Professional Documents
Culture Documents
CONTENTS
Chapter 3 Capitalization
Chapter 4 Leverage
8.1 Introduction
8.2 Scope of Management of Earnings
8.2.1 Determination of Profits
8.2.2 Surplus: Meaning and Importance
8.2.2.1 Kinds and Sources of Surplus
8.2.2.2 Uses of Surplus
8.2.2.3 Manufacturing of Surplus
8.2.2.4 Hiding Of Surplus
8.2.3 Reserves
8.2.4 Meaning And Concept Of Ploughing Back Of Profits
8.2.4.1 The Necessity of Ploughing Back of profits
8.3 Cost of Retained Earnings
8.4 Dividend Policy
8.4.1 Earnings capitalisation model
8.4.2 Walter's Model
8.4.3 Gordon's Model (continuing dividend growth valuation model)
8.4.4 Graham & Dodd Model
8.5. Company - Specific Policies and Procedures
8.5.1 Stability
8.5.2 Liquidity
8.5.3 Control
8.5.4 Shareholding pattern
8.5.5 Timing of investment opportunities
8.5.6 Legal constraints
8.5.7 Legal provisions in the Indian context
8.5.8 Procedural aspects
8.5.9 Bonus Shares
8.6 Dividend Policies In Practice
9.1 Introduction
9.2 Term loan appraisal
9.3 Security against term loans
12.1 Introduction
12.2 Lease, Hire-purchase and Installment Sale:
12.3 Types of Lease Arrangements
12.4 Lease Versus Buy: The Basic Decision
12.5 Evaluation of Lease-buy Decision:
12.6 Lease Financing-Leassor’s View Point:
Finance is the life blood of any business or industrial undertaking. It is a pre-requisite for starting and
running of the business. Financial management is concerned with the proper management of funds. It
involves managerial decisions relating to the procurement long term and short-term funds and their proper
utilization in the most productive and effective manner and also to framing of dividend policy.
According to J.F Bradley-“financial management is the area of business management devoted to the
judicious use of capital and careful selection of sources of capital in order to enable spending unit to
move in the direction of reaching its goals”. The main objective of financial management is
a) maximization of profits and assuring better returns on capital by employing funds most
profitably
b) procurement of funds at reasonable costs whenever needed
c) Coordinating the activities of the finance department with other departments to ensure timely
meeting of financial needs.
In his book the theory of financial management Ezra Soloman has defined the finance function as the
study of the problems involved in the use and acquisition of funds by a business. its main concern is
to find a rational basis for answering three questions
a) What total value of funds should be invested in the business? That is what size and growth rate
should the business aim to achieve?
b) What specific assets should the business acquire? That is in what form the assets be held?
c) How should the required funds be financed? Alternatively, how should the liability side of the
balance sheet be financed?
Financial management is broadly concerned with the acquisition and use of funds by a business firm.
Its scope may be defined in terms of the following questions:
a) how large should the firm be and how far should it grow ?
b) What should be the composition of the firms assets?
c) What should be the mix of firm’s financing?
d) How should the firm analyse, plan and control the financial affairs?
While the first three questions express Ezra soloman’s conception of financial management as
discussed in his classic work. The theory of financial management the fourth question represents an
addition that I feel is very relevant in the light of the responsibilities shouldered by financial
managers in practice.
Financing decision- financing decisions involve deciding on the most effective method of financing
the chosen investments. Should debt or equity finance be used or perhaps a mix of both. Basically
there are two main sources of finance for any firm, the shareholder fund and the borrowed funds.
Shares represent ownership right in the firm. Buyers of the share are known as shareholder. Legally
they are owners of the firm. Shareholder may get dividend and capital gains in the return of the
invested capital. Shareholders can be of two types – equity and preference shares
a) Equity shares- Equity shares are ordinary shares that do not carry any preferential right in
respect of dividend or repayment of capital. Dividend on them is payable after preference shares.
b) Preference shares- preference shares are those that enjoy preferential rights over equity shares in
matter of payment of dividend at a fixed rate, as well as the return of capital when the company is
wound up. However preference shareholders do not have a voting right except when dividend has
not been paid for more than two years in the case of cumulative preference shares and for more
than three years in the case of non-cumulative preference shares.
Another important source of securing capital is creditors or lenders. Lenders are not owners of the
company. The return on loans or borrowed funds is called interest. Payment of interest is a legal
obligation.
Financing decision involve formulation and designing of capital structure. The process entails
deciding about the form or pattern of capital structure and also fixing the relative proportion between
various types of funds from different sources proposed to induct in the capital structure. The total
funds collected should represent the ideal mix of cheaper and costlier funds. So the average cost of
overall capital for the company is kept at the minimum level. Some corporations face financial
problems due to wrong financing decisions. There are the corporations having high debt equity ratio
in the capital structure. In bad day it will be very difficult for the company to bear a burden of interest
which makes the company in the sick condition so it is very important for the company to take
financing decision carefully for the growth of the company.
Dividend decision- dividend decision involves deciding how much of the firms earning should be
paid out to shareholders in the form of shareholders in the form of dividends in return for their
investment in the firm and how much should be retained to finance the firm’s future investment plans.
All firms whether small or big have to decide how much of the profits should be reinvested back in
the in the business and how much should be distributed in the form of dividends. The finance
manager is required to take various decisions regarding distribution of profit as dividends; the finance
manager has to look into the fund requirement of the firm and the shareholders interest.
1.4 Objectives/ goals of Financial management
Financial management provides a framework for optimal decision-making. Financial management is
concerned with financing of a firm and with designing a method of operating the investment. The
objective of a company must be to create value for its shareholders. Value is represented by market price
of the company’s common stock. There are two broadly classified objectives of financial management in
terms of approaches:
a) Profit maximization approach
b) Wealth maximization approach
Profit maximization as decision criterion- According to this approach, action that increase profits should
be undertaken and those that decreases are to be avoided. In specific operational terms as applicable to
financial management, the profit maximization criterion implies that the investment, financing and
dividend policy decisions of a firm should be oriented to the maximization of profits. Profit maximization
would imply that a firm should be guided in financial decision making by one test. Select assets, projects
and decisions that are profitable and reject those, which are not the rationale behind profitability
maximization as a guide to financial decision making is simple. It provides the yardstick by which
economic performance can be judged. Finally it ensures maximum social welfare. The profit
maximization criterion is criticized in the following grounds:
Ambiguity
Timing of benefits
Quality of benefits
I) Ambiguity – this approach does not have any precise connotation. The profit as a criterion is a vague
and ambiguous concept. It is amenable to different interpretation by different people. For example profit
may be short tern or long term , it may be total profit or rate of profit; it may be before tax or after tax, it
may be return on capital employed or total employed or total assets or shareholders equity and so on.
Timing of benefit-this approach does not take into consideration the time value of money while working
out profitability “the bigger the better” principle is adopted.
