing funds in another country whereby a major
change in the political or economic environment could occur.

ix) Market Risk

The price fluctuations or volatility increases and decreases in the daily market. This type of risk mainly applies
to both stocks and options and tends to perform well in a bull (increasing) market and poorly in a bear
(decreasing) market.

x) Credit Risk

Credit risk is the risk of loss due to a debtor’s non-payment of a loan or other line of credit either the principal
or interest coupon or both.

xi) Operational Risk

Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and
systems or from external events.

RISK AND RETURN:

The portion of the variability of return of a security that is caused by external factors is called systematic risk. It
is also known as market risk or non-diversifiable risk. Economic and political instability, economic recession,
macro policy of the government, etc. affect the price of all shares systematically. Thus, the variation of return
in shares, which is caused by these factors is called systematic risk.

Low levels of uncertainty (low risk) are associated with low potential returns. High levels of uncertainty (high
risk) are associated with high potential returns. The risk/ return tradeoff is the balance between the desire for
the lowest possible risk and the highest possible return. This is demonstrated graphically in the chart below. A
higher standard deviation means a higher risk and higher possible return.

RISK AND UNCERTAINTY

Risk refers to the set of unique outcomes for a given event which can be assigned probabilities. Risk exists
when the decision maker is in a position to assign probabilities to various outcomes i.e. a probability
distribution is known. This happens when he has some historical data on the basis of which he assigns
probability to other projects of same nature.

Uncertainty refers to the outcomes of given event which are too unsure to be assigned probabilities
uncertainty exists when the decision maker has no historical data from which to develop a probability
distribution and must make intelligent guesses in order to develop a subjective probability distribution.

TECHNIQUES OF MEASURING RISKS

The following techniques are used for measuring risk:

1. Sensitivity Analysis

This is also known as a “what if analysis”. Because of the uncertainty of the future, if an entrepreneur wants to
know about the feasibility of a project in variable quantities, for example investments or sales change from the
anticipated value, sensitivity analysis can be a useful method. This is calculated in terms of NPV or net present
value.

2. Scenario Analysis

In the case of scenario analysis, the focus is on the deviation of a number of interconnected variables. It is
different from sensitivity analysis which usually concentrates on the change in one particular variable at a
specific point of time.
3. Break Even Analysis

The break even analysis allows a company to determine the minimum production and sales amounts for a
project to avoid losing money. The lowest possible quantity at which no loss/profit occurs is called the break-
even point. The break-even point can be delineated both in financial or accounting terms.

4. Hillier Model

In particular situations, the anticipated NPV and the standard deviation of NPV can be incurred with the help
of analytical derivation. This was first realized by F.S. Hillier. There are situations where correlation between
cash flows is either complete or nonexistent.

5. Simulation Analysis

Simulation analysis is utilized for formulating the probability analysis for a criterion of merit with the help of
random blending of variable values that carry a relationship with the selected criterion.

6. Decision Tree Analysis

Decision Tree is a schematic tree-shaped diagram used to determine a course of action or show a statistical
probability. Each branch of the decision tree represents a possible decision or occurrence. The tree structure
shows how one choice leads to the next, and the use of branches indicates that each option is mutually
exclusive. The principal steps of decision tree analysis are the definition of the decision tree and the
assessment of the alternatives.

7. Corporate Risk Analysis

Corporate risk analysis focuses on the analysis of risk that may influence the project in terms of the entire cash
flow of the firm. The corporate risk of a project refers to its share of the total risk of a company.

8. Risk Management

Risk management focuses on factors such as pricing strategy, fixed and variable costs, sequential investment,
insurance, financial leverage, long term arrangement derivatives, strategic alliance and Improvement of
information

9. Selection of project under risk

This involves procedures such as payback period requirement, risk adjusted discount rate, judgmental
evaluation and certainty equivalent method.

10. Practical Risk Analysis

The techniques involved the Acceptable Overall Certainty Index, Margin of Safety in Cost Figures, Conservative
Revenue Estimation Flexible Investment Yardsticks and Judgment on Three Point Estimates.

RISK ADJUSTED DISCOUNT RATE APPROACH

Risk adjusted discount rate approach is an estimation of the present value of cash for high risk investment. A
very common example of risky investment is the real estate.

The variation of risk premium is depending on the risk aversion of investor and the perception of investor
about the size of property’s investment risk.
Risk adjusted discount rate = Risk free rate + Risk premium

Under CAPM or capital asset pricing model

Risk premium = (Market rate of return - Risk free rate) x β of the project

The risk adjusted discount rates declare for that by altering the rate depending on possibility of risks of
investment projects. For higher risk investment project a higher rate will be used and for a lower risk
investment project, a low rate will be used.

Decision Rule

i) The risk adjusted approach can be used for both NPV and JRR.

ii) If NPV method is used for evaluation, the NPV would be calculated using risk adjusted rate. If NPV ¡s
positive, the proposal would qualify for acceptance, if it is negative, the proposal would be rejected.

iii) In case of IRR, the IRR would be compared with the risk adjusted required rate of return. If the ‘r’ exceeds
risk adjusted rate, the proposal would be accepted, otherwise rejected.

Advantages of risk adjusted discount rate approach

i) It is quite simple and easy to understand.

ii) Risk adjusted rate has a good deal of intuitive appeal in the eyes of risk averse business person.

iii) It integrates an attitude towards uncertainty.

Limitations of risk adjusted discount rate approach

i) There is no easy way of obtaining an adjusted rate. Capital asset pricing model offers a basis of computing
the risk adjusted rate. Its use has still to pickup and practice.

u) It is completely rely on the assumption that investors are risk averse. Through it is mostly true; however, a
group of seekers also exists who never demand premium for risk assumption.

iii) They willingly paying premium to take risks. Accordingly, with the level of increase, discount rate will
decrease

CERTAINTY EQUIVALENT APPROACH

The certainty equivalent approach is a guaranteed return that someone would

accept rather than taking a chance on a higher but uncertain return.

The certainty equivalent approach explicitly recognizes risk but the procedure for reducing the forecasts of
cash flows ¡s implicit and is likely to be inconsistent from one investment to another. Further, this method
suffers from many dangers in a large enterprise.

Decision Rule

i) If NPV method is used, the proposal would be accepted if NPV of CE cash flows is positive, otherwise it is
rejected.
ii) If IRR is used, the internal rate of return which equates the present value of CE cash inflows with the present
value of the cash outflows would be compared with risk free discount rate. If IRR is greater than the risk free
rate, the Investment project would be accepted otherwise it would be rejected.

Merits

i) It is simple to calculate.

ii) It is conceptually superior to time-adjusted discount rate approach because it incorporates risk by modifying
the cash flows which are subject to risk.

Demerits

i) This method explicitly recognizes risk, but the procedure for reducing the forecast of cash flows is implicit
and likely to be inconsistent from one investment to another.

ii) The forecaster expecting reduction that will be made in their forecast, may inflate them in anticipation. This
will no longer give forecasts according to “best estimate”.

iii) If forecast have to pass through several layers of management, the effect may be to greatly exaggerate the
original forecast or to make it ultra conservative.

iv) By focusing explicit attention only on the gloomy outcomes, chances are increased for passing by some
good investments

SENSTIVITY ANALYSIS

Sensitivity analysis helps a business to estimate what will happen to the project if the assumptions and
estimates turn out to be unreliable. Sensitivity analysis involves changing the assumptions or estimates in a
calculation to see the impact on the project’s finances. In this way, it prepares the business’s managers in case
the project doesn’t generate the expected results, so they can better analyze the project before making an
investment.

Steps Involved in Sensitivity Analysis

The following three steps are involved in the use of sensitivity analysis:

1. Identify the variables which can influence the project’s NPV or IRR.

2. Define the underlying relationship between the variables.

3. Analyze the impact of the change in each of the variables on the project’s NPV or IRR.

The Project’s NPV or IRR can be computed under following three assumptions in sensitivity analysis.

a) Pessimistic (i.e. the worst)

b) Expected (i.e. the most likely)

c) Optimistic (i.e. the best).

Advantages of Sensitivity Analysis

The sensitivity analysis has the following advantages:

i) It compels the decision maker to identify the variables affecting the cash flow forecasts which helps in
understanding the investment project in totality.

ii) It identifies the critical variables for which special actions can be taken.

iii) It guides the decision maker to concentrate on relevant variables for the project.

Disadvantages of Sensitivity Analysis

The sensitivity analysis suffers from following limitations:

i) The range of values suggested by the technique may not be consistent. The terms ‘optimistic’ and
‘pessimistic’ could mean different things to different people.

ii) It fails to focus on the interrelationship between variables. The study of variability of one factor at a time,
keeping other variables constant may not much sense. For example, sales volume may be related to price and
cost. One cannot study the effect of change in price keeping quantity constant.

PROBABILITY APPROACH

The concept of probability is for incorporating risk in evaluating capital budgeting proposals. The probability
distribution of cash flows over time provides valuable information about the expected value of return and the
dispersion of the probability distribution of possible returns which helps in taking accept-reject decision of the
investment decision.

PROBABILITY DISTRIBUTION APPROACH

The concept of probability is for incorporating risk ¡n evaluating capital budgeting proposals. The probability
distribution of cash flows over time provides valuable information about the expected value of return and the
dispersion of the probability distribution of possible returns which helps in taking accept-reject decision of the
investment decision.

The application of this theory in analyzing risk in capital budgeting depends upon the behaviour of the cash
flows, being (j) independent or (ii) dependent.

(i) Independent Cash Flows over Time: The mathematical formulation to determine the expected values of the
probability distribution of NPV for any project is as follows:

Where, CF t is the expected value of net CFAT in period t and ‘j’ is the risk free rate of interest.

(ii) Dependent Cash Flows: If cash flows are perfectly correlated, the behaviour of cash flows in all periods
alike. This means that if the actual cash flow in one year is a standard deviations to the left of its expected
value, cash flows in other years will also be a standard deviations to the left of their respective expected
values. In Other words, cash flows of all years are linearly related to one another. The expected value and the
standard deviation of the net present value, when cash flows are perfectly correlated, are as follows: (Need to
add some problems from Statistics.

Formula:

Illustration: 1
From the following information, ascertain which project is more risky on the basis of standard deviation and
also calculate co-efficient of variation.
Illustration: 2
The probability distributions of two projects and NPV are given below:
STANDARD DEVIATION
Standard deviation is defined as the Square root of the mean of the Squares of deviations from the mean.
The concept of standard deviation was introduced by Karl Pearsons in 1893. It is the most important and
widely used measures of studying dispersion. It overcomes the defects from the earlier methods.

Standard deviation is ‘the square root of the arithmetic mean of the square
deviations of various form of their arithmetic mean.

The formula is as follows:

Calculating Standard deviation on individual Series under direct method:

1. Find out the mean of the Series.

2. Find out the deviation of each value from the mean.

3. Square the deviations and add up the Squares of the deviations.

4. Apply the following formula to ascertain the Standard deviation.

Calculating Standard deviation ¡n individual Series under Short-cut method:

1. Assume any one of the values in the Series as an average.

2. Find out the deviation of each value from the assumed average.

3. Add up the deviation from the mean.

4. Square the deviations.

5. Add up the Squares of deviation.

6. Apply the following formula:

Calculating Standard deviation in continuous Series under step deviation method:

1. Find out the mid—value of each group.

2. Assume one of the mid—values as an average.

3. Find out the deviation of each mid—value from the assumed average in terms of class interval.

4. Multiply the deviation by its frequency.

5. Add up the Products.

6. Square the deviation.

7. Multiply the Square of deviation by its frequency.

8. Add up the Products

9. Apply the following formula

Merits of Standard Deviation

The advantages of Standard deviation are as follows:

1. Standard deviation is rigidly defined and its value is always a definite figure.

2. It takes into account every value in the series. Thus, it is based on all the observations of the data.

3. It is suitable for mathamatical treatment.

4. It is less affected by flactuations of Sampling.

Demerits of Standard Deviation

The following are the demerits of the Standard deviation:

1. As compared to other measures it is difficult to

2. It gives more weight to values which differ greatly from the mean
(i.e., extreme values) and less weight to values which are nearer to the mean. Suppose the mean of the series
is 20. Suppose 40 and 19 are 2 values in the series. The deviation of these values from the mean are 20 and —
1. The Squares of the deviations are 400 and 1. Thus, the standard deviation gives, more weight to extreme
values. This is the reason why it is not much useful in most economic studies.

Variance

Variance is defined as the mean of the Squares of deviation from the mean. It is also called mean Square
deviation

Illustration: 3
Calculate the Standard deviation of the following data

Age (in years): 23, 27, 28, 29, 30, 31, 33, 35, 36, 38
Co-efficient of Variation
Variance (σ2) is a measure of the dispersion of a set of data points around their mean value.

The Co-efficient of variation is a relative measure of standard deviation. It is obtained by dividing the Standard
deviation by the mean and expressing it in percentage. The following formula is used.

Illustration: 4
Following are the marks obtained by two Students A and B in 10 tests of 100
marks each:
Illustration: 5
DECO is a better run score and more consistent player than NEKO (because his average is more and variation is
less)

Illustration: 5
DECISION TREE

Decision tree is a decision support tool that uses a tree-like graph or model of decisions and their possible
consequences, including chance event outcomes, resource costs and utility. It is one way to display an
algorithm.

Meaning

Decision Tree is a graphical representation of various decisions techniques and sequence in events of decision
problem.

The Payoff matrix developed for decisfr1 situations is unable to display the logical interrelationship between
the different steps of a complicated situation. It is also difficult to introduce time relationship in a matrix.
These aspects can often be best displayed in network which is called decision tree.

DECISION TREES FOR SEQUENTIAL IN VESTMENT DECISIONS

A decision tree is a flowchart-like structure in which internal node represents test on an attribute, each branch
represents outcome of test and each leaf node represents class label (decision taken after computing all
attributes). The sequence of events is mapped out over time in a format similar to the branches of a tree.
While constructing and using a decision tree, some important steps should be considered:

i) Define Investment: The investment proposal should be defined. Marketing,

production or any other department may sponsor the proposal. It may be either to enter a new market or to
produce a new product.

ii) Identify decision alternatives: The decision alternatives should be clearly identified. For example, if a
company is thinking of building a plant to produce a new product, it may construct a large plant, a medium
sized plant or a small plant initially and expand it later on or construct no plant. Each alternative will have
different consequences.

iii) Draw a decision tree: The decision tree should be graphed indicating the decision points, chance event and
other data. The relevant data such as the projected can flows, probability distribution and the expected
present value should be located on the decision tree branches.

iv) Analyze data: The result should be analyzed and the best alternative should be selected.

Decision Tree Analysis

A decision tree is a graphic presentation of the present decision with future events and decisions. The
sequence of events is shown in a format that resembles the branches of a tree.

STEPS IN CONSTRUCTING DECISION TREE

The first step in constructing a decision tree is to define a proposal. It may be concerning either a new product
or an old product entering into a new market. It may also be an abandonment option or a continuation option,
expansion option or no expansion option, etc.

Advantages of Decision Tree

1. Decision tree analysis gives the clearity of sequential investment decisions.

2. It gives a decision maker to visualize assumptions and alternatives in graphic form which is easier to
understand than the analytical form. It helps in eliminating the unprofitable branches and determines
optimum decision at various decision points.

3. Decision tree is useful for portaring the interrelated sequential and multi-dimensional aspects of any major
decision problem within the system frame work.

4. It enables the decision maker to see various elements of problem in systematic manner.

5. It is a device which ¡s useful in cases where an initial decision and its outcome affects the subsequent
decisions.

6. It can be applied in various fields such as introduction of new product, marketing strategy, making a
decision.

Disadvantages of Decision Tree

i) The decision tree becomes more and more complicated if he includes more and more alternatives. It
becomes more complicated if the analysis includes interdependent variables which are dependent on one
another.

ii) It becomes very difficult to construct decision tree if the number of years expected life of the project and
the number of possible outcomes for each year are large.