Time pattern of profits
Period Reliance(crore) Tata(crore)
I 5000
II 1000 1000
III 3000 6000
IV 2000 3000
It can be seen from the above table that the profits associated with Reliance and Tata are same. If the
criterion is profit maximization both would be equally ranked. We can see that reliance provides higher
return in the earlier years in comparison to Tata whereas the return from Tata is larger in later years. If we
will take into consideration the TVM the reliance is superior because a basic doctrine of financial
planning is the earlier the better.
II) Quality of benefits- here the quality means the degree of certainty with which benefits are expected.
As a rule, the more certain the expected return, the higher is the expected benefits; the lower is the quality
of benefits. It is in practice that investors want to avoid or at least minimize risk.
Wealth maximization- it is also known as value maximization or net present worth maximization
approach. It takes into consideration the time value of money. As a decision criterion profit maximization
has three shortcomings, it does not take into account of risk, Time value of money and it is ambiguous,
due to these reasons value maximization has replaced ‘profit maximisation’as operational criterion.
Wealth maximization means maximizing the NPV of a course of action. The NPV of a course of action is
the difference between the present value of its benefits and the present value of its cost. A financial action,
which has a positive NPV, creates wealth and accepted whereas negative NPV should be rejected. This
can be expressed through the following formula
n
Npv = net present value A1 + A2 + A3 + A - C
2 3 n
A1, A2, A3and An are the NPV= (1+r) future
streams of expected (1+r)
cash (1+r)
inflows (1+r)
for different years .
R = discount rate
C = total of present value of the cash outflows.
It can be seen that value maximization is taking into considerations the tvm and handling of the risk as
measured by the uncertainty of the expected benefits is an important part. It would be noted that the focus
of financial management is on the value to the owners or suppliers of equity capital. The wealth of owners
is reflected in the market value of shares so wealth maximization implies the maximization of the market
price of shares.
Test Questions:
Q1. Define financial management? What are its characteristics? Discuss
Q2. What are the vital aspects of finance function in a business?
Q3. Explain wealth maximization and value maximization objectives of financial management?
Q4. Write a note on traditional VS modern concept of finance function?
Chapter 2 Financial Planning
2.1 Meaning Of Financial Planning.
Funds requirement decision and the financing decision are two major areas of financial decision-making.
Funds requirement decision is concerned with the estimation of the total funds or capital requirements for
the business enterprise, while the financing decision is concerned with the sources from which the funds
are to be raised. In order that the business enterprise get the funds required at reasonable cost, it is also
necessary to raise the funds at the proper time. It is, therefore, necessary that the promoters or the persons,
responsible for the management of the business enterprise take care of all these aspects right at the time of
formation of the company by having a proper financial planning. .
Financial Planning, therefore, includes:
(i) Estimating the amount of capital to be raised.
(ii) Determining the form and proportionate amount of securities.
(iii) Laying down the policies as to the administration of the financial plan.
MEANING OF FINANCIAL PLAN “Financial planning results in the formulation of the financial plan.
It is primarily a statement estimating the amount of capital and determining its composition.
It states:
(i} The quantum of finance, i.e., the amount needed for implementing the business plans.
(ij) The patterns of financing, i.e., the form and proportion of various corporate securities to be issued to
raise the required amount.
(iii)The policies to be pursued for the floatation of various corporate securities, particularly regarding
the time of their floatation.
Principles governing a Financial Plan .
The financial plan should be prepared keeping in view the following principles:
(1) Simplicity. The financial plan should envisage a simple financial structure capable of being
managed easily. The types of securities should be minimum, since securities of various types win- give
rise to unnecessary suspicion in the minds of the investing public and create avoidable complications.
(2).Long-term view. The financial plan should be formulated and conceived the promoters /management
keeping in view the long-term needs of the corporation rather than finding out the easiest way of
obtaining the original capital. This is because the original financial plan would continue to operate for a
long period even after the formation of the company.
(3) Foresight. The financial plan should be prepared keeping in view the future requirements of capital
for the business. Of course, it is a difficult task since it requires making of accurate forecast regarding the
future scale of operations of the company. Technological improvements demand forecast, resource
availability and other secular changes should be kept in view while drafting the financial plan. A plan
visualized without foresight may bring disaster for the company in case It fails to meet the requirements
for both fixedand working capital.
(4) Optimum use. The financial plan should provide for meeting the genuine needs of the company. The
business should neither be starved of funds nor it should have unnecessary spare funds. Wasteful use of
capital is as bad as inadequate capital. A proper balance should be maintained between the long- term and
the short-term funds since the surplus of one would not be able to offset a shortage of the other.
(5) Contingencies. The financial plan should keep in view the requirements of funds for contingencies
likely to arise. It does not, however, mean that capital should be kept unnecessarily idle for unforeseen
contingencies. Promoters' foresight will considerably reduce this risk.
(6) Flexibility. The financial plan should have a degree of flexibility also. Flexibility is helpful in making
changes or revising the plan according to pressure of circumstances with minimum possible delay.
(7) Liquidity. Liquidity- is the ability of the enterprise to make available the ready cash whenever
required to make disbursement. Adequate liquidity in the financial plan gives it a degree of flexibility too.
It could act as a shock absorber in the event of business operations deviating from normal course. This
will help in avoiding embarrassment to management and loss of goodwill of the company among the
public.
(8) Economy. The cost of raising the required capital should be the minimum. It should not impose
disproportionate burden on the company. This is possible by having a proper debt-equity mix.
It means the capital, which is meant for meeting the permanent or long-term needs of the business. In
other words fixed capital is required for the acquisition of those assets that are to be used over a long
period.
Fixed capital is required for acquisition of the following assets:
(i) Tangible assets such as land, buildings, plant and machinery, furniture and fittings, etc. -
(ii) Intangible assets such as goodwill, patents, copyrights, promotion, cost, etc.
It should be noted that the fixed assets couldn’t be withdrawn from the business without disturbing the
normal working of the undertaking. It is, therefore, necessary that sufficient funds are raised for
acquisition of fixed assets. These funds are required not only while establishing a new enterprise but also
for expanding, diversifying and maintaining intact the existing enterprise.
2.5 Management of fixed capital. Management of fixed capital is concerned with the raising of required
fixed capital at minimum cost and its effective utilisation. The following principles should be observed in
order to have an efficient management of fixed capital:
(i) Generally only such fixed assets should be purchased which are likely to increase the earning capacity
of the business.
(ii) Wherever feasible, fixed assets should be purchased on rental or hire purchase system. This would
result in releasing pressure on bulk funds.
(iii) Obsolete or outmoded fixed assets should not be bought even though they may be available at lower
prices.
(iv) There should not be any idle capacity. This would increase the overhead burden. In other words, new
fixed assets should be bought only when there is already full utilisation of the existing fixed assets.
(v) Fixed assets should be maintained properly. Periodical inspection, overhaul and scheduled repairs
would considerably increase the working life of the assets.
(vi) Proper depreciation should be provided out of profits to enable timely replacement of the fixed assets.
(vii) Investment in fixed assets should have a proper relationship with sales and profits. Fixed assets
turnover ratios for different years can be found out to determine whether investment in fixed assets has
been judicious or not. (viii) The requirements of fixed capital should be met out of long-term, funds such
as share capital, debentures, loans from financial institutions, etc.
All this indicates that proper estimation of the working capital requirements is a must for running the
business efficiently and profitably. The forecasts regarding working capital are made keeping this factor
in view. However, the requirements of working capital depend on a number of factors. These factors have
been explained below.
Chapter 3 Capitalization
3.1 Meaning of Capitalization
Capitalization is an important constituent of the financial plan. In common parlance, the term
capitalization means the total amount of capital employed in a business. However, like the broader
concept of capital, there is no universally accepted definition of capitalization. To note the variety of its
meaning, one authority defines' capitalization' as "the sum of the par value of the stocks and bonds
outstanding. This concept of capitalization given by Guthmann and Dougall excludes surplus and
reserves from the ambit of capitalization while they are an integral part of it. A. S. Dewing defines it as
follows: "The term capitalization or the valuation of the capital, includes the capital stock and debt;" But
it is also one-sided point of view. A good definition of capitalisation has been given by E. E. Lincoln,
which runs as follows:
"Capitalization is a word ordinarily used to refer to the sum of the outstanding stocks and funded
obligations... which may represent wholly fictitious values".
According to Gerstenberg: "For all capital purposes capitalization means the total accounting value of all
the capital regularly employed in the business".
Thus, the practical meaning of capitalization is the computation, appraisal or estimation of present value.
The value of the total assets employed in a business at a point of time is the figure obtained by the
valuation concept at a given rate of normal return. Thus, in capitalization the emphasis is placed upon the
amount of capital. The same thought is generally present in legal usage of the term also. Whenever a new
business is promoted, an existing business is expanded or two or more businesses are merged into one, the
problem of capitalization arises frequently. In brief, the term' capitalization' is generally used in the sense
of meaning the long- term financial structure and it embraces the composition of the structure in general
and the value of the structure in particular. So, when we decide what types of securities are to be issued, it
is a financial decision relating to the capital structure and knowing the relative amounts of various
securities to be issued is the problem of capitalization. As a matter of fact, the decisions relating to the
capital structure and capitalization are not altogether different. They are one and the same. Management
prepares an integrated plan to collect the required funds from a variety of sources.
Capitalization of a New Concern - The capitalization of a newly promoted concern has some typical
problems. A new enterprise operates at great disadvantage in the raising of capital because there is no
gauge of the risk involved. Promoters of a new company in the absence of sound background because
beggars instead of choosers of capital. The significance of capitalization is also weakened once the project
is put into operation because the early stages are in any respects a discounting of future possibilities.
To determine the amount of capitalization of a newly promoted concern, two theories have been
propounded:
(1) The Earning Theory, and
(2) The Cost Theory.
(1) The Earning Theory of Capitalization. Basically, a business concern is a profit earning institution
and earnings as a test of the amount of capitalization have its own significance. Under this method, the
probable earnings are forecast and then they are capitalized at a normal representative rate of return. The
forecast or projection of earnings is made on the basis of the study of demand of the product to be
produced, the expected competition and future prospects. On the one hand, the commitment of new
capital to a new venture is warranted only when a fair rate of return appears to be feasible. To project the
income, the Performa income statement is prepared and then this earning figure is capitalised at a normal
rate of return. This normal rate of return is the expectation of investor on a similar type of investment. The
management should very carefully decide both these variables. On the other hand, the profit levels should
be no higher than a reasonable amount and the rate of capitalization also should not be abnormally low or
high.
(2) The Cost Theory of Capitalization. In this theory the capitalization is regarded as the equivalent of
the cost actually incurred in setting up the business. The original out-of- pocket investment in land and
buildings, plant and machinery, patents, etc., is estimated and added together. Reasonable provision is
made for future as well as for current needs. Obviously, the use of initial cost facilitates the calculation of
the amount of capital to be raised but it cannot take care of future earning capacity. This approach gives
us only a momentary value of the capital, which would in no way reflect future changes. Not only it is
possible for the capital equipment to become obsolete, but. in addition, true worth is also dependent
primarily upon earnings.
Comparison of both approaches while making a comparison of both approaches, we come to the
conclusion that no approach is self-sufficient. Upon first thought, the cost principle may appear to give
assurance that the capitalisation would at least be representative of the value of the enterprise. But this
hope proves to be momentarily. Original cost is static in character and does not reflect future changes. On
the other hand, the earning approach is also incomplete in itself. A new enterprise has no past or present.
Future earnings cannot be forecast exactly and they depend to a large extent on such external factors
beyond the control of the management. So while taking any final decision, the management should test
the figure with the other approach too. Moreover, there is no final verdict possible as regards to the
capitalisation. As a general rule it will be desirable to allow for a comfortable margin of contingency and
changes in capitalization
3.5 Meaning of Over-capitalisation
The term 'over-capitalisation' is generally used to convey the sense of overstatement of the value of
properties held by the concern or a redundancy of capital. Gerstenberg defines" it as follows:
- A corporation is overcapitalized when its earnings are not large enough to yield a fair return on the
amount of stock and bonds that have been issued or when the amount of securities outstanding exceed the
current value of the assets. -
In the words of Gilbert Harold: -When a company has consistently been unable to earn the prevailing
rate of return on its outstanding securities, considering the earnings of similar companies in the same
industry and the degree of risk involved, it is said to be over capitalized.
Thus, from the above said definitions it is clear that overcapitalization is an economic irregularity
experienced in the long-term and caused by the inability of management in reading the future carefully. It
connotes the situation of issuing excess shares, debentures, bonds, etc. by the company than that is
required. Hence, there is a fall in the dividend rate as the earnings will be insufficient to pay suitably to
the investors. Over-capitalization does not imply a surplus of funds. It is quite possible that a company
may have more funds and yet have low earnings. Often funds may be inadequate. and the earnings, too,
may be low. In both situations, there is over-capitalization.
(1) Splitting-up Shares-If shares of large denomination are divided into the shares of low denomination;
the problem can be solved to a possible extent. Now the dividend per share can be distributed on a large
number of shares.
(2) Increase in the Par Value of Shares-If it is possible the par value of shares outstanding may be
increased equal to the total market value of those shares and amount required for it can be utilized from
reserves and surplus account.
(3) Capitalization of Earnings- Retained earnings has no explicit costs. They should be capitalized and
then they will also be part of cost bearing capital. It will bring down the dividend rate at a reasonable
level.
(4) Fresh Issue- If additional funds are needed, fresh unissued shares may be issued to the public and
total capital can be increased.
Under capitalization and overcapitalization both are economic irregularities relating to the capitalization
of a company. Over-capitalization is a more common phenomenon and under capitalization has rare
occurrence. However,' both are detrimental to the interests of the society. We may compare them in terms
of their effect on investors, on company and on the society in general.
Serial no Basis Over-capitalisation Under-capitalisation
1. Rate of dividend or It is lower. It is higher.
rate of earning per
share.
2. Possibility or nature Income is uncertain or Income is sure and
of income irregular regular.
3. Value of shares Capital value of shares Capital value of shares
decline. increases.