Example:
A businessman has 2 options to sell his products. He can set up a showroom in the city or can sell from his
factory outlet. Setting up a showroom will cost Rs.3,00,000 with a 60% probability of success. If the showroom
succeeds, he can gross a net profit of Rs.8,00,000 per year. If it fails, he can close the showroom or rent it out
for an annual rent of Rs.2,40,000 (for the rest of the year). The probability of getting rent is 80%.

1f he sells from the factory outlet, he has to incur Rs.50,000 as renovating charges. The chances of successful
selling here is 40% with a net profit of Rs.4,00,000 per year.

a) What would you advise the businessman to do?

b) Advise the businessman on how a decision tree helps him to make decisions.
Advice: The businessman should set up a showroom because it would give an expected monetary value of
Rs.4,36,800 over selling through the factory outlet which gives an EMV of Rs.1,30,0000.

- - - —- - -

REVIEW QUESTIONS

Conceptual Type

1. What is risk analysis?

2. What Is risk?

3. What is systematic risk?

4. What is unsystematic risk?

5. What is business risk?

6. What is financial risk?

7. What ¡s insolvency risk?

8. What is risk management?

9. What is meant by risk adjusted rate of returns?

10. What is certainty equivalent approach?

11. What is sensitivity analysis?

12. What ¡s probability approach?

13. What is standard deviation?

14. What is meant by co-efficient of variation?

15. What is decision tree analysis?

16. What do you mean by annual equivalent method?

Analytical Type

1. Explain nature and importance of risk management.

2. Explain risk and uncertainty.

3. Discuss measurement of risk.

4. What is sensitivity analysis? Explain its relevance in project appraisal.

5. Explain various techniques of measuring risks.

PRACTICAL PROBLEMS

1. Calculate the Standard deviation of the following data

Age (in years): 21, 25, 28, 29, 30, 31, 32, 35, 36, 39

2. Following are the runs scored by the two batsmen named Archita and Aditri in ten innings. Find who is
better scorer and who is more consistent.

Archita : 101 22 0 36 82 45 7 13 65 14

Adltri : 97 12 40 96 13 8 85 8 56 16

Computation of Standard Deviation.

 2. Cost of Capital

INTRODUCTION
Capital includes the money, property andother valuables which collectively
represent the wealth of an Individual or business. Classical economics regards capital as a factor of production,
distinguishing between financial capital and physical capital. Financial capital Is accumulated or inherited
wealth held in the form of assets such as stocks and shares, property andbank deposits, while physical capital
is wealth in the form of physical assets such as machinery, plant etc. The term is also used to investment in a
company as either share capital or debt called loan cap.

The cost of capital is a term used in the field of financial Investment to refer to the cost of a company’s funds
(both debt and equity) or from an investor’s point of view “the shareholder’s required return on a portfolio of
all the company’s existing securities” It is used to evaluate new projects of a company as it is the minimum
return that Investors expect for providing capital to the company, thus setting a benchmark that a new project
has to meet.

Meaning of Capital

Capital refers to cash or goods used to generate income either by investing in a business or a different income
property. It is the net worth of a business; that is, the amount by which its assets exceed its liabilities.

Definition of Capital

CHARACTERISTICS/FEATURES OF CAPITAL

The characteristics of capital are as follows:

i) Productive Factor: Capital helps in increasing level of productivity and speed of production.

ii) Elastic Supply: Supply of capital depends upon capital formation process. Capital formation depends upon
savings and Investment. By accelerating capital formation, capital Supply can be Increased. But it is a long term
process.
iii) Man-made Factor: Capital is not a gift of nature. So it is not a primary or natural factor, it IS made by man
in capital goods industry. It is secondary as well as an artificial factor of production.

iv) Durable: Capital is not perishable like labour. It has a long life subject to periodical depreciation.

v) Easy Mobility: Movement of capital from one place to another is easily possible.

vi) Derived demand: As a factor of production, capital has a derived demand to produce finished goods which
have a direct demand. e.g. demand for raw cotton is derived from demand for cotton cloth.

vii) Round about production: Capital goods don’t satisfy our wants directly. But resources should be diverted
towards production of capital goods first. And thereafter such produced mean can be used to produce
consumer goods having direct demand.

viii) Social Cost: Resources have alternative uses. Either they can be put to production of capital goods or
consumer goods. When resources are used for producing capital goods, it means society has sacrificed
enjoyment of consumer goods. This is called social cost.

COST OF CAPITAL

Cost of capital is an important component of business valuation work. Because an investor expects his or her
investment to grow by at least the cost of capital, cost of capital caLZ.be used as a discount rate to calculate
the fair value of an investment’s cash flows.

The cost of capital of a company is the average rate of return required by

investors who provide long term funds (equity, preference andlong term debt).

A central concept in financing decisions, the cost of capital is important for two reasons:

(i) For evaluating capital investment proposals an estimate of the cost of capital is required. The cost of capital
is the discount rate in NPV calculation and also the financial benchmark against which the Internal rate of
return compared.

(ii) To maximize the value of the firm, costs of all inputs (including the capital input) must be minimized.

Meaning of Cost of Capital

Cost of capital is the minimum required rate of earning or the cut off rate for capital expenditure. Cost of
capital is determined by the market and represent the degree of perceived risk by investors. When given the
choice between two investments of equal risk, Investors will generally choose the one providing the higher
return.

Cost of capital is the rate of return that a firm must earn on its -
project investments to maintain its market value and attract funds.

Definitions of Cost of Capital

According to John. J. Hampton, “Cost of capital is the rate of return the firm requirement from investment in
order to increase the value of the firm in the market place”.

According to Solomon Ezra, “Cost of cap is the minimum required rate of earnings or the cut-off rate of capital
expenditure”.
SIGNIFICANCE/IMPORTANCE OF COST OF CAPITAL

The concept of cost of capital is a very important concept in financial management decision making. The
concept is however, a recent development and has relevance in almost every financial decision making but
prior to that development, the problem was ignored or by-passed. The progressive management always takes
notice of the cost of capital while taking a financial decision. The concept is quite relevant ¡n the following
managerial decisions:

i) Capital Budgeting Decision: Cost of capital may be used as the measuring road for adopting an investment
proposal. The firm, naturally, will choose the project which gives a satisfactory return on investment which
would in no case be less than the cost of capital Incurred for its financing. In various methods of capital
budgeting, cost of capital is the key factor ¡n deciding the project out of various proposals pending before the
management. It measures the financial performance and determines the acceptability of all investment
opportunities.

ii) Designing the Corporate Financial Structure: The cost of capital is significant in designing the firm’s capital
structure. The cost of capital is influenced by the chances in capital structure. A capable financial executive
always keeps an eye on capital market fluctuations and tries to achieve the sound and economical capital
structure for the firm. He may try to substitute the various methods of finance in an attempt to minimize the
cost of capital so as to increase the market price and the earning per share.

iii) Deciding about the Method of Financing: A capable financial executive must have knowledge of the
fluctuations in the capital market and should analyze the rate of interest on loans and normal dividend rates in
the market from time to time. Whenever company requires additional finance, he may have a better choice of
the source of finance which bears the minimum cost of capital. Although cost of capital is an important factor
in such decisions but equally important are the considerations of relatinq control and of avoiding risk.

iv) Performance of Top Management: The cost of capital can be used to evaluate the financial performance of
the top executives. Evaluation of the financial performance will Involve a comparison of actual profitability’s of
the projects and taken with the projected overall cost of capital and an appraisal of the actual cost incurred in
raising the required funds.

v) Other Areas: The concept of cost of capital is also important in many others areas of decision making such
as dividend decisions, working capital policy etc.

FACTORS AFFECTING COST OF CAPITAL/FACTORS DETERMINING

THE COST OF CAPITAL

There are several factors that impact the cost of capital of any company. They are discussed below:

(i) Tax Rates: Tax rates are beyond the control of a firm. They have an important effect on the overall cost of
the capital. Tax rates affect the after-tax cost of debt. As tax rates increase, the cost of debt decreases
decreasing the cost of capital.

(ii) Level of Interest Rates: Cost of debt ¡s interest rate. If interest rate increases, automatically cost of debt
also increases. On the other hand, if interest rates are low then the cost of debt is less. The reduced cost of
debt decreases overall cost of capital and this will encourage an additional investment.

(iii) Amount of Financing: As the financial requirements of the firm become large the overall cost of capital
increases for several reasons. For instance, as more securities are issued, additional floatation cost (cost of
selling securities) will affect the percentage cost of the funds to the firm.

(iv) Operating and financial decisions made by management: If management accepts investments with high
levels of risk or if it uses debt or preferred stock extensively, the firm’s risk increases. Investors then require a
higher rate of return, which causes a higher cost of capital to the company.

(v) Marketability of a company’s securities: As the marketability of a security increases, investors required
rates of return decrease, lowering the corporation’s cost of capital.

(vi) General economic conditions: These include the demand for and supply of capital within the economy,
and the level of expected inflation. These are reflected in the risk less rate of return and is common to most of
the companies.

(vii) Source of Finance: There are various sources of finances namely internal sources and external sources.
Cost of capital is largely dependent on these sources of finance. There are some sources which are relatively
costly and, again, there are some sources which are relatively cheaper from the viewpoint of cost of capital.

(viii) Business Risk: Business risk is that which occurs from operating business of a firm. It is influenced among
others, largely by fixed costs incurred. The higher the fixed costs the greater will be the business risk and vice-
versa. It is one of the important factors that influence the determination of cost of capital. The more the
business risk, the higher will be the cost of capital.

(ix) Financial Risk: Financial risk is one that an enterprise will be unable to satisfy its financial obligations. The
risk that will reduce the financial resources of a firm is known as financial risk. The more the financial risk the
higher will be the cost of capital.

(x) Dividend Policy: Dividend policy and Dividend payout and profit retention policies of a firm influences the
determination of cost of capital.

ASSUMPTIONS OF COST OF CAPITAL

Cost of capital is based on certain assumptions which are closely associated while calculating and measuring
the cost of capital. It is to be considered that there are three basic concepts:

1. It is not a cost as such. It is merely a hurdle rate.

2. It is the minimum rate of return.

3 It consists of three important risks such as zero risk level, business risk and financial risk.

Cost of capital can be measured with the help of the following equation:

K = rj + b+ f.

Where,

K = Cost of capital.

rj = The riskless cost of the particular type of finance.

b = The business risk premium.

f = the financial risk premium.

CLASSIFICATION OF COST OF CAPITAL

Following are the classification cost of capital:

1. Historical and Future cost: Historical costs are book costs which are related to the past. Future costs are
estimated costs for the future. In financial decisions future costs are more relevant than the historical costs.
However, historical costs act as guide for the estimation of future costs.

2. Specific cost and Composite cost: Specific cost refers to the cost of a specific capital while composite cost is
combined cost of various sources of capital. It is the weighted average cost of capital.

3. Explicit cost and implicit cost: An explicit cost is the discount rate which equates the present value of cash
inflows the present value of cash outflows. In other words, it is the internal rate of return. Implicit cost also
known as the opportunity cost, is the cost of the opportunity foregone in order to take up a particular project.

4. Average cost and Marginal cost: An average cost refers to the combined cost of various sources of capital
such as debentures, preferences shares and equity shares. It is the weighted average cost of the costs of
various sources of finance. Marginal cost of capital refers to the average cost of capital which has to be
incurred to obtain additional funds required by the firm.

COMPUTATION OF COST OF CAPITAL

Computation of overall cost of capital of a firm involves the following components:

1. Computation of cost of specific sources of finance

a. Cost of Equity Share Capital

b. Cost of Preferred Share Capital

C. Cost of Debt Capital

d. Cost of Retained Earnings (Cost of internally generated funds)

2. Computation of weighted Average Cost of Capital

Cost of Equity Share Capital

The cost of equity is the maximum rate of return that the company must earn on equity financed portion of its
investment in order to leave unchanged the market price of its stock.

a) Dividend Yield Method

When dividend is constant, below mentioned formula will be used:

Where,

Ke = Cost of equity capital

D = Expected dividend rate per share

Mp = Net proceeds of an equity share

Illustration: 1

The expected average earning per share of company is Rs.16. The current market price of the share is Rs.160.
Find out cost of equity capital.

Solution:

Where,

Illustraion: 2

ABC Ltd. has disbursed dividend of Rs.50 on each equity share of Rs.10. The current market price of equity
shares is Rs.120. Calculate the cost of equity as per dividend yield method.

Solution:

Illustration: 3

A company issues 20,000 equity shares of Z 100 each at a premium of 10%. The company has been paying 20%
dividend to equity shareholders for the past five years and expects to maintain the same in the future also.
Compute the cost of equity. Will it make any difference if the market price of equity share is Rs.180?

b) Dividend Yield plus Growth in dividend Method

When the dividends of the firm are expected to grow at a constant rate and the dividend—pay-out ratio is
constant this method may be used to compute the cost to equity capital. According to this method the cost of
equity capital is based on the dividends and the growth rate.

In case cost of existing equity share capital is to be calculated, the NP should be changed with MP (market
price per share) in the above equation:

Illustration: 4
The market price of share is Rs.125 and company plans to pay a dividend of Rs.5 per share. The growth ¡n
dividend expected at the rate of 8%. Find out of cost of equity capital.

Where,

Ke = ?, Dl = 5, MP = 125, G = 8% or 0.08

Illustration: 5

a) A company plans to Issue 2.000 shares of ‘loo each at par. The flotation costs are expected to be 5% of the
share price. A company pays a dividend of Rs.10 per share initially and the growth in dividends is expected to
be 5%. Compute the cost of flew equity share.

b) If the current market price of an equity share is Rs.160, calculate the cost of existing equity share capital.
Illustration: 6
The shares of a company are selling at Rs.40 per share and it had paid divided of Rs.4 per share last year. The
Investors market expects a growth rate of 5% per year.

a) Compute the company’s equity cost of capital.

b) If the anticipated growth rate is 7% p.a, calculate indicated market price per share.
Cost of Preferred or Preference Share Capital

A fixed rate of dividend is payable on preference shares. Though dividend is payable at the discretion of the
Board of Directors and there is no legal binding to pay dividend, yet it does not mean that preference capital is
cost free. The cost of preference capital is a function of dividend expected by Its Investors, I.e. its stated
dividend. In case dividends are not paid to preference shareholders, it will affect the fund raising capacity of
the firm. Hence, dividends are usually paid regularly on Preference shares except when there are no profits to
pay dividends. For
the calculation of cost of capital, preference shares are made into two forms, one is irre1eemable preference
shares and redeemable preference shares

i) Cost of Irredeemable preference Shares

The cost of preference capital which is perpetual can be calculated as:

Where,
PD Preference Dividend

NP = Net Proceeds

Kp = Cost of preference Shares.

Illustration: 7
ii) Cost of redeemable Preference Share Capital

Redeemable preference shares are issued which can be redeemed or cancelled on maturity date. The cost of
redeemable preference shares can be calculated by using the following formula:

Cost of Debt Capital

Cost of debt is a rate of return expected by lenders. Before tax the cost of debt is equal to the rate of interest
payable on debt. For calculating real cost of debt it is necessary to consider not only contractual cost but also
imputed cost.

Illustration:
Cost of Irredeemable Debt

A company may issue irredeemable debentures or bonds In order to retain

constant debt in its capital structure. It is also called perpetual debt.

i) Before tax cost of debt:

Illustration:

Cost of Debt issued at Par

Debt issued at par means, debt is issued at the face value of the debt. It may be calculated with the help of the
following formula:

Illustration:

Debt issued at Premium or Discount

When the debentures are issued more than the face value, it is called premium. And when the debentures are
issued less than the face value, it is called discount.

If the debt is issued at premium or discount, the cost of debt ¡s calculated with the help of the following
formula:
Illustration:

Illustration:
AVERAGE COST OF CAPITAL

Weighted average cost of capital is the expected average future cost of funds over the long run found by
weighting the Cost of each specific type of capital by its proportion in the firm’s capital structure.

The computation of the overall cost of capital (Ko) involves the following steps:

(a) Assigning weights to specific Costs.