4. Real worth of shares Real worth of shares is Real worth of shares
reduced. increases.
Test Questions
Q1. Explain the meaning of capitalization. How would you estimate the capital requirements of a
newly promoted corporation?
Q2. Define capitalization and discuss the theories of capitalization?
Q3. What do you mean by over capitalization? Critically discuss its causes and disadvantages. What
will you do for controlling the over capitalization?
Q4. What do you mean by under capitalization? Explain its causes and effects. Give the suggestion to
overcome them.
Q5. “Under capitalization leads to over capitalization “ do you agree with this statement? Give
reasons
Q6. Write a short note on ‘watered capital’?
Chapter 4 Leverage
The degree of operating leverage may be defined as percentage change in the profits resulting from a
percentage change in the sales. It may be put in the form of following formula:
Degree of Operating Leverage = % change in operating profit
% change in sales
The Financial1everage is also known as capital leverage. It may be defined as the tendency of the residual
net income to vary disproportionately with operating profit. It measures the effect of fixed charges
payable on long-term funds on the earnings belonging to the shareholders and indicates the change that
takes place in the taxable income as a result or change in the operating income. It signifies the existence
of fixed interest/fixed dividend bearing securities in the total capital structure of the company. Thus, the
use of fixed interest/dividend bearing securities such as debt and preference share capital along with the
owners' equity in the total capital structure of the company is described as financial leverage. Where in
the capital structure of the company, the fixed interest/dividend bearing securities are greater compared to
the equity capital, the leverage is said to be larger. In a reverse case the leverage will be said to be smaller.
Weston Holt opines "financial leverage may be defined either by the ratio of total debt to net worth or by
the ratio of total debt to total assets." According to this definition financial leverage may be called capital
leverage also.
4.2.2.1Favourable and Unfavourable Financial Leverage- Financial leverage may be favour- able or
unfavourable depending upon whether the earnings on total capital employed exceeds the explicit fixed
cost of funds or not. The leverage will be considered to be favourable so long the firm earns more on
assets purchased with the funds than the fixed costs of their use. Unfavourable or negative leverage
occurs when the firm does not earn as much as the fund's cost.
4.2.2.2Requirements or Conditions for Trading on Equity The following are the important
requirements for successful operation of this policy:
(1) Stable Earnings-The permanent borrowing should be undertaken only when a reasonable stability of
income makes the required payment of interest to the debenture-holders fairly certain. A company whose
earnings are reasonably stable may be justified in trading on equity. But if the earnings are subjected to
violent fluctuations, borrowings should be resorted to on a limited scale.
(2) Large Investment in Fixed Assets-Large amounts of fixed property constitute a valuable adjunct for
borrowing money, since they give the lender a feeling of security and an assurance that the company will
not vanish overnight. Generally, stable earnings and large fixed assets accompany each other. The public
utility services provide such unique combination; hence, they are in a position to benefit from this policy.
(3) Well Defined and Established Field of Enterprise- Third requirement for satisfactory trading on the
equity is that the field of enterprise be well defined and established. The new and untried ventures should
be invariably financed with the equity shares.
(4) Cost of Borrowings-The next condition on this policy is the increasing cost of borrowings. As the
proportion of funds borrowed from debentures increases, increased investment risk tends to increase the
rate of interest to be paid. But this check is operative in a perfect money market only where tenders are
thoroughly competent to measure the risks involved.
(5) Custom or Usage-The next important restriction on this policy is of a practical character. It is the
custom or usage of the industry concerned which builds the general standard beyond which neither
issuing company nor the purchasing institutions would like to go. "Although custom will neither gain
universal observance nor guarantee certain safety, it nevertheless plays an extremely useful part in the
world of finance." I Trading on Equity and Financial Leverage. Financial leverage is also some times
termed as "trading on equity". However, most of the authors on Financial Management are of the opinion
that the term trading on equity should be used for the financial leverage only when the financial leverage
is favourable. The company resorts to trading on equity with the objective of giving the equity
shareholders a high rate of return than the general rate of earning on capital employed in the company, to
compensate them for the risk that they have to bear. For example, if a company borrows Rs. 100 at 8 %
interest per annum, and earns a return of 12 %, the balance of Rs. 4 per annum after payment of interest
will belong to the shareholders and, thus, they can be paid a higher rate of return than the general rate of
earnings of the company. But in case, the company could earn a return of only 6 % on Rs. 100 employed
by it, the equity shareholders will lose Rs. 2 per annum. Thus, the financial leverage is a double- edged
sword. It has the potentiality of increasing the return to equity shareholders, but at the same time creates
additional risk for them. Mr. Waterman in his 'Essays on Business Finance' has beautifully described the
role of financial leverage in the following words: "the role of financial leverage suggests a lesson in
Physics, and there might be some point to considering the rate of interest paid as the fulcrum used in
applying forces through leverage. At least it suggests consideration of pertinent variables; the lower the
interest rate, the greater will be the profit and less the chances of loss. The less the amount borrowed, the
lower will be the profit or loss; also a greater the borrowing the greater the risk of unprofitable leverage
and greater the chances of gain. Often corporate management in its enthusiasm to maximise the return on
equity shares, follows a policy of high degree of leverage. It is dangerous. The limitations of the policy of
trading on equity must always be kept in mind. "Financial leverage is like a structure which requires a
solid foundation. This foundation is provided by the low operating leverage. Mere dependence on high
financial leverage without paying adequate attention to operating leverage results in a lop-sided capital
structure." So, this policy must be adhered to only when the requirements of trading on equity are well
satisfied. A mere dependence on high leverage without paying adequate attention to operating leverage
results into a lop-sided capital structure, high burden of fixed capital costs, low profits, low market price
of equity shares and ultimately early winding up of the company. Debt is just like consumption of fat,
which is good for a healthy living for a healthy person who is capable of digesting .it.
4.2.2.3 Computation of Financial leverage It takes place as follows:
Financial Leverage = EBIT = EBIT
EBIT – INT PBT
EBIT stands for earning before interest and tax
INT stand for interest on borrowed capital
PBT stands for profit before tax
The degree of financial leverage can be computed by measuring percentage change in profits caused by a
given percentage change in EBIT. This can be expressed as follows:
DFL= % Change in sales
% Change in EBIT
DFL stands for degree of financial leverage
PBT for profits before tax
EBIT for earning before interest and tax
Examples of Leverage
OPERATING LEVERAGE
Measures the change in ebit for a given change in sales; caused by fixed operating costs
Remember breakeven analysis?
DOL = % EBIT
% SALES
FINANCIAL LEVERAGE
MEASURES THE CHANGE IN EPS FOR A GIVEN CHANGE IN EBIT;
CAUSED BY FIXED FINANCIAL COSTS
EARNINGS TO COMMON
SHAREHOLDERS -1000 2000 5000
DEGREE
EPS OF(1000
FINANCIAL
shares) = EPS
%-Rs1.00 Rs2.00 Rs5.00
LEVERAGE (DFL) % EBIT
% EPS -150% BASE +150%
4.3 Total Leverage
Combines Effects Of Using Fixed Operating And Financial Costs To Magnify Impact Of Changes In
Sales On Eps
There are only two ways in which a business can make money:
The first is debt. The essence of debt is that you promise to make fixed payments in the future
(interest payments and principal repayment). If you fail to make those payments, you lose control of
your business. For a publicly traded firm, debt can take the form of bonds, in addition to bank loans.