(b) Multiplying the cost of each 0f the sources by the appropriate weights.

(c) Dividing the total weighted cost by the total weights.

The Weighted average cost of capital can be calculated with the help of the following formula:
Illustration:
Illustration:
Illustration:
Illustration:
REVIEW QUESTIONS

Conceptual Type

1. Define cost of capital.

2. What do you mean by cost of debenture capital?

3. Give the meaning of cost of preferential capital?

4. Give the meaning of cost of term loan?

5. Give the meaning of cost of equity capital?

6. What is CAPM?

7. What is retained earnings?

8. What is weighted average cost of capital (WACC)?

9. Distinguish between internal and external equity and how the cost of internal and external equity capital are
estimated?

Analytical Type

1. How will you compute the cost of equity Capital?

2. How will you compute the cost of Debt capital?

3. Explain dividend discounting model.

4. Explain what is CAPM and its assumptions.

5. Write a note on cost of retained earnings.

6. Explain what is WACC.

7. State the benefits of adequate and dangers of inadequate working capital.

8. Explain Beta factor with example.

9. How will, you compute Marginal cost of capital.

10. Explain the different types of cost.

PRACCAL PROBLEMS

1. AB Ltd. Issues Rs.1,00,000 9% debentures at a premium of 10%. The cost of floatation isRs.2,500. The tax
rate applicable 2,500. The tax rate applicable is 50%. Compute the cost of debt-capital.

2. What IS the net benefit cost ratio when benefit cost ratio ¡s 1.40:1?

3. The Market price of the equity of a Ltd. Co. is Rs.160. The dividend expected after a year is Rs.12 per Share.
The dividend ¡S expected to grow at a constant rate of 4 percent per annum. Find the rate of return required
by shareholders.

4. The expected average earnings per share of a company are Rs.16 and the current market price of the shares
is Rs.160. Find Out the cost of equity.

5. The shares of a leather company are selling at 60 per shares. The firm has paid dividend at the rate of Rs.3
per share. The growth rate is 9%. Compute cost of equity capital of the company.

6. 20 years 20% debentures of a firm are sold at a rate of! 180. The face value of the debenture is 200, 50% tax
is assumed. Find the cost of debt.

7. Mr. Kiran is considering to purchase 200% Rs.2,000 preference share redeemable after 6 years at par. What
should he be willing to pay now to purchase the share assuming that the required rate of return is l4%.

8. As a financial analyst of a large company, you are required to determine the weighted average cost of
capital of the company using
i) Book value weights.
ii) Market value weights.

The additional information is given below:

All these securities are traded ¡n capital market. Prices are: Debentures Rs.110 per debenture, preference
shares Rs.120 per share, equity shares
Rs.22 per share.

Anticipated external financing opportunities are i) Rs.100 per debenture redeemable at par, 10 year maturity
11% coupon rate, 4% flotation costs, sale price Rs.100. ii) Rs.100 preference share, redeemable at par, 10 year
maturity 12% dividend rate, 5% flotation Costs, sale price Rs.100. iii) Equity shares, Rs.2 per share flotation
costs, sale Rs.22.

In addition, the dividend expected on equity share at the end of the year is Rs.2 per share; the anticipated
growth rate ¡s 7% and the firm as a practice of paying all its earnings in the firm of dividend. The corporate tax
rate is 35%

9. As a financial analyst of a large electronics company, you are required to determine the weighted average
cost of capital (WACC) of the company using (a) book value weight and (b) market value weights. The following
Information is available for your perusal:

Anticipated external financing opportunities are:

(i) Rs.100 per debenture redeemable at par; 10 years maturity, 13% coupon
4% flotation costs, sale price t 100

(ii) Rs.100 preference shares redeemable at par; 10 years maturity; 14% dividend rate, 5% floatation costs, sale
price t 100.

(iii) Equity shares; t 2 per share floatation costs, sale price at t 22

In addition, the dividend expected on the equity shares at the end of current year is Rs.2 and the earnings are
expected to increase by 7% p.a. The firm has policy paying all its earning sin the form of dividends, the
company’s corporate tax rate is 50%.

10. Kishan Limited wishes to raise additional finance of t 20 lakh for meeting its investment plans. It has
Rs.4,20,000 in the form of retained earnings available for

Investment purposes. The following details are available.

1. Debt /equity mix 30%:7O%

2. Cost of debt upto Rs.3,60,000 — 10% (Before tax)

Cost of debt beyond Rs.3,60,000 — 16% (Before tax)

3. Earnings per share: 4

4. Dividend payout : 50% of earnings

5. Expected growth rate of dividend: 10%

6. Current market price: 44

7. Tax rate: 50%

You are required:

a. To determine the pattern for raising the additional finance.

b. To determine the post-tax average cost of additional cost.

c. To determine the cost of retained earnings and cost of equity.

d. Compute the overall weighted average after tax cost of additional finance.

11. ABC Ltd. has the following book value 65

Equity capital (1,00,000 shares @ 10 each) 10,00,000

11% preference capital (20000 shares of Rs.10 each) 2,00,000

13.5°h debentures (l0,000 debentures @ Rs.100

per debentures) 10,00,000

Dividend expected at the end of the year Rs.3.00 per share and growth rate in dividends is 7%. All these
securities prices are: are traded in the stock market. The present

Equity Rs.20 per share

Debenture Rs.110 per debenture

Preference share Rs.13 per share

The company tax rate IS 5O%. Calculate the weighted average cost of capital using:

i) Book Value Weights

ii) Market Value Weights

12. From the following capital structure of a company, calculate the overall cost of capital using:

i) Book value weights and ii) Market value weights.

13. The following is the capital structure of Zenith Co. Ltd. as on 31.12.2014
 3. Capital Structure Theories

INTRODUCTION

Capital structure is a mix of a company’s long-term debt, specific short-term debt, common equity and
preferred equity. The capital structure is how a firm finances its overall operations and growth by using
different sources of funds. Debt comes in the form of bond issues or long-term notes payable, while equity is
classified as common stock, preferred stock or retained earnings. Short-term debt sub as working capital
requirements is also considered to be part of the capital structure.

A company’s proportion of short and long-term debt is considered when analysing capital structure. When
people refer to capital structure they are most likely referring to a firm’s debt-to-equity ratio which provides
insight into how risky a company is. Usually a company more heavily financed by debt poses greater risk as this
firm is relatively highly levered.

Capital structure of the firm is the combination of different permanent long term financing like debt, stock,
preferred capital etc. It also refers to the long-term obligations, which are distributed between owners and
creditors.
It can be defined as the judicious use of different long term sources of financing such that the overall cost of
capital of the firm does not increase and remains minimum and constant, thereby maximizing the value of the
firm.

In other words, it is the determination of ratio of capital to be raised from different sources. Equity and debt
are the two principal sources of finance. The capital structure decision involves the proportion of equity and
debt. It is frequently used to indicate long term sources of funds employed in a business enterprise.

Meaning of Capital Structure

Capital structure is the composition of long-term liabilities, specific short-term liabilities like bank
notes, common equity and preferred equity which makes up the funds with which a business firm
finances its operations and its growth. The capital structure of a business firm is essentially the right
side of it balance sheet.

FEATURES OF CAPITAL STRUCTURE

A sound or an appropriate capital structure should have the following features:

(i) It allows maximum Possible use of leverage.

(ii) It involves minimum possible risk of loss of control.

(iii) It helps to avoid undue restrictions in agreement of debt.

(iv) It helps to avoid undue financial risk with the increase of debt.

(v) It takes care that the use of debt is within the capacity of a firm.

(vi) The firm should be in a position to meet its obligations in paying the loan and

interest charges as and when they fall due.

NEED FOR CAPITAL STRUCTURE

Capital structure describes how a corporation has organized its capital how it obtains the financial
resources with which it operates its business. Businesses adopt various capital structures to meet
both internal needs for capital and external requirements for returns on shareholders investments.
As shown on its balance sheet, a company’s capitalization is constructed from three basic blocks:

i) Long term debt: By standard accounting definition, long-term debt Includes obligations that are
not due to be repaid within the next 12 months. Such debt consists mostly of bonds or similar
obligations, Including a great variety of notes, capital lease obligations and mortgage issues.

ii) Preferred stock: This represents an equity (ownership) interest in the corporation, but one with
claims ahead of the common stock and normally with no rights to share in the increased worth of a
company if it grows.

iii) Common stockholders’ equity: This represents the underlying ownership. On the corporation’s
books, it is mde up of: (a) the nominal par or stated value assigned to the shares of outstanding
stock (b) the capital surplus or the amount above par value paid the company whenever it issues
stock and (c) the earned surplus (also called retained earnings), which consists of the portion of
earnings a company retains after paying out dividends and similar distributions.
NATURE OF CAPITAL STRUCTURE
Capital structure describes the amount of debt a company uses as opposed to equity and it is often
measured with the ratio of debt to equity. The more debt a company has the more it has to pay
creditors for the use of those funds. However, the more debt a company takes on, the more cash it
has to generate sales. The challenge is in finding the right equilibrium between debt and equity for
an optimal capital structure, which can be leveraged to grow the business.
For example, companies that are exposed to significant commodity risk with large price swings might have less
predictable cash flows. The more volatile and uncertain a company’s cash flows, the more uncertainty there is
regarding its ability to meet interest and principal repayment obligations. Companies with extremely
unpredictable cash flows should usually assume that less debt is advisable.

ADVANTAGES OF CAPITAL STRUCTURE

The advantages of capital structure are:

1. Amplifies Return-on Equity

Return on equity (ROE) is commonly used as a measure of business performance. It is the product of earnings,
asset turnover and financial leverage or debt. The more leverage or debt you have in your capital structure,
the more it amplifies your potential earnings. At the same time, an increase in debt or leverage also reduces
earnings since, interest is paid out of net earnings.

2. Greater Control and Flexibility

Debt financing allows keeping full ownership over your business. With ownership comes complete control.
Equity financing is an Investment in the oWflersh1 rights of the company.

3. Framework for Negotiation

Capital structure provides an organized way to raise capital. Both debt and equity have their advantages and
disadvantages.

4. Equity Advantages

Capital structure also provides flexibility in raising funds. One advantage to equity financing for small business
is that it is generally more available than debt financing.

DISADVANTAGES OF CAPITAL STRUCTURE

The various disadvantages of capital structure are as follows:

1. Investor Expectations

Neither profits nor business growth nor dividends are guaranteed for equity
investors. The returns to equity Investors are more uncertain than returns earned by debt holders. As a result,
equity investors anticipate a higher return on their investment than that received by lenders.’

2. Business Form Requirements

Legal restrictions govern the use of equity financing and the structure of the financing transactions. In fact,
equity investors have financial rights, including a claim to distributed dividends and proceeds from the sale of
the company in which they invest.
3. Financial Returns Distribution

Each investor in a company has a right to the cash flow generated by the
business after all other claims are paid.

OPTIMUM CAPITAL STRUCTURE

Optimum capital structure will play a vital role in terms of cost of capital. Effective combination of capital (debt
and equity) should try to minimize the overall cost thereby the value of company can increase.

The combination of debt and equity that leads to the maximization of the value of the firm is called Optimum
capital structure. It maximizes the wealth of the owners and minimizes the cost of capital. So every firm should
definitely try to achieve optimum capital structure.

Qualities of Optimum Capital Structure

1. Simplicity: Initially the capital structure should be raised from ordinary and preference share. Only in case of
crisis, debt funds should be used. The capital structure should be simple.

2. Flexibility: The capital structure should be flexible enough, so that wherever required it can be increased or
decreased depending on the need at that moment.

3. Minimum cost of capital: The funds acquired from different sources have different costs associated with it.
By acquiring funds at a low costs, It can invest in new projects and therefore, earn huge profits.

4. Liquidity: The company has many commitments for making payments like interest, dividend, wages,
premium, rent etc., this affects the liquidity of the firm. If the provisions are maintained to retain adequate
liquidity separately, it will be beneficial to the company as it will not affect capital.

5. Maximum return: The borrowed funds increase the level of risk because interest of such funds has to be
paid before making payment to the shareholders. If the track record is good, it can avail more funds in the
future if needed.

6. Legal requirements: It should determine that the debt to equity ratio as prescribe the capital issue Control
Act.

FACTORS AFFECTING CAPITAL STRUCTURE

The effective capital structure is based on certain basic factors, which have a bearing on the capital
combination.

External factors are the factors which ¡s over and above the control of individual firm. These factors have a
bearing on the capital structure of the individual firm. The following are the factors:

1. Market: It plays a vital role in terms of the sources of finance. Efficient market can always provide required
quantum of funds in different combination. When the firm formulated the capital structure, it has to consider
the prevailing market environment and act accordingly.

2. Investor’s behaviour: Capital structure of the firm is purely based on the behavioural aspect of the investor.
It is proven from many theories that the human behaviour changes frequently and one will not have control on
the behaviour of the human being.
3. Required rate of return: The investors required rate of return will be volatile frequently in the market.

4. Business risk: The greater the firm’s business risk, the lower its debt ratio. It is the risk which is measured by
determining the Inability of the firm to generate profit to cover up its operating cost.

5. Taxation policy: Each component of capital may demand for different kinds of return. For example equity
demands for dividend, debt demands for Interest. In case of interest on debt, the corporate tax is exempted,
but in case of dividends on equity, it is taxable.

6. Competition: The volatile capital structure is purely based on the market competition.

7. Legal Issues: Due to the change ¡n the legal aspects by the statutory governing bodies like SEBI, company
law board etc., the corporate companies has to plan for the issuance of capitals.

8. Inflation: Inflation may, have an impact on the investment pattern of an individual. If an individual investor
has higher borrowing capacity, he go for risky return by borrowing funds at the lower rate of interest.

9. Conservatism or aggressiveness: Some managers are more aggressive than

others therefore some firms are inclined to use debt in an effort to boost profits.

10. Growth opportunities: The mix of assets in place versus growth opportunities has four implications for
capital structure.

CAPITAL STRUCTURE THEORIES

The capital structure theories are assisting the business organization to identify the optimum capital structure.
The capital structure of the organization differs from one approach to another due the assumption which are
underlying with reference to many factors of influence. The success of the firm is normally depending upon the
rate at which the financial resources are raised, differs from one organization to another depends upon the
needs.

Assumptions of Capital Structure Theories

The various assumptions of Capital Structure Theories are:

i) There are only two resources in the capital structure viz Debt and Equity shares capital.

ii) The dividend payout ratio 100% which means that there is no scope for the retained earnings.

iii) The life of the firm is perpetual.

iv) The total assets of the firm do not change.

v) The total financing remains constant through balancing taking place ¡n between the debt and share capital.

vi) No corporate taxes this was removed later.

VARIOUS CAPITAL STRUCTURE THEORIES

Various Capital Structure Theories are as follows:

1. Net Income Approach

2. Net Operating Income Approach

3. The Traditional Approach

4. Modigliani—Miller Hypothesis

1. Net Income Approach

According to this approach, the cost of equity capital and cost of debt capital are assumed to be independent
to the capital structure. The value of the firm rises by the use of more and more leverage and the weighted
average cost of capital declines.

The cost of debt rd and cost of equity re remain unchanged when DIE varies. Because of rd and re being
constant with respect to DIE, it means that rA, the average cost of capital is

rA = rD(D/D+E) + rE (E/D+E)

Declines as DIE increases. This occurs because w en DIE increases, rD. which lower than rE, have higher weight
in the calculation of rA.

Assumptions:

1. 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.

2. The debt capitalisation rate is less than the equity capitalisation rate.

3. Corporate income taxes do not exist.

2. Net Operating Income Approach

According to the net operating approach, the cost of equity Increases In accordance with leverage. Due to
Which the Weigh average or capital remains constant and the value of the firm also remains Constant as
leverage Is changed.

The overall capitalization rate and the cost of debt remain constant for all degrees of leverage.