The other is equity. With equity, you get whatever cash flows are left over after you have made debt
payments. For a publicly trade firm, equity takes the form of common stock.
Capital structure decisions are about how much debt and how much equity will be used in a firm. Does
the amount of debt used have an effect on firm value? Or in other words, is there an optimal debt-equity
ratio that maximizes the shareholders’ wealth or the firm’s value?
Our presentation starts with an ideal, prefect and frictionless world. In this world:
There are no taxes.
There are no transaction costs.
There is no default risk associated with the use of debt.
There are no agency costs, either between shareholders and bondholders, or between shareholders
and managers.
Debt-equity mix in the total capitalization of a firm is determined by a variety of qualitative and
quantitative considerations already discussed in the preceding chapter. The main considerations are
concerned with income, control, risk and value of the firm. A capital structure, which minimizes the
weighted average cost of capital and maximizes EPS and thus the value of the firm can be called an
optimum capital structure. Truly speaking there is much divergence of views about the term optimum
capital structure. According to one view a change in capital structure (leverage or debt-equity mix) causes
a corresponding change in the EPS and the value of the firm. The other view contends that the value of a
firm has nothing to do with change in capital structure or debt-equity mix. The value of a firm is not
dependent on capital structure; but on the risk perception by investors; who assess the value on the basis
of overall capitalisation rate; irrespective of its debt- equity mix. These are two extreme views and the
other approaches in fact try to balance these two theories.
The various theories in this regard are based on three basic variables. These are earnings, cost of capital
and financial risk. A decline in earnings may cause a crisis before a highly leveraged firm and thus may
make the position of equity shareholders very risky; causing a decline in their EPS and a fall in the market
prices of their shares. Additional doses of leverage in the capital structure are likely to reduce the overall
cost of capital (Ko) of the firm, because cost of debt (Ki) is a cheaper source of capital due to tax
advantage. But this is possible upto a certain point beyond which the cost of debt (Ki) may rise and be
equal to overall cost of capital (Ko). Financial risk may change due to variability in earnings of equity
shareholders and also due to the possibility of probable insolvency caused by cash inadequacy to meet
even the non-discretionary obligations or payments. All the approaches or theories of capital structure try
to analyze inter-relationship between debt- equity mix (capital structure) cost of capital and the value of
the firm. The four theories of capital-structure are:
1. Net Income Approach
2. Net Operating Income Approach
3. Traditional Appr0ach
4. Modigliani-Miller (MM) Approach.
Before discussing the above theories, it would be more appropriate to mention certain common terms and
symbols and the underlying assumptions.
NI = Net Income available to equity shareholders.
NOI = Net Operating Income or (0)
I = Interest amount on long-term debt,
B = Total market value of debt
S = Total market value of equity
V = Total market value of the firm.
Symbols used to express costs of various funds are as follows: . Interest
KI = Cost of Debt = Interest __________
Market Value of Debt
Ke = Cost of equity = ______NI_________
Market value of equity
Ko = Overall cost of capital or weighted average cost of capital can be computed as below:
Ko = Ki ___b____ + Ke ____S______
(B+S) (B+S)
Alternatively,
Ko = EBIT + I+NI
V V
Whenever debt-equity mix (leverage) changes the relative total values of debt (B) and equity (S) also
change; which ultimately causes change in Ki (cost of debt), Ke (cost of equity) and Ko (overall cost of
capital). Thus, the analysis of the various approaches is mainly based on changes in Ki, Ke and Ko on
account of changes in degree of financial leverage.
The underlying assumptions are as follows:
1. There are no income taxes. This implies that use of debt capital does not attract tax benefit. This
assumption is only for the sake of simplifying the analysis.
2. Dividend payout ratio is kept 100 per cent. This means that the entire earnings available to equity-
holders are distributed as cash dividend and nothing is kept in the form of retained earnings.
3. There are only two sources of capital- bonds (debt) and equity share capital.
4. Operating profits (EBIT) remain constant. This implies that probability distribution of EBIT is known
and the mean values of each years EBIT distribution is constant.
5. Operating risk (business risk) is constant and on the basis of this assumption the effects of financial risk
are isolated and analysed.
6. Total capitalisation remains constant. This means that the firm can make changes in leverage (debt-
equity mix) either by selling equity shares and using the proceeds to repay bonds or debt; or by selling
bonds and using the proceeds to repurchase equity shares (reduce stock).
The exponent of this theory is David Durand. According to this approach capital
structure decisions regarding leverage or debt-equity mix exercise an important impact on the value of the
firm. An increase in the degree of leverage or debt in the capital structure will bring down the overall cost
of-capital (Ko) of the firm (given a constant EBIT) and will increase the total market value (V) of the
firm; resulting in raising the market price of equity shares. On the contrary, given the same EBIT, if ratio
of debt to total capitalisation is brought down (by issuing additional equity shares and utilising the
proceeds for retiring bonds or making repayment of debt of equal amount) then this will increase the
overall cost of capital (Ko) for the firm and. will bring down the total value of the firm causing a decrease
in the market price per equity share.
The inter-relationship between financial leverage, cost of capital and the value of the firm hold good with
certain assumptions.
Firstly, there are no taxes on income.
Secondly, the rate of interest on debt (Ki) is lower than rate of return on equity or equity-capitalisation
rate (Ke).
Thirdly, the investors (shareholders and lenders) perceive no change in financial risk. In other words, cost
of debt (Ki) and cost of equity (Ke) remain unchanged or constant. In case these assumptions hold true,
then the financial manager of a firm can try to attain an optimum capital structure through an ideal debt-
equity mix, which will minimise the overall, cost of capital (Ko) and maximise the total market value (V)
of the firm. The approach can be explained better by taking an example.
it can be said that Net Income (NI) Approach explains that higher leverage in capital structure lowers
overall cost of capital (Ko) and increases total value of the firm (V). It focuses attention to the fact that if
financial leverage is favourable (i.e., Ke> Ki) then increase of debt ratio to total capitalisation will
maximise the total value of the firm as well as the market value of its equity shares.
On the contrary, Net-income theory also suffers from certain shortcomings, as it is not based on practical
or realistic considerations or assumptions. It ignores the fact that increase of leverage in capital structure
also increases risk perception of equity-holders who rightly expect a higher return on their equity, which
raises Ke (in contrast to a constant Ke as assumed in NI theory). Similarly, the theory assumes a constant
EBIT and a constant Ki which in actual practice cannot be realistic.
Net Operating Income (NOI) Approach: An Appraisal NOI approach is extremely opposite to NI
approach. Net operating income (NOI) theory was also presented by David Durand. According to this
approach the overall cost of capital (Ko) is not dependent on debt-equity mix in capital structure.
Investors (both equity-holders and lenders) determine the total value of the firm as a whole. It is not
necessary to split up total capitalisation of a firm into debt and equity and then aggregate the total values
of debt and equity to find out the total value of the firm.
The NOI theme contends that the net operating income is capitalised by the market at a constant rate of
overall capitalisation to ascertain the total market value of a firm. The overall capitalisation rate (Ko) is
assessed by investors operating in the capital market as a fixed percentage for firms in similar line of
business and with similar risk perception. Thus, Ko remains constant under this approach and that is why
this theory is called as fixed Ko approach. The market capitalises the value of a firm as a whole by
dividing EBIT by Ko (overall capitalisation rate for firms in the category) as follows:
V= EBIT
Ko
In this way the rate of overall capitalisation can be considered a key-determinant in ascertaining the total
value of a firm. This follows that a firm has no relevance to changes in capital structure. The total value of
a firm will remain constant irrespective of its degree of leverage or ratio of debt to equity. In other words,
it can be said that given a constant EBIT and a constant rate of overall capitalisation, a change in degree
of leverage or debt- equity ratio will not make any change in the total market value of the firm.
As contrary to NI approach (in which Ke was deemed to remain constant) cost of equity (Ke) does not
remain constant under NOI approach. Thus, an increase in degree of financial leverage increases financial
risk for equity shareholders; which raises their expectations and they expect a high return on their
investment with a view to counter-balance the increased risk. In this way cost of equity (Ke) goes up with
every increase in financial leverage. Moreover with a higher debt or increase in the degree of leverage the
cost of debt (Ki) also does not remain constant. With higher doses of debt the lenders certainly perceive a
higher risk. However they do not press on an increase in explicit cost of debt 1. But there is a hidden cost
of debt, which can be called as implicit cost of debt. Although the explicit cost of debt remains the same
with increase in leverage in capital structure; yet the implicit cost goes up. This follows that the benefit of
a constant Ki (explicit cost of debt) is offset by a corresponding rise in its implicit cost (as represented by
increase in Ke).
The above account leads one to conclude that NOI approach accords no role to capital structure planning
decisions. According to it, any capital structure can be optimum as the total market value of a firm is not
related to degree of financial leverage. According to this logic financing decision-making pertaining to
debt-equity mix is a matter of indifference for investors in the capital market as they capitalise NOI at a
fixed Ko (overall rate of capitalisation) to determine the total market value of a firm. The following
illustrations will make the analysis more clear.
NI approach and NOI approach (discussed above) represent two extreme themes to analyse inter-
relationship between capital structure decisions, the value of the firm (V) and the overall cost of capital
(Ko). The basic contention under NI approach is that changes in capital structure (through variation in
debt-equity ratio) always affect Ko and V, The NOI theme, on the other hand assumes that changes in
capital structure in the form of increase or decrease in leverage do not exercise any impact on V and Ko
which are totally independent and not related to financing decisions.
The traditional theory of capital structure is an intermediary approach, which reconciles NI, and NOI
approaches. This theory assumes that (a) there is relevance of capital structure and through proper
increase in leverage or debt-equity mix a firm can have an optimum capital structure in which the total
market value (V) of the firm will be maximum and overall cost of capital (Ko) minimum. The optimum
capital structure for firm will be at that level of debt-equity mix at which the marginal real cost of debt
(both explicit and implicit) is equal to the real cost of equity. (b) The overall cost of capital' (Ko) is
affected 'by capital structure decisions. (c) Beyond a particular point increase in leverage causes rise in
equity capitalisation rate (Ke) at a rapid rate. That is why this theory is also known as 'varying Ke at
varying leverage theory'. (d), Beyond a certain critical point cost of debt (Ki) also shows tendency to rise;
although such increase is not rapid.
The traditional theory assumes that as financial leverage goes up on its path from 0 to 1, three distinct
phases can be perceived. These are:
I. The First Phase is the initial stage in which there is increase in total market value of the firm (V) and
decrease in overall capitalisation rate (Ko) along with increase in leverage. The Ke, no doubt, shows signs
of increase, but the rise in Ke is too moderate and too insignificant to neutralize the benefit of additional
debt, which is a cheaper source of capital.
2. The Second Phase is characterised by a constant V and constant Ko. During this phase the total market
value of the firm (V) and the overall cost of capital (Ko) remain almost constant as degree of leverage in
capital structure rises. This is because the benefit of using debt (at cheaper Ki) is neutralized by a
corresponding higher rise in equity capitalisation rate (Ke).
3. The Third Phase is characterised by a decrease in total market value of the firm (V) and increase in
overall cost of capital (Ko) with every increase in financial leverage beyond a critical level. Beyond this
critical point increase in rate of debt to total capitalisation causes substantial increase in risk and as a
result both Ke (equity capitalisation rate) and Ki (rate of interest on debt) show a rapid increase.
M. M. theory of capital structure has been named after Franco Modigliani and Merton H. Miller.' This
approach closely resembles NOI approach so far as' the theme of irrelevance of capital structure in
determining V and Ko /1le concerned. Both the approaches contend that cost of capital (Ko) is
independent of the degree of leverage in capital structure and hence the value of the firm (V) also is not
affected by financing decisions. M.M. approach, however, goes a step further and provides a 'rational'
explanation and operational justification (which is lacking in NOI approach) for the independence or
irrelevance of the degree of financial leverage in the valuation of a firm and in computing its Ko. NOI
approach, no doubt, assumes that there is no inter-relationship between cost of capital (Ko) and the debt-
equity ratio; but does not give any behavioural or operational justification for such a contention. This has
been explained by M.M. approach in a rational manner.
Modigliani and Miller in their approach have given certain simplified assumptions and have also provided
three basic propositions. These have been summarised below.
Simplified Assumptions M.M. approach develops its theme on the basis of the following four
assumptions:
I. The Capital Markets are perfect. This implies that the investors in the capital market think and behave
in a rational manner and can sell and purchase securities without any restrictions, The capital market has a
perfect information system which means that the required information is made available to each investor
promptly and without any cost. The securities traded in the market are divisible infinitely and the
borrowing facilities are freely available to investors on similar terms and conditions; at a risk- free
interest rate.
2, There are no transaction costs (stamp duty, commission, brokerage, etc.) involved in or attached to sale
and purchase of securities.
3. All the firms can be classified into 'equivalent risk class or group' and that the extent of risk is equal for
firms in a particular equivalent risk class or 'homogeneous risk category'. The values of probability
distribution of estimated future operating earnings are the same for firms within the homogeneous or
equivalent risk category.
4. There are no taxes on corporate income-an assumption, which was subsequently removed by
Modigliani and Miller. It is' also assumed that the firms pay 100% of their earnings as dividend and thus
do not retain any earnings in business.
Basic Propositions
1. The total market value of a firm (V) and its overall cost of capital (ko) are not dependent on the degree
of leverage in their capital structure and remain constant irrespective of any level of debt-equity mix.