Illustration:
3. Traditional Approach

The Net Income theory and Net Operating Income theory stand in extreme forms. Traditional approach stands
in the midway between these two theories. This Traditional theory was advocated by financial experts
Ezta Solomon and Fred Weston. According to theory a proper and right Combination of debt and equity will
always lead to market value enhancement of the firm. This approach accepts that the equity shareholders
perceive financial risk and expect premiums for the risks undertaken. This
theory also states that after a level of debt in the capital structure, the cost of equity capital increases.

Capital structure Theories and its different approaches put forth the relation between the proportion of debt
in financing of a company’s assets, the weighted average cost of capital (WACC) and the market value of the
company. While Net Income Approach and Net Operating Income Approach are the two extremes Approach
are the two extremes, traditional approach, advocated by Ezta Solomon and Fred Weston is a midway
approach also known as intermediate approach”.

Assumptions under Traditional Approach

i) The rate of interest debt remains constant for a certain period and thereafter with Increase in leverage, it
increases.

ii) 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.

iii) 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 capital structure.
Traditional Approach specifying Optimum Capital Structure

First stage: In the first stage, the overall cost of capital falls and the value of the firm increases with the
increase in leverage. This leverage has beneficial effect as debts are less expensive. The cost of equity remains
constant or increases negligibly. The proportion of risk is less in such a firm.

Second stage: A stage is reached when increase ¡n leverage has no effect on the value or the cost of capital of
the firm. Neither the cost of capital falls nor the value of the firm rises. This is because the increase in the cost
of equity due to the assed financial risk offsets the advantage of low cost debt. This is the stage wherein the
value of the firm is maximum and cost of capital minimum.

Third stage: Beyond a definite limit of leverage the cost of capital increases with leverage and the value of the
firm decreases with leverage. This is because with the increase in debts investors begin to realize the degree of
financial risk and hence they desire to earn a higher rate of return on equity shares. The resultant increase in
equity capitalization rate will more than offset the advantage of low-cost debt.

4. Modigliani and Miller Approach

This theory was first proposed by Franco Modigliani and Merton Miller in their classic contribution in capital
structure which is regarded by many as the most important paper on modern finance. This work stands as the
watershed between old finance an essentially loose connection of beliefs based on accounting practices, rules
of thumb and modern financial economics, with its rigorous mathematical theories and carefully documented
empirical studies.

Assumptions:

1. No corporate taxes.

2. Perfect market.
3. Expected earnings of all firms have same risks.

4. Investors act rationally.

5. The cut-off point of investment is capitalization rate.

6. Earnings are distributed to the shareholders.

The value of the firm is equal to its expected operating income divided by the discount rate appropriate to its
risk class. It is independent of its capital structure.

Revised M and M proposition

The Modigliani-Miller theorem (of Franco Modigliani, Merton Miller) forms the basis for modem thinking on
capital structure. The basic theorem states that, under a certain market price process (the classical random
walk), in the absence of taxes, bankruptcy costs, agency costs and asymmetric information and in an efficient
market, the value of a firm is unaffected by how that firm is financed.

Historical background

Miller and Modigliani derived the theorem and wrote their groundbreakm9 article when they were both
profeSs0t at the Graduate School of Industrial Administration (GSIA) of Carnegie Mellon University The story
goes that Miller and Modigliani were set to teach corporate finance for business students despite the fact that
they had no prior experience in corporate finance. When they read the material that existed they found it
inconsistent SO they sat down 0gether to t to figure it out. The result of this was the article ¡n the American
Economic Review and what has later been known as the M&M theorem.

Consider two firms which are identical except for their financial structures. The first (Firm U) is unlevered: that
is, financed by equity only. The other (Firm L) is levered: it is financed partly by equity and partly by debt. The
Modigliani-Miller theorem states that the value of the two firms is the same.

Without Taxes
Proposition I

Vu = VL where Vu is the value of an unlevered firm = price of buying a firm composed only of equity and V L is the
value of a levered firm = price of buying a firm that is composed of some mix of debt and equity. Another word
for levered is geared, which has the same meaning to raise.

To see why this should be true, suppose an investor is considering buying one of the two firms U or L.
Instead of purchasing the shares of the levered firm L, he could purchase the shares of firm U and borrow the
same amount of money B that firm L does. The eventual returns to either of these investments would be the
same. Therefore, the price of L must be the same as the price of U minus the money borrowed B, which is the
value of L’s debt.

This discussion also clarifies the role of some of the theorem’s assumptions. We have implicitly assumed
that the investor’s cost of borrowing money is the same as that of the firm which need not be true in the
presence of asymmetric information, in the absence of efficient markets or if the investor has a different risk
profile to the firm.
Proposition II

Proposition II with risky debt. As leverage (D/E) increases, the WACC (kO) stays constant.

ke = ko ÷ DIE (ko—kd)

ke ¡s the required rate of return on equity or cost of equity.

ko ¡s the company unlevered cost of capital (ie assume no leverage).

kd is the required rate of return on borrowings or cost of debt.

D/E is the debt-to-equity ratio.

REVIEW QUESTIONS
Conceptual Type
1. Define capital structure.

2. What is a capital structure?

3. What is optimal capital structure?

4. What is capital expenditure/budget?

5. Give the meaning of Net Income Approach.

6. What is Net Operating Income Approach?

7. Give the meaning of traditional approach of capital structure.

8. What is Modigliani—Miller hypothesis?

Analytical Type
1. Explain the basic principles of financial decisions.

2. Explain the different theories of capital structure.

3. DiscuSS Net Income Approach.

INTRODUCTION
The diyidend decision is a decision made by the directors of a company about the amount and
timing of any cash payments made to the company’s stockholders. The dividend decision is an
important part of the present day corporate worId.

The shareholders investment should fetch the rewards/returns to them.

Meaning of Dividend
The term dividend refers to that part of after-tax profit which is distributed to the owners (shareholders) of
the company. The undistributed part of the profit is known as Retained Earnings. In other words it is that
portion of company’s net earnings that is paid out to equity shareholders.

Meaning of Dividend Decision

Dividend decisions refer to companies’ policies to distribute the earning between payments to shareholders
and retained earnings. Retained earnings are nothing but the profits of the company used for the growth and
expansion of the company.

SIGNIFICANCE OF DIVIDEND DECISION

1. The firm has to balance between the growth of the company and the dividend distribution to the
shareholders.

2. It has a critical influence on the value of the firm.

3. It has to also strike a balance between the long term financing decision (company distributing dividend in
the absence of any investment opportunity) and the wealth maximization.

4. The market price gets affected if dividends paid are less.

5. Retained earnings help the firm to concentrate on the growth, expansion and modernization of the firm.

6. To sum up, dividend decisions to a large extent affects the financial structure, flow of funds, corporate
liquidity, stock prices and growth of the company and investors satisfaction.

FACTORS INFLUENCING DIVIDEND DECISIONS

There are certain issues that are taken into account by the directors while making dividend decisions:
1. Free Cash Flow Theory

The free cash flow theory is one of the prime factors of consideration when a dividend decision is taken. As
per this theory, the companies provide the shareholders with the money that is left after investing in all the
projects that have a positive net present value.

2. Signaling of Information

It has been observed that the increase of the worth of stocks in the share market is directly proportional to
the dividend information that is available in the market about the company. Whenever, a company announces
that would it provide more dividends to its shareholders, the price of the shares increases.

3. Clients of Dividends

While taking dividend decisions the directors have to be aware of the needs of the various types of
shareholders since a particular type of distribution of shares may not be suitable for a certain group of
shareholders.

DIVIDEND POLICY
Diviaend policy refers to the policy of management concerning to the quantum of profit to be distributed to
shareholder as returns on their investments.

Dividend policy of a firm decides the portion of earnings to be paid as dividend to Ordinary shareholders
and the portion that is ploughed back in the firm for investment purpose.

Legal aspects: The dividend policy of the firm has to be evolved within the Iegalframework and restrictions.

Financial aspects: It is not only the desires of the shareholders but also future financial requirements of the
company that have to be taken into consideration. While making a dividend decision, the management of a
concern has to reconcile the conflicting interests of the shareholders and those of the company’s financial
needs.

FACTORS/DETERMINANTS OF DIVIDEND POLICY

A number of factors influence the dividend decision of a company. These factors are explained below:

(1) General state of the economy

General state of the economy influences the dividend decision of a company to a great extent. Generally,
management retains greater part of its profits in the following cases.

(a) When there is an uncertain economic and business condition.

(b) During the period of depression.

(C) During the period of inflation.

Thus, management follows a conservation divided policy.

(2) State of Capital market

If the capital market is comfortable and funds can be raised from the capital market easily, a company
adopts a liberal dividend policy. On other hand, if the capital market is stringent, a company is forced to follow
a conservative divided policy.
(3) Legal restrictions

The dividend policy of a company has to be formulated within the legal framework and restrictions.

Following are the legal restrictions which influence the dividend Policy:

(a) The board of directors of a company is not legally bound to declare dividends.

(b) Dividend must be paid only in cash.

Cc) There are also some restrictions under the income-tax act on the payment of dividend.
(4) Contractual restrictions

Restrictions imposed by the lenders such as debenture holders and financial institutions also influence the
dividend decision of a company. For instance, there may be an agreement between the company and the
lenders that the company should not give more than 10% dividend until the loan is repaid.

(5) The tax policy of the government

The tax policy of the government affects the dividend decision of a firm. If the tax rates are high, the
company may follow the policy of low dividend and vice-versa

(6) Inflation

If there is inflation and if the assets of the company are required to be replaced in the near future, the
company has to arrange its financial resources through retained earnings. Under such situation company may
not adopt liberal dividend policy. Thus inflation also influences the dividend policy of a company.

(7) Access to capital market

If the company has easy access to capital market, It can adopt a liberal dividend policy. On the other, hand if
the company does not have easy access to the capjtal market, the company has to follow a conservative
dividend policy.

(8) Stability of dividend

The profits of a company may fluctuate from year to year. But the shareholders of the company prefer
stable dividend to fluctuating dividend. Thus, the preference of share holders also influences the dividend
policy of a company.

(9) Earnings of the company

If the earnings of the company are stable, the company can afford to declare a higher rate of dividend. On
the other hand, if the earnings of a company are fluctuating, the company can not afford to declare a higher
rate of dividend.

(10) Liquidity position of the company

If the liquidity position (short term financial position) of the company is good, it follows a liberal dividend
policy and vice-versa.

(11) Past dividend rates

The board of directors should take into consideration the past dividend rates while determining the current
percentage of dividend.

(12) Growth needs of the firm

The companies who have expansion programmes retain good amount of profits for the purpose and
thereby follow a stringent dividend policy.

(13) Cost of capital

If the cost of capital involved in external financing is more, then the company may go for conservative dividend
policy.

(14) Age of the company

 The age of the company also determines the dividend decisions of the company. A established company
with sufficient reserves can go for liberal dividend policy. On the other hand a newly established company
prefers stringent dividend policy and retain substantial amount of profits for its growth and expansion. .

(15) Nature of the industry

Nature of the industry also has an impact on the dividend decisions of the company. Certain companies
have stable and steady demand irrespective of the prevailing economic conditions.

1.Cash Dividend
It is the dividend paid to the shareholders in the form of cash. Generally, many companies pay dividend in
the form of cash. But payment of cash dividend requires enough cash in the bank or in hands. It means there
should not be shortage of cash to pay this form of dividend.

2. StOCk Dividend
Stock dividend is the payment of additional shares of common stock to the ordinary shareholders. In other
words, distribution of bonus shares to the shareholders instead of cash dividend stock dividends simply
amount to distribution of additional shares to existing shareholders. Because of the capital impairment rule
stock dividends reduce the firm’s ability to pay dividends in the future.

The objectives of issuing stock dividend are as follows:

(1) Cash outflow restrained: The cash doesn’t go out of the organisation because the profits are not
distributed but are capitalised and issued in the form of additional shares to the existing shareholders.

(2) Lower rate of dividend: With the increase in the share capital additional burden of dividend is reduced.
According to a study it was observed that, as many as one third of the companies issuing bonus shares did not
increase the total quantum of dividend on the enlarged capital, a significant number of them even reduced the
total dividend distribution.

(3) Growth and expansion: The company by capitalising its profits can restrain cash outflow and utilise the
funds to implement its growth and expansion plans.

3. Property Dividend
 A company may issue a non-monetary, dividend to investors rather than making a cash or stock payment.
You record this distribution at the fair market value of the assets distributed. Since, the fair market value IS
likely to vary somewhat from the book value of the assets,the company will likely record the variance as a gain
or loss.

4. Scrip Dividend/Bond Dividend

A company may not have sufficient funds to issue dividends in the near future, so instead it issues a scrip
dividend, which is essentially a promissory note (which may or may not include Interest) to pay shareholders at
a later date. This dividend creates a note payable.

In this form of dividend the shareholders are issued transferrable promissory notes for a shorter maturity
period that may or may not be interest bearing. Companies resort to this form of dividend when it is suffering
from shortage of cash or weak liquidity position.

TYPES OF DIVIDEND POLICY

1. Stable Dividend Policy
Stable dividend policy refers to t3. STOCK SPLIT

Stock split is an increase in number of shares outstanding by reducing the face

value of the stock. For example, Shares of 10 may split into two shares of 5 each.

Another version of a stock split is the reverse split. This procedure is typically

used by companies with low share prices that would like to increase these prices tohe consistency or lack of
variability ¡n the stream of dividend payments. In other words, ¡t means payment of a certain minimum
amount of dividend regularly.

2. Bonus Shares
The term bonus means an extra dividend paid to shareholders In a joint stock company from Surplus profits.
When a company has accumulated a large fund out of profits - much beyond its needs, the directors may
decide to distribute a part of it amongst the shareholders in the form of bonus.

3. STOCK SPLIT
Stock split is an increase in number of shares outstanding by reducing the face value of the stock. For
example, Shares of Rs.10 may split into two shares of Rs 5 each.

Another version of a stock split is the reverse split. This procedure is typically used by companies with low
share prices that would like to increase these prices to either gain more respectability in the market or to
prevent the company from being delisted.

Reasons of stock spilt

(i) To make trading more attractive: The prime reason of Stock split is to reduce the market price to the share,
to attract small investors.
(ii) To give higher dividend: The total dividend of a shareholder increases after a share split.

WALTER’S MODEL(REELEVANCE THEORY)

Professor James E Walter has strongly stated that the choice of dividend policies always affects the value of
the firm. Walter strongly argues that, in determining the dividend policy, establishing a relationship between a
firm’s rate of return (r) and its cost of capital (k) is very essential. By establishing such relationship the
objective of maximising the returns to shareholders can be achieved. But the theory of Walter is based on few
assumptions:

(1) Life of the firm is infinite: The first assumption by Walter is that the firm has a very long life.

(2) Constant Dividend and Earnings per share: The second assumption is that the dividends and earnings
remain constant without change.

(3) Total payout or retention: The third assumption is that the total earnings are either distributed among the
shareholders as dividend or the total earnings are reinvested internally.

(4) Financing from retained reserves: The fourth assumption is that the firm finances all investment avenues
by utilizing funds from retained earnings.

Assumptions of Walter’s Model

(i) The firm finances its entire investment by means of retained earnings only.

(ii) Internal rate of Return (R) and cost of capital (K) of the firm remains constant.

(iii) The firm’s earnings are either distributed as dividend or reinvested internally.

(iv) The firm has a very long life.

Limitations of this model

(i) Walter’s model assumes that the firm’s investments are purely financed by retained earnings. So this model
would be applicable only to all-equity firms.

(ii) The assumption of R as constant is not realistic.

(iii) The assumption of a constant K ignores the effect of risk on the value of the firm.

Criticisms for Walter’s Model

(i) The model assumes that the investment opportunities of the firm are financed by retained earnings only
and the firm should avoid external financing. If this situatjon persists, either the firm’s investment or its
dividend policy or both will be suboptimum.

(ii) Walter’s model also assumes that the cost of capital (k), dividend and earnings per share remains constant.

Walter’s formula for determining the market price of the share:

Where,

P = Market price per share.

D = Dividend per share.

EPS = Earnings per share.

r = Rate of return.

k = Cost of capital.

Illustration

The dividend payout ratio of the following three companies iS 50%. From the other details. Calculate the value
of an equity share of each of these companies by Walter’s Formula.

Illustration-3

From the following information supplied to you determine the theoritical market value of equity shares as
per Walter’s model.
Are you satisfied with current dividend policy? If not, what should be the optimal dividend payout ratio in this
case?

Solution:

As per Walter’s model, market price of the share is

Since, this is a growth firm having internal rate of return (r) > cost of capital (Ke), i.e. r (15%) > Ke (12.5%), the
firm’s payout ratio of dividend of 60% is not optimal as per Walter’s model. The market price of the company’s
share shall be maximum if it retains 1OO% of the profits and dividend payout ratio is zero. This can be proved
as below:
Thus, the firm can increase the market price of the share upto Rs. 48 by increaslng the retention ratio to 100%
the optimal payout ratio for the firm is zero.

Illustration

Ihe following information is available in respect of a firm:

Capitaltion rate = 10%

Earnings per share = Rs. 60

Assumed rate of return on investments:

i) 1O% ii) l2%

Show the effect of dividend policy on market price of shares using Walter’s formula When dividend payout
ratio is a) 20% and b) 60%

Solution
Thus, the firm can

Illustration:

The following Information is available in respect of a firm:

Capitalisation Rate- 10%

Earning per share 50

Assumed rate of return on investments: i) 12% ii) 8% iii) 10%

Show the effect of dividend policy on market price of shares by applying Walteri formula when dividend pay-
out ratio is a) 0%, b) 25%, c) 50%, d) 100%.

SolutIon:
GORDON’S MODEL (REELEVANCEThEORY)
Dividend policy is relevant to the value of the Company. Dividend policy is relevant as the investors prefer
current dividends as against the future uncertain capital gains. Investors discount the firm’s earnings at lower
rate when they are certain about returns, placing a higher value for the share and that of the firm.

Assumptions of GORDON’S MODEL

(i) The firm is all equity fìrm(no debt).

(ii) There is no outside financing and all investments are financed

exclusively by retained earnings.

(iii) Internal rate of return (R) of the firm remains constant.

(iv) Cost of capital (K) also remains constant.

(V) The firm derives its earnings in perpetuity.

(vi) The retention ratio (b) once decided upon is constant. Thus, the

growth rate (g) is also constant (g = b).

(vii) Corporate tax does not exist.

(viii) K > g

Where,

P = Price per share

K = Cost of capital

El = Earnings per share

b = Retention ratio

(l-b) = Payout ratio

g = br growth rate, (r = internal rate of return)

According to Gordon:

(i) When R > K the price per share increases as the dividend payout ratio decreases.

(ii) When R < K the price per share increases as the dividend payout ration increases.

(iii) When R = K the price per share remains unchanged in response to change in the payout ratio.

Illustration

A company has a total investment of 10,00,000 in assets and Rs. 1,00,000 outstanding ordinary shares at
Rs. 10 per share (per value). It earns a rate of 15 per cent on its investment and has a policy of retaining 50
percent of its earnings. If the appropriate discount rate of the firm is 10 percent, find the price of its share
using Gordon’s Model of Dividend Relevance. .
Solution:

The share valuation model of Gordon is:

Where,

A = Investment per share, which is Rs.10 in this case

Po = Price of share

b = Retention ratio

r = Rate of return on investment

k = Discount rate

At a payout rate of 50% the price of the share is:

Illustration

The book value per share of a company is Rs.145.50 and its rate of return on equity is 10 percent. The
company follows a dividend policy of 60% pay-out what is the price of its share if the capitalisation rate is 12
percent.

Solution:

Calculation of price of its share using Gordon’s Model

Illustration:

The following information is available in respect of the rate of return on investments (r), the capitalisation
rate (ke) and earnings per share (E) of XYZ Ltd.
MIILER AND MODIGLIANI MODEL (IRRELEVANCE ThEORY)
Miller and Modigliani model assume that the dividends are irrelevant. Dividend irrelevance implies that the
value of a firm is unaffected by the distribution of dividends and is determined solely by the earning power and
risk of its assets. Under conditions of perfect capital markets, rational investors, absence of tax discrimination
between dividend income and capital appreciation, given the firm’s investment policy, its dividend policy may
have no influence on the market price of the shares.

Assumptions of MM model
1. Existence of perfect capital markets and all investors in it are
rational. Information is available to all free of cost, there are no transactions costs, securities are
infinitely divisible, no investor is large enough, to influence the market price of securities and there
are no floatation costs.
2. There are no taxes. Alternatively, there are no differences in tax rates applicable to capital gains and
dividends.
3. A firm has a given investment policy which does not change. It
implies that the financing of new investments out of retained earnings will not change the business
risk complexion of the firm and thus, there would be no change in the required rate of return.
4. Investors know for certain the future investments and profits of the firm (but this assumption has
been dropped by MM later).

Argument of MM Model
1. By the argument of arbitrage, MM model asserts the irrelevance of divide

Arbitrage implies the distribution of earnings to shareholders and

raising an equal amount externally. The effect of dividend payment would

be offset by the effect of raising additional funds.

2. MM model argues that when dividends are paid to the shareholders, the

market price of the shares will decrease and thus whatever gained by the

investors as a result of increased dividends will be neutralized

completely by the reduction in market value of the shares.

3. The cost of capital is independent of leverage and the real cost of

debt is the same as the real cost of equity, according to this model.

4. That investors are indifferent between dividend and retained earnings

implies that the dividend decision is irrelevant. With dividends being irrelevant, a firm’s cost capital
would be independent of its dividend-payout ratio.

5. Arbitrage process will ensure that, under conditions of uncertainty also the dividend policy would be
irrelevant.

MM Model:

Market price of the share in the beginning of the period = Present value of dividends paid at the end of the
period + Market price of share at the end of the period.

P0 = 1/(1 + ke) X (D1 +P1)

Where,

P0 = Prevailing market price of a share

ke = Cost of equity capital .

D1 = Dividend to be received at the end of period 1 and

P1 = Market price of a share at the end of period 1.

Value of the firm, nP0 = (n + n) P1 - I + (1 +_ke)

Where,

n = Number of shares outstanding at the beginning of the period

n = Change in the number of shares outstanding during the period/additional

shares issued.

I = Total amount required for investment.

E = Earnings of the firm during the period.

Residual approach towards dividend

According to this theory, dividend decision has no effect on the wealth of the shareholders or prices of the
share and hence it is irrelevant as far as the valuation of the firm Is concerned. According to this theory the
firm should retain the earnings if it has profitable investment opportunities otherwise it should pay them as
dividend.

Problems on MM Model of Dividend

According to MM Model dividend policy of the firm has no impact on the market priceof its shares. This can
be put in the form of the following formulae.

Price of the share at the end of the current flnancial year

P1 = Po (1 + Ke) — D1

Where,

P1 = Market price per share at the end of the period

po = Market price per share at the beginning of the period, or prevailing

market price of a share

Ke = Cost of equity capital or rate of capitalization

D1 = Dividend to be received at the end of the period

The MM hypothesis can be explained in another form also presuming that

investment required by the firm on account of payment of dividends is financed out of the new issue of the
equity shares. In such a case, the number of shares to be issued can be computed with the help of the
following equation:

Further the value of the firm can be ascertained with the help of the following formula:
Where,

m = Number of shares to be issued

I = Investment required

E = Total earnings of the firm during the period

P1 = Market price per share at the end of the period

Ke = Cost of equity capital or rate of capitalization

n = Number of shares outstanding at the beginning of the period

D1 = Dividend to be paid at the end of the period

nP0 = Value of the firm

REVIEW QUESTIONS
Conceptual Type

1. What do you mean by dividend?

2. What is dividend decision?

3. What do you mean by dividend policy?

4. State the different practices of dividend.

5. State any three characteristics that influence dividend Policy.

6. What are bonus shares?

7. What is cash dividend?

8. What is bond or scrip dividend?

9. What is property dividend?

10. What is stock dividend?

11. What is a stock split?

1. What are the factors influencing the dividend decision of a company?

2. Analyse the significance of dividend policy.

3. Analyse the factors which determine the dividend policy.

4. State the different types of dividends that a company can declare and

pay.

5. Distinguish between share dividend and cash dividend.

6. State the merits and demerits of stock dividend.

7. What are the different forms or types of dividend?

8. What are the advantages of stable dividend policy?

9. What are the main features of interim dividend?

10. What are the legal and financial aspects of a dividend policy?

11. What are the essentials of Walter’s dividend model?

12. Explain bonus shares and stock splits as form of dividend.

13. What is a bonus issue or stock dividend? Explain stock split with

illustration?

14. State the objectives of stock dividend. What are its advantages and

disadvantages?

Descriptive Type

1. What do you mean by Stable Dividend Policy? Why should it be followed? What are the consequences
of changing a stable divided policy?
2. State the advantages and disadvantages of stock dividend to the company and the shareholders.
3. “Liberal dividend policy followed by a company is not always in the
interest of its shareholders” explain.
4. Discuss some of the important practices followed for the payment of
dividends.
5. Explain the provision regarding dividend as stated in Indian companies Act.
6. Explain various dividend theories.
7.
PRACTICAL PROBLEMS
1. The dividend payout ratio of the following three companies is 50%. From the following other details
calculate the value of an equity share of each of these companies by Walter’s Formula.

2. The following information is available in respect of a firm. Capitalisation rate (Ke) = 0.40
Earnings per share (E) = Rs.40
Assumed rate of return on investments (r) (î) 60, (ii) 32 and (iii) 40
Show the effect of dividend policy on the market price of shares. Using Walter’s model.
3. The following information is available in respect of a firm:
Capitalisation rate = 6%
Earnings per share = RS.36
Assumed rate of return on investments: i) 12% ii) 10%
Show the effect of dividend policy on market price of shares using Walter’s formula when dividend
payout ratio is a) 30% and b) 40%.
4. The book value per share of a company is 190 and its rate of return on equity is 12 percent. The
company follows a dividend policy of 50% pay - out What is the price of its share if the capitalisation
rate is 10 percent.
5. The following information ¡S available in respect of the rate of return on investments (r), the
capitalisation rate (ke) and earnings per share (E) of Saha & Sons Ltd. r = 24%, E = 40
Dertermine the value of shares under Gorden’s Model assuming the following:

6. Archlta and Aditri Ltd. had 50,000 equIty shares of Rs.10 each outstanding on January
1. The shares are currently being quoted at par in the market. In the wake of removal of dividend
restraint, the company now intends to pay a dividend of Rs.2 per share for the current calendar
 year. It belongs to a risk-class whose appropriate capitalization rate is 15%. Using MM Model and
assuming no taxes, ascertain the price of company’s share as it is likely to prevail at the end of
the year (i) when dividend is declared and (ii) when no dividend is declared. Also find out the
number of equity shares that the company must issue to meet its investment needs of Rs.2 lakhs,
assuming a net income of Rs. 1.1 lakh and also assuming that the dividend is paid.

7. A publishing company belongs to a risk-class for which the appropriate P/E ratio is 10. It currently
has 10,000 equity shares (outstanding) selling at Rs.100 each. The firm is contemplating the
declaration of dividend of Rs.8 per share at the end of fiscal year which has just started. Given the
assumptions of Modigliani and Miller, answer the following questions:

(i) What will be the price of the share at the end of the year (a) if dividend is not declared: (b) if
it is declared?

(ii) Assuming that the company pays the dividend, has a net income (Y) of Rs.10,00,000 and
makes new investments of Rs.20,00,000 during the period, how many

(iii) 8new shares must be issued?

SIGNIFICANCE OF ADEQUATE WORKING CAPITAL

The following are some of the reasons for maintaining adequate

amount of working capital:
1. Adequa working capital can provide uninterrupted flow of production which strengthens the
solvency of a business.

2. Sufficient working capital can help the business to pay all its current liabilities and operating
expenses in time which will enhance, create and maintain goodwill.

3. The adequate reserve of working capital ensures a steady flow of

raw materials to production process leading to continuous production.

4. The adequate stock of working capital makes it possible for a

company to purchase the trading goods in cash and cash purchase always carries the benefit of
getting cash discount.
 5. An organization can make regular payment of salaries, wages and
other day-to-day commitments only when it has sufficient working capital.

6. A company can avail the opportunities of price fluctuations if it

has adequate working capital in business.

7. It creates ability in the business to face emergencies such as strikes, flood, fire etc.,

DISADVANTAGES OF EXCESS WORKING CAPITAL

Excess working capital is a threat to the company. The following are the disadvantages of excess
working capital:

1) Leads to low profitability even though sufficient cash ¡s available.

2) Outstanding liabilities and losses may be faced.

3) Creates an imbalance between liquidity and profitability.

4) It leads to greater production level but not having a matching

demand in market.

5) High level of inventories and its maintenance and storage cost

increases.

6) It may lead to carelessness about costs and therefore,

inefficiency of operations.

7) Unwise dividend policies.

DEMERITS OF INADEQUACY OF WORKING CAPITAL

1. The firm is unable to take advantage of new opportunities to develop new products or adopt to
modification of production techniques needed when new opportunities arise.

2. A firm will lose its reputation when it is not in a position to honour its short term obligations.

3. It becomes difficult for the firm, to exploit favourable market situations.

4. A company can not avail cash discounts facilities in case of bulk order.

5. A company may have to borrow funds at higher rates on interest.

6. It becomes impossible to utilize the fixed assets efficiently.

FACTORS DETERMINING WORKING CAPITAL.

The amount of working capital required varies from one business to another. The requirement for fixed and
working capital increases with the growth and expansion of business. Additional funds are required for
upgrading the technology or to meet current debts or expand the business etc. Therefore, it become
important to evaluate the various factors that determines the need for working capital.
DEMERITS OF INADEQUACy OF WORKING CAPITAL
1. The firm is unable to take advantage of new opportunities to develópñew products
or adopt to modification of produio techniques needed when new opportunities
arise.

2. A firm will lose Its reputation when it IS not in a position to honour Its short term
obligationS. .

3 It becomes difficult for the firm to exploit favourable market situations.

4. A company can not avail cash discounts facilities in case of bulk order.

5. A company may have to borrow funds at higher rates on interest.

6. It becomes impossible to utilize the fixed assets efficiently.

FACTORS DETERMINING WORKING CAPITAL .

The amount of working capital required varies from one business to another. The
requirement for fixed and working capital increases with the growth and expansion of
business. Additional funds are required for upgrading the technology or to meet current
debts or expand the business etc. Therefore, it becomes important to evaluate the
various factors that determines the need for working capical.

Some of the major factors are:

1. Nature of business

The equirement of working capital largely depends upon the nature or character of its business.
Public utility companies like railways, transport etc. employs Iess amount of working capital because
no funds are tied up in investories and receivables.

2. Size of business

The composition of assets in the business depends upon the size of a business and the scal0e in which it is
operating. Small companies require smaller propo0 working capital than large companies. But in some cases,
even smaller concern need more working capital due to high overhead charges, inefficient use of available
resources etc.

3. Cash requirements

Cash is one of the essential components for successful operation of the production in business. Adequate cash
is always required to carry on the operations and to maintain good credit relations. But, it would be expensive
to hold excessive cash. Hence, cash Is one of the important factors to determine working capital.

4. Volume of sales

This is an important factor which affects the size and components of working capital. A firm maintains current
assets as they are needed to support the operational activities which results ¡n sales. As the volume of sales
increases, there is an increase in the investment of working capital and vice versa. Hence, the volume of sales
determines the amount of working capital.
5. Terms of Purchases and Sales

If the credit terms of purchases are more favourable and those of sales are less liberal, less cash will be
invested in inventory. A firm gets more time for payment to creditors or suppliers. Hence, if the business has
favourable terms and conditions of credit, it can reduce working capital. On the other hand if the terms are
unfavourable, it increases the requirement of working capital.

6. Price level changes

The requirement of working capital is also affected by the changes in price levels. The rise in prices will require
the organization to maintain larger amount of working capital as they have to meet the needs of business
operations.