2. The cost of equity (Ke) is equal to the rate of capitalisation of pure equity earnings stream plus a risk-
premium. This implies that a risk-premium is added to the pure equity capitalisation rate in order to
ascertain the total cost of equity (Ke). The risk-premium can be defined as the difference between the
pure equity capitalisation rate (Ke) and Ki multiplied by the ratio of debt to equity (that is Ke-Ki x B/S).
In this way increase in Ke exactly offsets the increased risk on account of the use of debt, which is a
cheaper source of funds.
3. For investment purpose the cut-off rate or the hurdle rate is independent of the manner in which an
investment is actually financed.
In the present context of exploring a behavioral justification for the irrelevance of financing decisions in
the valuation of a firm, Proposition 1 is relevant and needs a detailed treatment.
Basic Proposition I
This proposition under M.M. approach presents an operational justification for the argument that total
market value of firms (of course within the homogeneous risk-category) remains constant irrespective of
the degree of financial leverage. Accordingly, the overall cost of capital (Ko) and the market price of
equity shares are the same; no matter what the debt-equity ratio of the firm may be.
It may be pointed out that the entire M.M. theme is built-up on the process known as 'arbitrage'.
Therefore, before explaining the practical implications of the basic Proposition No. I, it would be most
appropriate to explain the meaning of 'arbitrage'. In security market terminology arbitrage is known as
"simultaneous purchase and sale of the same or equivalent security in. order to profit from price
discrepancies." In other word the process of arbitrage balances the discrepancies and restores equilibrium
in 'V' and Ko of the two firms (belonging to the same risk equivalency class). In case the V of a levered
firm is higher and its Ko is lower as compared to an unlevered firm (whose V is lower and Ko is higher)
the rational investors will start selling their proportionate share in the levered firm (using debt in capital
structure) borrow funds proportionate to the debt of the levered firm at the same rate of interest (in the
terminology used M.M the rational investors will substitute home made leverage or personal leverage for
corporate leverage and purchase equivalent share in the equity of the unlevered firm (not using debt, in its
capital structure). By doing so the rational investors (or arbitragers) will be having the benefit of the same
return after arbitrage as they were having before such arbitrage at lower outlay and at the same time with
lower risk. Such arbitrage operations will continue till a state of equilibrium is restored in the market
value (V) and overall cost of capital,. (Ko) of the levered and unlevered firms.
The M.M. theory advocates that in a perfect capital market discrepancies in V and Ko of two equivalent
risk category are temporary and in the long run tend to square up on account of arbitrage operations.
(1) Modigliani and Miller (MM) irrelevance theorems
Let’s assume the change in capital structure has a positive effect on the stock price: stock price rises from
Rs20/share to Rs22/share, and correspondingly, the total assets increase from Rs8000 to Rs 8400. We will
show this change creates an arbitrage opportunity.
First, Let’s look at the earnings per share (EPS) before and after the capital structure change:
Unlevered Equity
Recession Normal Expansion
Earnings 400 1200 2000
EPS (unlevered) 1 3 5
Levered Equity
Recession Normal Expansion
Earnings before interest 400 1200 2000
Interests 400 400 400
Earnings after interest 0 800 1600
EPS (levered) 0 4 8
The two strategies produce the same returns whatever the scenario is, but Strategy A is more expensive.
Rational investors will use Strategy B rather than Strategy A; they will borrow on their personal account
to buy more shares of unlevered firm. This strategy is often called homemade leverage, meaning
investors can duplicate the effects of corporate leverage on their own. Price of levered firm will decline
and price of unlevered firm will increase, till they become equal. Similarly, if value of levered firm is less
than value of unlevered firm, equilibrium will force them to be equal. This proves:
MM Proposition I (no taxes): Other things equal, the value of the levered firm is the same as the value of
the unlevered firm.
The implication is straightforward: there exists no optimal capital structure. The capital structure
decisions have no effect on the real operations of a firm, and thus no effect on firm’s value and
shareholders’ welfare. Capital structure decisions determine only how the pie is sliced.
From the above tables, we see EPS for the levered equity is more variable than EPS for the unlevered
equity, implying levered equity is more risky than unlevered equity, and so should have a higher required
return. We have:
MM Proposition II (no taxes): Cost of equity (required return on equity) rises with leverage. More
specifically,
B
rS r0 (r0 rB )
S
where rS is the cost of equity, or required return on equity or stock
rB is the cost of debt
r0 is the weighted average cost of capital (WACC), or cost of equity for an otherwise identical all-
equity firm
B is market value of the firm’s debt
S is the market value of the firm’s equity or stock
Summary:
In an MM no-tax world, what will be changed by capital structure decisions?
Risk of equityrequired return for equity (cost of equity)
We relax the first assumption about MM world. Here, companies are levied corporate taxes. In this case,
debt represents one of its benefits over equity. Unlike dividends, payments to bondholders, interest
payments, are deductible from corporate taxes. The annual tax savings (called tax shield from debt) from
use of debt is equal to:
TC rB B
where TC is corporate tax rate
rB is interest rate of the debt
B is the total amount of debt
For simplicity, assume the tax shield is perpetual, then the present value of tax shield is:
TC rB B
TC B
rB
MM Proposition I (with corporate taxes): The value of levered firm rises with leverage, with the
increase in value equal to the present value of tax shield from debt. More specifically,
EBIT (1 TC ) TC rB B
VL VU TC B
r0 rB
What is the implication of this proposition on the optimal capital structure for a firm? The more debt
used, the better. Is the implication consistent with the reality?
Hypothesis I: Other things equal, the higher the marginal tax rate of a firm, the more debt it will have in
its capital structure; As tax rates increase over time for a firm, debt ratio will also go up as well.
The effect of leverage on cost of equity persists under MM world with corporate taxes, but somewhat
abated, because the tax savings from debt make the equity less risky.
MM Proposition II (with corporate taxes): Cost of equity (required return on equity) rises with
leverage. More specifically,
B
rS r0 (1 TC ) (r0 rB )
S
where rS is the cost of equity, or required return on equity or stock
rB is the cost of debt
r0 is the cost of equity for an otherwise identical all-equity firm
TC is corporate tax rate
B is market value of the firm’s debt
S is the market value of the firm’s equity or stock
The weighted average of cost of capital (WACC) under MM world with corporate tax will become:
B S
rWACC rB (1 TC ) rS
BS BS
In an MM world with no taxes, WACC does not change with leverage. But in an MM world with
corporate taxes, WACC will typically decrease with leverage. The intuition is that the increase in firm
value from debt use will make the capital the firm employs less risky, leading to decrease in cost of
capital.
Summary:
In an MM world with corporate taxes, what will be changed by the use of leverage?
Risk of equityrequired return for equity (cost of equity): increase
Risk of the firmcost of capital (WACC): decrease
Firm value: increase
Equity value / stock price per share: increase
First, as we know, heavy use of debt subjects a firm to financial distress (default risk or bankruptcy). Two
types of cost are involved in bankruptcy proceedings:
Direct costs: legal and administrative costs
Indirect cost: impaired ability to do business: customers, suppliers and financiers will be reluctant
to do business with the bankrupt firm.