7. Inventory turnover

If the inventory turnover is high, the working capital requirement will be low. Thus the finance manager should
determine the minimum level of stock to be maintained throughout the period of operations.

8. Receivables turnover

A prompt collection of receivables and good facilities for setting payables results in low working capital
requirements. Hence, it is necessary to have an effective control of receivables.

9. Production schedule

The availability of working capital ensures the continuity of production schedule. Delay in production slows
down the operations of business. So an organization should have a systematic planning and smooth flow of
production from raw materials stage to the end of production.

10. Business cycle

The requirements of working capital depend upon the stage of business cycle. During the period of prosperity
the requirement of working capital will be more since the business expands less during the period of
depression. In the growth stage of business, there is a need for large amount of capital to cover the needs of
business cycle whereas in decline stage, there may be a brief period when business faces difficulties in
collection and sales. Thus, depending on the phase, the organization should make the availability of funds.

11. Production cycle.

Production cycle refers to the period taken to convert raw materials into finished goods. The longer the
production cycle the greater is the requirement of working capital. To minimize the requirement, the
production cycle should be shortened without affecting the manufacturing process.

12. Seasonal fluctuations

The organizations which produce seasonal products require adequate working

capital during one period and less in the other period. In some cases, the raw material may not be available
throughout the year. Hence, huge amount of inventory has to be purchased during such seasons which give
rise to more working capital requirements.

13. Repayment ability

An organization’s ability will determine the level of working capital to employs. Based on repayment plans, it
prepares cash flow projections to fix working capital accordingly.

14. Changes in technology

Technological developments related to production can have an impact on the need working capital.

15. Firm’s polices

There are various firms’ policies like credit policy, production policy etc which will the size of working capital.

1. Permanent Working capital

It refers to the minimum level of current assets which is continuously required by the enterprise to carry on its
regular business operations. For instance, eve organization has to maintain a minimum stock of raw material,
finished goods cash balance etc. for smooth functioning of their production. Since, working capital invested in
these current assets is permanently blocked. Hence, it is also known as fixed working capital. The need for
permanent working capital will fluctuate depending upon the growth of the business. The permanent working
capital can be further classified into regular working capital and reserve working capital.

(i) Regular working capital

Regular working capital assists in circulation of current assets from cash to inventories, from inventories to
receivables and from receivables to cash and so on.

(ii) Reserve working capital

Reserve working capital ¡s the excess capital which may be provided for
contingencies that may arise at unstated periods such as strikes, depression etc.

2. Temporary or variable working capital

It is the additional working capital needed to Support the changing production and sales in the business. In
other words, it represents additional current assets required at different times during the operating year. For
example, extra inventory has to be maintained to support sales during peak period. Investment in inventories,
receivables, etc., will decrease in periods of depression. As the amount of working capital keeps on fluctuating
from time to time on the basis of business activities, it is termed as temporary working capital. Variable
working capital can be further classified as seasonal working capital and special working capital.

(i) Seasonal working capital

The capital required to meet the seasonal needs of the enterprise is called
seasonal working capital. During the season time, firm require to source its needs to meet the seasonal
demand.

(ii) Special working capital

The capital which is required to meet the special exigencies such as launching extensive marketing campaigns
for conducting research, extra production, extra purchase etc., is referred as special working capital.

The above figure depicts that the permanent working capital is stable. But over the period it may increase or
decrease, depending upon the firms requirement of working capital. But the temporarily working capital is
always fluctuating sometimes increases and sometimes decreases.

OPERATING CYCLE

The operating cycle is the time gap between the sales and their actual realization in the form of cash. In simple
terms, the duration of time required to complete the various stages of business activity ¡s called the operating
cycle.

Generally in a manufacturing process, the operating cycle involves the following events which is shown below:

(Ji Conversion of cash into raw materials.

(ii) Conversion of raw materials to work in progress.

(iii) Conversion of work In progress to finished goods.

(iv) Conversion of finished goods into accounts receivables.

(v) Conversion of accounts receivables into cash.

Due to the circulating nature of current assets it is known as Circulating revolving capital.

In case of trading business, the operating cycle will include the length of time taken for conversion of cash into
debtors and conversion of debtors to cash.

Illustration:
Illustration:
Illustration:
 CASH MANAGEMENT
CASH

In narrow sense cash includes currency notes, coins, cheques, demand drafts and bank demand deposits. But
In broad sense It includes not only the above stated items but also bank time deposits and marketable
securities. Cash is one the current assets of a company. Cash means liquid assets that a business owns.

MOTIVES OF HOLDING
A film holds cash for the following purpose:

1. Transaction motive

Under this motive cash is held for paying the day-to-day operating expenses. For example: Purchase of raw
materials, payment of business expenses, payment of tax, payment of dividends. The need to hold cash would
not arise if there is perfect synchronization between the cash receipts and cash payments.

2. Precautionary motive

Under this motive cash is held by a business concern to meet various contingencies. Contingencies could be
floods, strikes and failure of important customers, slow down in collection of accounts receivables, sharp
increase in the cost of raw materials etc. It provides a cushion or buffer to withstand some unexpected
emergency.

3. Speculative motive

This motive comes from a desire of holding cash to gain in speculative transaction such as purchase of raw
materials at reduced prices on payment of immediate cash, dealing in commodities in bulk purchasing and
selling when rates are considered favourable.
OBJECTIVES/GOALS OF CASH MANAGEMENT

Cash management aims to achieve the following objectives:

(j) To maintain minimum cash receive.

(ii) To meet cash disbursement as per Payment schedule.

(iii) To meet cash collection as per repayment schedule.

(iv) To minimize funds locked up as cash balance by maintaining optimum cash balance.

(v) To seize potential opportunities for profitable long term investments.

(vi) To minimize the operating cost of cash management.

(vii) To earn on cash balance.

(viii) To build the image of creditworthiness.

(ix) To meet requirements of bank relationships.

(x) To satisfy day-to-day business requirements.

IMPORTANCE OF CASH MANAGEMENT

Cash management has assumed importance because of the following points:

1. Cash forecasting

Cash inflow and outflows should be planned to project cash surplus or deficit for each period of planning. Cash
budget should be prepared for this purpose. Cash Budget means estimation of cash receipt and cash
disbursement during a future period of time. Cash budget is a forecast of future cash receipts and cash
disbursement over various intervals of time.

2. Managing the Cash Flows

The Inflow and outflow of cash should be properly managed. The Inflows of cash should be accelerated while
the outflow of cash should be decelerated as far as possible.

3. Optimum Cash Level

The firm should decide on the appropriate level of cash balances. The cost of excess cash and the danger of
cash deficiency should be matched to determine the optimum level of cash balances.

4. Investing Idle Cash

The Idle cash or precautionary cash balance should be properly invested to earn profit. The firm should decide
on the division of such cash balance between bank deposits and marketable securities.

5. Cash Planning
Cash inflows and outflows are inseparable parts of the business operations of all firms. The firm needs cash to
invest in inventories, receivables and fixed assets and to make payments for operating expenses In order to
maintain growth in sales and earnings. It is possible that a firm may be making adequate profits but may suffer
from the shortage of cash as its growing needs may be consuming cash very fast. Thus cash planning is
essential.

FUNCTIONS OF CASH MANAGEMENT

The finance manager has to ensure that investment ¡n cash ¡s efficiently utilized.

Efficient cash management functions calls for cash planning, evaluation of benefits and costs of policies,
procedures and practices and synchronisation of cash inflows and outflows.

1. It forecasts the cash inflows and cash out flows.

2. It determines the safety level of cash balance.

3. It monitors the safety level of cash balance.

4. It regulates the cash Inflows.

5. It regulates the cash out flows.

6. It undertakes aggressive search for relatively more productive uses for surplus funds. .

7. Plans the Investment avenues for excess ‘cash balance.

8. It avails the banking facilities and maintains good relationship with bankers.

9. It protects the organization from cash embezzlement through strict supervision.

10. It ensures the liquidity position of the organisation.

BENEFITS OF CASH MANAGEMENT

(i) Increase amount and speed of cash flowing into the company.

(ii) Reduces the amount and speed of cash flowing out.

(iii) Makes the most efficient use of available cash.

(iv) Takes advantage of money-saving opportunities such as cash discounts.

(v) Develops a sound borrowing and repayment program.

(vi) Impresses lenders and investors.

(Vii) Reduces borrowing costs by borrowing only when necessary.

(viii) Provides funds for expansion.

(ix) Plans for investing surplus cash.

(x) Finances seasonal business needs.

TOOLS/TECHNIQUESF CASH MANAGEMENT

The following are some of the techniques which ensure speedy collection of cash slowing disbursements:

1. Cash management planning

Cash planning is a technique to plan and control the use of cash. It protects the financial condition of the firm
by developing a projected cash statement from a forecast of expected cash inflows and outflows for a given
period. The forecast may be based on the present operations or the anticipated future operations. Cash plans
are very crucial in developing the overall operating plans of the firm.

Cash planning may be done on daily, weekly Or monthly basis. The period and frequency of cash planning
generally depends upon the size of the firms and
philosophy of the management. Large firms prepare daily and weekly forecasts. Medium-size firms usually
prepare weekly and monthly forecasts. Small firm may not prepare formal cash forecasts because of the non-
availability of information and information and small-scale operations. As a firm grows and business operat’0’5
become complex, cash planning becomes inevitable for its continuing success. In order to take care of all these
considerations, the firm should prepare a cash budget.

Cash Budget means estimation of Cash Receipt and Cash Disbursement during a
future period of Time. Cash Budget is a forecast of future Cash Receipts and Cash Disbursement over various
intervals of Time.

According to Guthmen and Dougal, Cash budget is an estimate of cash receipts and disbursements for a future
period of time”.

Characteristics of Cash Budget

1. Cash budget is a statement of anticipated cash receipts and payments.

2. Cash budget is related to predetermine future period.

3. Cash budget is expressed ¡n terms of monetary values.

4. Cash budget is forecast of financial aspirations of the enterprise.

5. Cash budget is an outline of future, policies and actions of the management.

Importance/Benefits of Cash Budget

Following are the benefits of preparing the cash budget:

. Cash budget is helpful in planning.

. It helps in forecasting the future needs of funds.

. It helps in maintenance of optimum cash balance.

. It aids ¡n controlling cash expenditure.

. It facilitates evaluation of performance.

. It helps in the formulation of sound dividend Policy.

. It is a basis of long term planning and co-ordination.

. Testing the influence of proposed expansion.

2. Cash management control

This technique in volves:

a) Accelerating cash inflows.

b) Slowing down cash outflows.

(a) Accelerating Cash Inflows

Cash management is successful only when collections are accelerated and cash disbursement, as far as
possible delayed. The following methods of cash management will help to accelerate cash inflows

. Prompt payment by customers

. Quick conversion of payment into cash

. Decentralized collection

. Lock box system

Prompt Payment by Customers

Following are the ways through which a firm can prompt payment from customers:

. In order to accelerate cash inflows the collections from customers should be prompt. This will be possible by
prompt billing. The customers should be promptly informed about the amount payable and the time by which
it should be paid. It will be better if self addressed envelope is sent along with the bill and quick reply is
request

. Another method for prompting customers to pay earlier is to allow them a cash discount. The availability of
discount is a good saving for the customers and in an anxiety to earn it they make quick payments. Cash
discount is an allowance given the customers to enable them to make the payment promptly.
. Cash inflows can be accelerated by improving the cash collecting process. Once the customer writes the
cheque In favour of the concern the collection can be quickened by Its early collection.

Quick conversion of payment Into Cash

This is another method of accelerating cash inflows. It includes the following:

. Managing time, time taken by post office for transferring the cheque from customer to the firm. It is referred
to as postal float.

. Time taken in processing the cheque within the organization and sending it to bank for collection, it is called
lethargy

. Collection time within the bank i.e., time taken by the bank in collecting the payment from the customer’s
bank, it is called bank float

. The postal float, lethargy and bank float are collectively referred to as deposit float.

• The term deposit float refers to the cheques written by the customers but amount not yet usable by the
firm. An efficient cash management will be possible only if the time taken in deposit float is reduced and make
the money available for use. This can be done by decentralizing collections.

Decentralized Collection

This is also one of the techniques of accelerating cash inflows. A big firm operating over wide geographical
area can accelerate collections by using the system of decentralized collections. Under this method a number
of collection centres are opening in different areas instead of collecting receipts at one place. The idea of
opening different collecting centres ¡s to reduce the mailing time from customer’s despatch of cheque and its
receipt in the firm and then reducing the time in collecting these
cheques. On the receipt of the cheque ¡t is immediately sent for collection. Since the party may have issued
the cheque on a local bank, it will not take much time in collecting it. The amount so collected is sent to the
central office at the earliest. Decentralized collection system saves mailing and processing time.

Lock Box System

Under this system the firm selects some collecting centres at different places. The places are selected on the
basis of number of customers and the remittances to be received from a particular place. The firm hires a post
box in a post office and the parties are asked to send the cheques on that post box number. A local bank is
authorized to operate the post box. The bank will collect the post a number of times in a day and start the
collection process of cheques. The amount so collected is credited to the firm’s account. The bank will prepare
a detailed account of cheques received which will be used by the firm for processing purpose. This system
reduces the delays due to mailing and processing time.

(b) Deaccelerating/Slowing Cash Outflows

Following are the methods of deaccelerating cash outflows/cash payments:

. Paying on last date

. Adjusting payroll

. Centralization of payments

. Making use of float

(i) Paying on Last Date

The disbursements can be delayed on making payments on last date only. If the credit is for 10 days then
payment should be made on 10th day only. It can help in using the money for short periods.

(ii) Adjusting payroll

Economy can be exercised on payroll funds also. It can be done by reducing the frequency of payments. If the
payments are made weekly then this period can be extended to a month. Secondly the finance manager can
plan the issuing of salary cheques and their disbursements. If the cheques are issued on Saturday then only a
few cheques may be presented for payment, even on Monday all cheques may not be presented. On the basis
of his past experience finance manager can deposit the money in bank because it may be clear to him about
the average time taken by employees in encashing their pay cheques.

(iii) Centralization of Payments

The payments should be centralized and payments should be made through drafts or cheques. When cheques
are issued from the main office then it will take time for the cheques to be cleared through post. The benefit of
cheque collecting time is availed.

(iv) Making use of Float

There is a time lag between the issue of a cheque by the firm and its presentation to its bank by the customer’s
bank for payment. The implication is that although the cheque has been issued, cash would be required later
when the cheque is presented for encashment. Therefore a firm can send remittances although it does not
have cash in its bank at the time of issuance of the cheque. Meanwhile funds can be arranged to make
payment when the cheque is presented for collection after a few days. Float
used in this sense is called cheque kiting.

3. Determining the Optimum Cash Balance

One of the primary responsibilities of the financial manager is to maintain a sound liquidity position of the firm
so that the dues are settled in time. The firm needs cash to Purchase raw materials and pay wages and other
expenses as well as for paying dividend, interest and taxes. The test of liquidity is the availability of cash to
meet the firm’s obligations when they become due.

Liquid balance must be maintained at the optimum level. It is the level which gives the minimum cost of
holding the liquid balance. Determination of such a level I very important for an efficient cash management. If
the liquid balance exceeds the required balance, it remains Idle and, therefore, it Involves opportunity costs in
the sense that the amount could have been put to more effective use. None the less, liquidity position of the
enterprise becomes more sound. On the other hand, if liquid balance is short of the requirements, the firm
may have to incur storage costs.

Thus, if a firm maintains less cash balance, then its liquidity position will be weak. If higher cash balance is
maintained, then there will be wastage. Thus a firm should maintain an optimum cash balance, neither a small
nor a larger cash balance

4. Investing Surplus Cash

Cash not required for temporary periods of short durations can be invested in near-cash assets, i.e. marketable
securities which are readily convertible into cash. Even though the cash is temporarily idle, it should not be
kept so because if the firm has an opportunity to earn interest through investing it in marketable securities,
why should it not avail of the same.

PREPARATION OFCASH BUDGET

X Co. wishes to arrange overdraft facilities with its bankers during the period April to June 2015, when it will be
manufacturing mostly for stock. Prepare a cash budget for the above period from the following data, indicating
the extent of the bank facilities the company will require at the end of each month.

RECEIVABLES MANAGEMENT
Meaning of Receivables

Receivables represent amounts owned to the firm as a result of sale of goods or services in the ordinary course
of business. These are claims of the firm against its customers and form part of its current assets. Receivables
are also known as accounts receivables, trade receivables, customer receivables or book debts”

COST OF MAINTAINING RECEIVABLES

The allowing of credit to customers means giving of funds for the customer’s use. The concern incurs the
following costs on maintaining receivables:

1. Cost of Financing Receivables

When goods and services are provided on credit then concern’s capital is allowed to be used by the customers.
The receivable are financed from the funds supplied by share holders for long term financing and through
retained earnings. The Concerns incur some cost for collecting funds which finance receivables. In other words,
it is capital blocked in bills receivables or credit sales.

2. Cost of Collection

A proper collection of receivables is essential for receivables management. The customers who do not pay the
money during a stipulated credit period are Sent reminders for early payments. Some persons may have to be
sent for collecting these amounts. All these costs are known as collection costs which a concern is generally
required to incur.

3. Bad debts

Sometimes customers may fall to pay the amounts due towards them. The
amounts which the customers fall to pay are known as bad debts.

Characteristics of Receivables

The Receivables have the following characteristics:

. Receivables involve the risk of bad debts.

. Implies futurity i.e., buyers mak the payment in future.

. It is based on economic value.

RECEIVABLES MANAGEMENT

Receivables management is the process of making decisions relating to investment in trade debtors. Certain
investment in receivables is necessary to increase the sales and profits of a firm. But at the same time
investment in this asset involves cost consideration also. Further there is a risk of bad debts too.
Importance of Receivables Management

The main purposes of accounts receivables arising out of credit sales from the view points of manufacturers,
wholesalers and other sellers of goods and services are:

(1) To increase the sales volume by selling large quantity to customers without demanding for immediate
payment.

(2) To increase profitability of the firm. Increase in sales volume on credit basis increases profit. Besides firm
enjoy the advantages of higher margin in credit sales.

(3) To meet the competition and to retain market shares, a firm resorts to credit sales in order to follow similar
practices of the competitors.

(4) To avoid diminishing sales turnover.

(5) To avoid sadling a company with unnecessary long-term debt.

(6) To establish a continuous source of liquid working capital.

(7) To increase working capital turnover.

(8) To improve return on Invested capital.

(9) To protect and improve credit ratings.

(10) To take advantage of profitable opportunities requiring additional cash.

Objectives Receivables Management

The basic objectives of Accounts Receivables are as follows:

(i) To maximize firm’s value.

(ii) To ensure optimum investment in sundry debtors.

(iii) To control the cost of credit.

Benefits of Receivables Management

(i) It results in increase in sales.

(ii) It leads to increase in profits.

(iii) It results in increase in market share

FACTORS INFLUENCING THE SIZE OF RECEIVABLES

The amount to be blocked in receivables depends upon the following factors:

MONITORING ACCOUNTS RECEIVABLES/CONTROLING
RECEIVABLE/TECHNIQUES OF RECEIVALBES MANAGMENT

There are traditional techniques for monitoring accounts receivables. They are-

(a) Receivables turnover

(b) Average collection period

(C) Aging schedule and

(d) Collection matrix

(a) Receivables Turnover

Receivables turnover provides relationship between credit sales and debt of a firm. It indicates how quickly
receivables or debtors are converted into cash.
Ramamurthy observes collection of debtors is the concluding stage for process of sales transaction.

Debtors or Receivables Turnover ratio = Credit Sales /Average Debtors or

receivables.

(b) Average Collection Period (ACP)

It tells how long a firm takes to convert its credit sales into cash. It is calculated with the help of the following
formula

ACP = 365/ Debtors or receivables turnover

(c) Aging Schedule

Aging schedule is a statement that shows age wise grouping of debtors. In other words, it breaks down debtors
according to the length of time for which they have been outstanding. Aging schedule is helpful for identifying
slow paying debtors, with which firm may have to encounter a stringent collection policy. The actual aging
schedule of the firm is compared with industry standard aging schedule or with bench mark aging schedule for
deciding whether the debtors are in control or not.

(d) Collection Matrix

Collection matrix is a method or statement showing percentage of receivables collected during the month of
sales and subsequent months. It helps in studying the efficiency of collections whether they are Improving or
deteriorating.

PREPARAION OF AGEING SCHEDULE AND DEBTORS TURNOVER RATIO

Illustration:

INVENTORY MANAGEMENT

INTRODUCTION

Inventories constitute a major element of w irking it&. It is therefore important that investment in inventory is
properly controlled. The inventory management has to take care of deciding minimum and maximum level,
issues, receipts and inspection of inventory, determining EOQ proper storage facility keeping check over
obsolescence ensuring control over movement of inventories.

Inventory

Inventory means stock of goods meant for sale. The term inventai)’ consists of:
. Raw materials

. Work-in-progress

. Finished goods

. Spares

. Consumables-e.g.: cotton waste, oil soaps etc.

INVENTORY MANAGEMENT

Inventory management is concerned with the activities employed in maintaining the optimum number or
amount of each inventory item. The objective of inventory management is to provide uninterrupted
production, sales, and/or customer-service levels at the minimum cost.

OBJECTIVES OF INVENTORY CONTROL/MANAGEMENT

The inventory management aims at achieving the following objectives:

(i) To keep the investment on Inventories to the minimum.

(ii) To minimize ordering and carrying cost.

(iii) To improve quality of products.

(iv) To ensure uninterrupted supply of raw materials to production dept.

(v) To maintain sufficient finished goods to ensure smooth sales operations and efficient customer service.

INVENTORY MANAGEMENT MOTIVES

1. Transaction Motive

It includes production of goods and sale of goods. And facilitates uninterrupted production and delivery of
order at a given time.

2. Precautionary Motive
Precautionary motive ensures holding of Inventory for unexpected changes in
demand and supply factors.

3. Speculative Motive

Speculative motive compels to hold some inventories to take advantage of

changes in prices and getting quantity discounts.

IMPORTANCE OF INVENTORY CONTROLIMANAGEMENT

The signif1cance of inventory management is:

1. To have the stocks available when they are required.

2. To manage the space availability by preventing stock level going beyond the fixed level.

3. To facilitate purchasing economies.

4. To eliminate duplication in ordering or in replenishing stocks by centralizing the stores from which purchase
requisition arise.

5. To maintain adequate accountability of inventory assets.

6. To keep down investment in inventories, Inventory carrying costs and obsolescence losses to the minimum.

7. To serve as a means for the location and disposition of inactive and obsolete items of stores. .

8. To decide which item to stock and which items to procure on demand.

EOQ

It is Economic order quantity is the quantity of materials which can be purchased at minimum cost. It aims at
minimizing ordering cost and carrying cost.

Assumptions of EOQ Model

(i) Demand for the product is constant and uniform throughout the period.

(ii) Lead time is constant.

(iii) Price per unit of the product is constant.

(iv) Inventory holding cost is based on average inventory.

(v) Ordering costs are constant.

(vi) All demands of the product will be satisfied.

Illustration:
Illustration:
Two materials A and B are used as follows:
Illustration:
In a manufacturing company a material is used as follows:
REVIEW QUESTIONS

Conceptual Type

1. What is working capital?

2. What do you mean by working capital management?

3. Mention main components of working capital.

4. Differentiate between Gross and Net working Capital.

5. Mention any two objects of working capital management.

6. What is capital rationing?

7. Explain in brief current asset policy.

8. What is (i) Operating cycle (ii) Cash cycle?

9. Give the meaning of trade credit.

10. What is the nature of cash?

11. Name various motives for holding cash.

12. What are cash inflows?

13. What are the methods of slowing down the disbursements?

14. What is lock box system?

15. What is postal float?

16. What is bank float?

17. What is lethargy?

18. What is a cash budget?

19. Distinguish between a deposit float and bank float.

20. What is optimum cash balance?

21. What is cash palnning?

22. What do you mean by Receivables?

23. Enumerate various costs of Receivables.

24. Name various factors influencing the size of Receivables.

25. What is aging schedule?

26. What is the optimum level of Receivables?

27. What do you mean by inventory?

28. State a firm’s major types of inventories.

29. Give three objectives of holding inventories?

30. What are the risks and costs of holding inventories?

31. Name various tools/techniques of inventory management.

32. Explain danger level of inventories.

33. What ¡s VED analysis?

34. What is inventory turnover ratio?

35. What S Inventory Conversion Period?

36. What is ABC Analysis?

7. What is FSN Analysis?

38. What is EOQ?

9. What ¡S Inventory Management?

40. What s perpetual inventory system? .

41. What is HML Analysis?

42. What is SDE Analysis?

43. What is JIT Analysis?

44. What is Maximum Stock Level?

45. What S Re-Order Level?

Analytical Type

t. Explain the different principles of Working Capital.

2. Briefly explain the necessity of investments in working capital and the factors affecting the level of such
investments.

3. What are the reasons for adequate working capital?

4. What are the problems associated with inadequate working capital?

5. Explain current assets policy and current assets finance policy.

6. Discuss determination of cash operating cycle and cash cycle.

7. Explain the methods of estimating working capital requirements.

8. Explain the kinds of working capital.

9. What do you understand by cash management? How can ¡t be undertaken?

10. Efficient cash management will aim at maximizing the cash inflows and slowing cash outflows.” Discuss.

11. What are the benefits of cash management?

12. What is the significance of cash management ¡n today’s corporate world?

13. What is receivables management? How is it useful for business concerns?

14. What are the techniques of Monitoring Receivables?

15. Explain the significance of Receivables Management.

16. Discuss ¡n detail the objectives of Inventory Management.

17. Define the term 9nventory Control”. What are the inventory Control Systems?

18. What is A-B-C analysis? How is It useful as a tool in inventory management?

Descriptive Type
1. Define working capital. Explain the factors influencing the working capital?

2. Explain the different sources of finance for funding working capital or short term finance requirements.

3. Explain various methods in investing surplus cash. What criteria should a firm use in investing in marketable
securities?

4. Explain and illustrate the utility and preparation of cash budget as a tool of cash management.

5. Discuss the factors influencing the size of receivables.

6. “Receivables forecasting ¡s very important for proper management of receivables” Discuss.

7. What is meant by Inventory Management? Why is ¡t essential to a business

concern?

8. Explain various tools and techniques used for inventory management.

9. What is meant by “Economic Order Quantity”? What are the various costs which effect economic order
quantity?

PRACTICAL PROBLEMS

1. From the following information compute the working capital requirement for a company.

(a) Annual sales 52,00,000 units

(b) Selling price ₹.10 per unit

(C) Percentage net profit on sales 20%

(d) Average credit period allowed to customer - 9 weeks

(e) Average credit period allowed by suppliers - 5 weeks

(f) Average stock holding in terms of sales requirement - 12 weeks

(g) Allow 12% for contingencies.

2. Prepare an estimate of working capital requirement from the following date of a trading concern.

a) Projected annual sales - 5,80,000 units

b) Selling price - ₹.4 per unit

c) Percentage of profit - 18%

d) Average credit period allowed to debtors - 8 weeks

e) Average credit period allowed by suppliers - 6 weeks

f) Average stock holding In terms of sales requirement - 5 weeks

g) Allow 15% for contingencies.

3. A firm sells 80,000 units of its product per annum @ ₹.15 per unit and the variable cost per unit is 18. The
average collection period is 30 days. Bad debt losses are 2.5% of sales and the collection charges amount to
₹.5,000.

The firm is considering a proposal to follow stricter collection policy which would reduce bad debt losses to 1%
of sales and average collection period to 25 days. It would, however reduce sales volumes by 1000 units and
increase the collection expenses to ₹.l5,000.

The firm’s required rate of return is 15%, would you recommend the adoption of new collection policy?

4. You are the management accountant of Ganesha Ltd. The following information is made available to you:

a) Budgeted production - 2,00,000 units

b) Details of stock holding: Raw materials- 2 months; Work in progress -1

month; Finished goods -1 month.

c) Credit granted by customers- 2 months, credit availed from supplies- 1 month.

d) Minimum cash balance required at all times ₹30,000

e) Cost structure of the product is as under:

From the above you are required to forecast the working capital requirements of the company.

5. Anand Ltd. sells its product at gross profit to 20% on sales. The following information extracted from
Company’s annual accounts for the year ended 31.3. 2015.

Sales at 3 months credit: 50,00,000

Raw materials: 15,00,000

Wages paid (15 days in arrears): 10,60,000

Manufacturing expenses (paid one month in arrears): 15,00,000

Administration expenses (paid one month in arrears): 5,80,000

Sales promotion expenses payable half year in advance: 3,00,000

The company enjoys one month credit from the suppliers of raw materials and
maintains two months stock of raw materials and half month finished goods stock.
Cash balance is ₹.2,00,000. Find out net working capital requirements for the company.
6. A cost sheet of a company provides you the following information.

The following further particulars are available:

a) Raw materials are in stock for one month.

b) Raw materials are in process on an average for half a month.

c) Finished goods are in stock on an average for one month

d) Credit allowed by supplier one month.

e) Lag in payment of overheads is one month.

f) Lag in payment of wages is 2 weeks.

g) l/4 output is sold against cash.

h) Cash in hand and at bank is expected to be ₹.125,000.

i) Credit allowed to customers 2 months.

You are required to prepare a statement showing the working capital needed to finance level of activity of
2,08,000 units of production.

7. Prepare the stores ledger under first in first out method.

1st January 2015 Opening balance 200 units at ₹.25 per unit.
8. Calculation the economic order quality from the following information. Also state the number of orders that
has to be placed in a year.

From the following find out how much should be ordered each time?

9. The following transactions, occur in the purchase & issue of a material.

 6. Corporate Validation

What do you mean by Valuation?

Valuation is a process of calculating the monetary value of an asset. Valuation is the process of estimating the
value, or worth, of an asset or investment. It is the process of estimation the worth of something.

Corporate Valuation/Business Valuation?

Business valuation ¡s a process and a set of procedures used to estimate the economic value of an owner’s
interest in a business. Valuation is used by financial market participants to determine the price they are willing
to pay or receive to effect a sale of a business.

Purpose of Corporate Valuation

Businesses or their assets are valued for a variety of reasons. Some of the most noticeable purposes for
valuation of business are demonstrated below:

(i) Mergers and acquisition.

(ii) Recapitalizations / Restructuring the business / Raising funds.

(iii) Litigation issues involving lost profits or economic damages.

(iv) IPO.

(v) Acquisition/investment

(vi) Voluntary assessment.

REASONS OF CORPORATE VALUATION

The heed for valuation arises due to the following reasons:

1. Sale of a business
If you are about to put your oilheat company on the market, you must first know what It is worth so that you
can set an asking price. In such a case, you want the valuation to be as high as possible, rating your assets at
their maximum value. Although the market will eventually set the true value of the business (which is what
someone is willing to pay for it) you want to start the bidding as high as you can.

2. Buying another business

Conversely, if you are looking to expand and grow by acquiring a competitor’s company, you want to have it
valued as low as possible. Do not rely on the valuation given by the seller but pay to have your own valuation
done. You will be surprised by the difference in asking price and true value.

3. You are seeking financing

Banks and other lenders will peg the amount they will lend and the interest rate they will charge to the
security you can provide them. The higher the value of your business, the more comfortable a lender will be in
providing capital. Time to crank the valuation knob “up” again.

4. Succession planning

It’s time to give the next generation a chance to own and run the business. This could be in a planned and
organized gifting/transfer strategy or a complete succession plan. Whether gifting or selling or some of both, a
valuation is critical to the success of the plan.

5. Shareholder and Partner agreements

What happens if you or your partner dies, becomes disable or wants to retire?
First, you need an agreement. Second, the agreement will require an ‘agreed to valuation. This can be by
formula or by an outside appraiser. Either way, you will need to agree to a starting value to get the ball rolling
and avoid disputes when the time comes.

BASIS OF VALUATION

There are several basis of valuation as enlisted below:

1. Assets value or goodwill of going concern basis

2. Capitalized Earning Power

3. Market value

4. Investment value

5. Book value

6. Cost basis (excluding depreciation)

7. Reproduction cost basis

8. Substitution cost basis

1. Assets value

In the valuation, based on assets value, the business is taken as going concern. Open market value of the
freehold land and building is assessed by valuers. Similarly, unexpired period of the leasehold property has
open market value i.e., the value which could be realized through open sale in the market
2. Capitalized earnings

For valuation based on earnings, the popular method in use is the predetermined rate of return expected by
an investor routine course on the investments. This is simple rate of return on capital employed.

3. Mar1et value

Market value is the value quoted for listed company’s shares at the stock exchanges. Market value does not
exactly depict the real worth of the company because it takes into consideration various intangible factors
which cannot be measured like abilities of management, prospects of the industry in which the company
operated, and strategic value possessed by the company on account of Patents, technical collaboration
locational benefits, institutional finance.

4. Investment value

Investment value signifies the cost incurred to establish an enterprise. These costs include the original
investment plus the Interest accrued thereon. This determines the sale price of the target company which the
acquirer may be asked to pay for the negotiated merger where it could be taken into consideration for
valuation.

5. Book Value

Book value represents the total worth of the assets after depreciation but with revaluation. It may represent
fair and equitable basis of value in determination of purchase price of the target company. For negotiated
mergers, book value could be taken into consideration.

6 Cost basis valuation

Cost less depreciation becomes the basis of fair value only when company’s
depreciation policies are fair. This method ignores intangible assets like goodwill. It is not a fit measure of
valuation in takeover cases. It alsa.4oes not give weight to changes in price level. This method is good for
negotiations.

7. Reproduction cost

Reproduction cost method is basis on assessing the current cost of duplicating the properties or constructing
similar enterprise in design and material. It does not take into account the Intangible assets for negotiations to
settle the bargain price of assets; but It Is a good method of evaluation for preliminary negotiations

8. Substitution cost

Substitution cost is the estimate of the cost of the construction of the undertaking or enterprise ¡n the same
utility and capacity. It need not necessarily be similar in design to one being substituted. The method is good
for valuation when plant, machinery and other assets are important considerations in acquisition bargaining.
This method is also good for negotiated bargaining.

METHOD OF CORPORATE VALUATION

Choosing the right model to use in valuation is as critical to arriving at a reasonable value as understanding
how to use the model. In broadest possible terms, there are three approaches to value any asset, business or
business interest:
1. Discounted Cash Flow Method

2. Comparable company market multiple mtIird4ComParable transaction

3. Market Valuation/Relative Valuation method.

Discounted Cash Flow Method

DCF models are premised on one of the most fundamental tenets of corporate
finance. The value of a company today is equal to the present value of the future cash flows to be generated
by the company’s operations discounted at a rate that reflects the riskiness of

This method works on the premise that the value of business is measured in
terms of future cash flow streams, discounted to the present time at appropriate discount rate.

There are two ways to value a company using the DCF approach-

. Adjusted Present Values (APV) method.

. Weighted Average Cost of Capital (WACC) method.

Both methods require calculation of company’s free cash flows (FCF) as well as the net present value (NPV) of
these FCFs

DCF Valuation in 5 steps

(i) Project the free cash flows of a business over the forecast period. Typical forecast period is 10 years.
However, the range can vary from five to 20 years.

(ii) Use the weighted average cost of capital (WACC) to determine the appropriate discount rate range.

(iii) Estimate the terminal value of the business at the end of the forecast period.

(iv) Determine the value for the enterprise by discounting the projected free cash flows and terminal value to
the present.

(v) Interpret the results and perform sensitivity analysis.

DEBENTURE OR BOND VALUATION

DEBENTURE OR BONDS

A debenture is an acknowledgement of a debt. According to Thomas Evelyn. “A

debenture is a document under the company’s seal which provides for the payment of a principal sum and
interest thereon at regular intervals, which is usually secured by a fixed or floating change on the company’s
property or undertaking and which acknowledges a loan to the company’s property or undertaking and which
acknowledges a loan to the company”.

Features of Debentures or Bonds

The salient characteristics of debentures are as follows:

1. Maturity

Although debentures provide long-term funds to a company, they mature after a specific period. Generally,
the debentures are to be repaid at a definite time as stipulated in the issue. The company must pay back the
principal amount on these debentures on the given date otherwise the debenture holders may force winding
up of the company as creditors.

2. Claims on Income

A fixed rate of interest is payable on the debentures. A company has a legal obligation to pay the interest on
due dates irrespective of its level of earnings. Even if a Company makes no earnings or incurs loss, it is under
an obligation to pay Interest to its debenture holders,

3. Claim on Assets

Even in respect of claim on assets, debenture holders have priority of claim on assets of the company. They
have to be paid first before making any payment to the preference or equity shareholders in the event Of
liquidation of the company.

4. Control

Since, debenture holders are creditors of the company and not its owners; they do not have any control over
the management of the company. They do not have any voting rights to elect the directors of the company or
on any other matters.

5. Call Feature

Issue of debentures sometimes provides a call feature which entities the company to redeem its debentures at
a certain price before the maturity date. Since, the call feature provides advantages to the company at the
expense of its debenture holders; the call Price is usually more than the issue price.

TYPES DEBENTURES

The debentures are of the following types:

1. Secured or Mortgaged Debentures.

These debentures are given security on assets of the company. In case of default in the payment of interest or
principal amount, debenture holders can sell the assets in order to satisfy their claims. The debentures may be
given a floating charge over all assets of company. In this case debentures are paid in priority to unsecured
creditors. The sale proceeds of assets are first applied to pay debentures with a floating charge.

2. Simple, Naked or unsecured debentures

These debentures are not given any security or assets. They have no priority as compared to other creditors.
They are treated along with unsecured creditors at the time of winding up of the company. So, they are just
unsecured creditors.

3. Bearer Debentures
These debentures are easily transferable. They are just like negotiable
instruments. The debentures are handed over to the purchaser without any
registration deed. Anybody purchasing them with a consideration and in good faith becomes the lawful owner
of the debentures. The coupons for interest are attached to the debentures. The bearer can get interest from
the company’s bank when it becomes due.

4. Registered Debentures

As compared to bearer debentures which are transferred by mere delivery,

resisted debentures require a procedure to be followed for their transfer. Both the transfer and the transferee
are expected to sign a transfer voucher. The form is sent to the company along with the registration fees. The
name of the purchaser is entered in the register. The coupons for interest are sent only to the persons in
whose names the debentures are registered. Every transfer of debenture required the same transfer
procedure to be repeated.

5. Redeemable Debenture

These debentures are to be redeemed on the expiry of a certain period. The interest on the debentures is paid
periodically but the principal amount is returned after a fixed period. The time redeeming the debentures is
fixed at the time of their issue.

6. Irredeemable debentures

Such debentures are not redeemable during the life time of the company. They are payable either on the
winding up of the company or at the time of any default on the part of the company. The company can retain
the right to redeem these debentures after giving due notice to the debenture holders.

7. Convertible Debentures

Sometimes convertible debentures are issued by a company and the debenture

holders are given an option to exchange the debentures into equity shares after the lapse of a specified
period.

8. Non- Convertible Debentures

These debentures are not given the option of conversion into equity share. They remain non-convertible for
the life time.

Advantages of debentures

Debentures offer a number of advantages both to the company as well as

investors. These are discussed as below:

1. Advantages to the Company

The company has the following main advantages of using debentures, and bonds as a source of finance:

(i) Debentures provide long-term funds to a company

(ii) The rate of Interest payable on debentures is, usually, lower than the rate of dividend paid on shares.
(iii) The interest on debentures is a tax-deductible expense and hence the effective cost of debentures (debt-
capital) is lower as compared to ownership securities where dividend is not a tax-deductible expense.

(iv) Debt financing does not result into dilution of control because debenture holders do not have any voting
rights.

(v) A company can trade on equity by mixing debentures in its capital structure and thereby Increase its
earnings per share.

(vi) Many companies prefer Issue of debentures because of the fixed rate of Interest attached to them
irrespective of the changes in price levels.

(vii) Debentures provide flexibility in the capital structure of company as the same can redeemed as and when
the company has surplus funds and desires to do so.

(viii) Even during depression, when stock market sentiment is very low, a company may be able to raise funds
through Issue of debentures or bonds because of certainly of income and low risk to Investors.

2. Advantages to Investors

It Is not only the company, but also the investors who are benefited by investing in debentures or bonds.

The following are the main advantages from the point of view of investors.

(i) Debentures provide a fixed, regular and stable source of income to its investors.

(ii) It is comparatively a safer investment because debenture holders have either a specific or a floating charge
on all the assets of the company and enjoy the status of a superior creditor in the event of liquidation of the
company.

Illustration:
Illustration:

VALUATION OF EQUITY SHARES

Equity Shares

Equity shares also known as ordinary shares or common shares, represent the
owner’s capital in a company. The holders of these shares are the real Owners of the company.

The rate of dividend on these shares depends upon the profits of the company. These shareholders take more
risk as compared to preference shareholders.

CHARACTERISTICS OF EQUITY SHARES

1. Maturity

Equity shares provide permanent capital to the company and cannot be redeemed during the lifetime of the
company. Under the Companies Act, 1956, a company cannot purchase its own shares. Equity shareholders
can demand refund of their capital only at the time of liquidation of a company. Even at the time of
liquidation, equity capital is paid back after meeting all other prior claims including that of preference
shareholders.

2. Claim on the Income

Equity share holders have a residual claim on the income of a company. They have a claim on the income left
after paying dividend to preference shareholders. The percentage of dividends to equity shareholders depend
on the earnings of the company. If the company makes the losses, they will not get anything.

3. Claim on assets

When the company goes into liquidation, they will get their investment back only after all the company’s
obligations are paid such as payments to creditors, debenture holders and preference shareholders.

4. Voting rights

Equity shareholders are the real owners of the company; they have the voting rights ¡n the meetings of the
company and have a control over the working of the company.

5. Pre-emptive rights

Whenever the public limited company proposes to increase its subscribed capital by the allotment of further
shares, such shares should be offered to existing shareholders. This is called as Pre-emptive rights.

6. Limited Liability

The liability of equity shareholders ¡s limited to the face value of shares held by them. In the event of
liquidation he IS not liable for any losses of the company.

Advantages of Equity Shares

i. Equity shares do not create any obligation of pay a fixed rate of dividend.

2. Equity shares can be issued without creating any change over the assets of the company.

3. It is a permanent source of capital and the company has not to repay it except under liquidation.

4. Equity shareholders are the real owners of the company who have the voting rights.

5. In case of profits, equity shareholders are the real gainers by way of increased dividends and appreciation in
the value of shares.

Disadvantages of Equity Shares

1. The company cannot take the advantage of trading on equity ¡f only equity shares are issued.

2. As equity capital cannot be redeemed during the life time of the company, there is a danger of over
capitalization.
3. Equity shareholders can put obstacles in management by manipulation and
organizing themselves.

4. During Prosperous periods higher dividends have to be paid leading to increase in the value of shares in the
marker and speculation.

5. Investors who desire to invest in safe securities with a fixed income have no attraction for such shares.

Two-Period Value Model

Under this model the investor plans to hold the equity share for two years and then sells it.

The value of the share to the Investor today would be:

Dividend Valuation Model
No growth case

If a firm has future dividend pattern with no growth or where the dividends remain constant over time, the
value of the share shall be capitalization of perpetual stream of constant dividends.
Constant growth case

If the dividends of a firm are expected to grow at a constant rate forever, the value of the share can be
calculated as:

TYPES OF PREFERENCE SHARES

Following are the types of preference shares:

1. Cumulative preference shares

These shares have a right to claim dividend for those years also for which there are no profits. Whenever there
are divisible profits, cumulative preference share are paid dividend for all the previous years in which dividend
could not be declared.

2. Non-cumulative preference shares

The holders of these shares have no claim for the arrears of dividend. They are paid dividend if there are
sufficient profits. They cannot claim arrears of dividend in subsequent years.
3. Irredeemable preference shares

Those shares which cannot be redeemed unless the company is liquidated are
known as irredeemable preference shares.

4. Participating preference shares

The holders of these shares participate in the surplus profits of the company. They are firstly paid a fixed rate
of dividend and then a reasonable rate of dividend is paid on equity shares. If some profits remain after paying
both these dividends, than preference share holders participate in the surplus profits.

5. Non — participating preference shares

The shares on which only a fixed rate if dividend is paid are known as non-participating preference shares.
These shares do not carry the additional right of sharing profits of the company.

6. Convertible preference shares

The holders of these shares are given a right to convert their holdings into equity shares after a specific period.

7. Non — convertible preference shares

The shares which cannot converted into equity shares are known as non -
convertible preference shares.

Advantages or Merits of Preference Shares

Preference shares provide a number of advantages both to the company as well as Investors or shareholders.

(A) Company’s Point of View

The company has the following advantages by issuing the preference shares:

1. There is no legal obligation to pay dividend on preference shares. Preference dividend is payable only out of
distributable profits at the discretion of the management. Hence, a company does not face a financial burden
or legal action if it does not pay dividend.

2. Preference shares provide a log-term capital for the company.

3. There is no liability of the company to redeem preference shares during the life time of the company. Even
in case of redeemable preference shares, they have to be redeemed either out of accumulated profits or out
of the proceeds of a fresh issue of shares. Further, there are no significant penalties for delaying redemption of
preference shares.

4. Redeemable preference shares have the added advantages of repayment of capital whenever there are
surplus funds with the company.

5. As a fixed rate of dividend is payable on preference shares, these enable a company to adopt trading on
equity i.e. to increase rate of earnings on equity shares after paying a lower rate of fixed dividend on
preference shares.

6. As preference share capital is generally regarded as part of company’s net worth, it enhances the credit
worthiness of a firm.
7. Preference shares do not carry voting rights under normal circumstances and hence there is no dilution of
control.

8. As no specific assets are pledged against stock, the mortagageable assets of the company are conserved

REVIEW QUESTIONS

Conceptual Type

1. What do you mean by Valuation?

2. What is Corporate Valuation?

3. What ¡s DCF?

4. What do you mean by Debentures?

5. What do you mean by Equity Shares?

6. What is Preference Shares?

Analytical Type

1. What are the Purpose of Corporate Valuation?

2. Explain the Elements of Business Valuation.

3. What are the Reasons of corporate valuation?

4. Explain the Basis of Valuation

5. Explain the Method of corporate valuation.

6. Explain the Relative Valuation method.

7. What are the Features of Debentures or Bonds?

8. Explain briefly Types of Debentures.

9. What are the Advantages and disadvantages of debentures?

10. Explain the Valuation of Equity Shares.

11. What are the Characteristics of Equity Shares?

12. Explain the Valuation of Preference Shares.

PRACTICAL PROBLEMS

1. An investor is considering the purchase of an 12% ₹.3,000 bond redeemable after 5 years at par. The
investor’s required rate of return is 14%. What should he be willing to pay now to purchase the bond?

2. A debenture is available in the market for ₹.1,500 with 60 as the interest for a year for a period of 4 years
with the maturity value of ₹.1,330. The debenture capitalization rate is 8%. Advise Mrs. Mita in her buying
decision of this debenture.
3. What is the value of irredeemable debenture which has ₹.220 as the interest for an infinite period with the
discount rate at 12%?

4. Mrs. Aarohi has a perpetual bond of the face value of ₹.1,200. He receives an interest of ₹.80 annually. Its
current value is ₹.700. What ¡s the yield to maturity?

5. Mr. X is planning to buy an equity share, hold it for one year and then sell it. The expected dividend at the
end of year 1 is 5 and the expected sale proceeds ₹.170 after 1 year. Determine the value of the share to the
investor assuming the discount rate of 12%.