Hypothesis II: Other things equal, the greater the indirect bankruptcy cost and/or probability of
bankruptcy, the less debt the firm can afford to use. For example, firms producing products that require
long-term servicing and support (e.g., personal computer manufacturer or copier producer) generally
should have lower leverage.
Agency costs of debt result from conflicts between shareholders and bondholders. Thus, we are relaxing
the fourth assumption underlying MM world. Bondholders care about the safety of their promised
payments, while shareholders as the residual claimant, only care about the cash flows beyond the
promised debt payments. Agency costs of debt may take the following forms:
Risk shifting: Shareholders and managers tend to take on much riskier projects than
bondholders expect them to, especially when the financial distress is imminent. Shareholders
could expropriate wealth from the bondholders by taking high-risk projects, even though
these projects may decrease the total value of firm.
Under investment: In case of possible financial distress, shareholders and managers may choose to give
up some positive NPV projects, because increase in value from these projects
Milking the property: Firms tend to pay out extra dividends and other distributions in times
of financial distress, leaving less for the bondholders.
Of course, bondholders are smart enough to expect the perverse behaviors of the shareholders. To protect
their own interests, bondholders may (1) build the expectation into bond prices by demanding much
higher interest rates on debt; or (2) write protective covenants to restrict the flexibility enjoyed by the
firm. Both actions by bondholders force extra cost on shareholders, meaning the ultimate assumers of
agency costs of debt are shareholder themselves. Part of solution to agency costs of debt is financing by
issuing convertible bonds, one of the hybrid securities with features of both debt and equity. We will talk
about it in the topic “options in corporate finance”.
Hypothesis III: Other things equal, the greater the agency problems associated with lending to a firm, the
less debt the firm can afford to use. For example, regulated utility companies have little chance to take
high-risk projects, so they can afford to use high level of debt. Pharmaceutical companies have
historically maintained low debt ratios, possibly because their projects are basically long-term ones and
follow unpredictable paths, making monitoring by bondholders relatively unlikely.
Hypothesis 4: Other things equal, the greater the agency problems between shareholders and managers
in a firm, the more debt the firm tends to use. For example, a private firm, for which there exits no
separation of ownership and management, should use less debt, according to this hypothesis.
Combining the above section (2)-(4), an optimal debt-equity ratio could be established for an individual
firm, based on the arguments of benefits and costs associated with use of debt. The benefits include the
tax shield and the reduction of agency costs of equity; the costs include the bankruptcy costs and agency
costs of debt. Initially, firm value increases with leverage, but at the level of debt, the risk of financial
distress will rise due to heavy use of debt, and bankruptcy costs and agency costs begin to dominate the
benefits of debt, leading to declining of firm value. The optimal debt ratio occurs at the point of change
this line of interpretation of the optimal financial structure in reality is called trade-off theory of capital
structure.
It is conceivable that managers of a firm know more about their company than financial market /
investors: a case of information asymmetry. When a company decides to issue stock or bond, financial
market tends to infer that the stocks and bonds of the company are overvalued, and accordingly, investor
do not want to pay much for the issues. Thus, the decision of equity or debt issuance is a signal of
overvaluation of the company’s securities, even if the firm’s securities are actually not overvalued (market
simply cannot distinguish the good companies from bad companies).
Due to information asymmetry and the resultant signaling of equity or debt financing, a firm tends to use
internal retaining earnings firstly when it comes to financial its new projects, because doing so does not
depend on whether markets are pricing its securities correctly, in addition to floatation costs can be
avoided. Only when the internal resources are exhausted, it turns to financial market for outside
financing. Since mispricing of equity is likely to be much greater than debt, and so information
asymmetry is more severe in the case of equity, the firm will typically use debt first, and equity is last
resort. Such an interpretation of financial structure using the different degree of preference over different
financial vehicles is called pecking-order theory of capital structure. Retained earnings low-risk
debt high-risk debt (e.g. convertibles) equity. Pecking-order theory seems to be practically
relevant. See the following survey results:
Ranking Sources Reasons Cited Score
1 Retained Earnings None 5.61
2 Straight Debt Maximize Stock Prices 4.88
3 Convertible Debt Cash Flow & Survivability 3.02
4 External Common Equity Avoiding Dilution 2.42
5 Straight Preferred Stock Comparability 2.22
6 Convertible Preferred None 1.72
MM Propositions with corporate taxes override the conclusion that debt is irrelevant to firm value. But by
introducing also personal taxes, Miller argued that the debt irrelevance theorem could be resuscitated
even in the presence of corporate taxes if taxes on the dividends and interest income individuals receive
from firms were factored into the analysis.
(1 TC ) (1 TS )
V L VU 1 B
(1 TB )
where VL is the value of levered firm
VU is the value of unlevered firm
TC is corporate tax rate
TS is personal tax rate on equity distributions (dividends or capital gains)
TB is personal tax rate on interest income
B is the amount of debt
If TS = TB, then we have: V L VU TC B , the same result as MM proposition with corporate taxes. But
in reality, companies often distribute earnings through stock buyback, because tax rate on capital gain is
traditionally lower than tax rate on ordinary income such cash dividends or interest income. In this case,
TS < TB, so the tax benefits of debt will reduce. If further, (1 TC ) (1 TS ) 1 TB , then we have
V L VU , the tax benefits are eliminated completely, and debt irrelevance result remains. This means the
lower corporate taxes for a levered firm are exactly offset by higher personal taxes on interest income.
This is a possibility, however. Another force that works against tax shield of debt is the limited tax
deductibility of debt, because firm can deduct interest only to the extent of profits. This implies that the
first unit of debt should increase firm value more than the last unit, because the interest on later units may
not be deductible. In economic term, the marginal benefits of debt are declining. When marginal benefits
of debt is equal to the marginal disadvantages of debt (such as bankruptcy costs, or disadvantaged
treatment of tax on interest income relative to the tax on capital gains), an optimal capital structure
results.
One of the objectives of capital management is to find the right mixes of capital. A comparison of Earnings
Before Interest Taxes (EBIT) with Earnings per Share (EPS) under different financing plans can help determine
which type of financing is most advantageous - debt financing or equity financing. Since debt has little effect on
EBIT, we start our analysis with EBIT. We simply want to calculate what EPS will be under each financing
plan. Both the debt and equity financing plans are plotted on a graph. Depending upon what we expect EBIT to
be, the graph can tell us which financing plan will give us the highest EPS.
At a level of Rs 2 million EBIT, EPS is the same under either the equity or debt-financing plan. If we expect
EBIT to be below Rs 2 million, then we would favor the equity plan since it yields a higher EPS. If we expect
EBIT to be above Rs 2 million, then debt would be preferred over equity after considering the increased risk.
ABC Corporation wants to raise Rs 4 million in capital for production facilities. ABC can
issue stock (200,000 shares @ Rs 20) or issue bonds at 10% interest. ABC's tax rate is 45%.
ABC's projected EBIT is Rs 6.5 million and it has long-term capital consisting of Rs 2
million in debt @ 8% and 100,000 shares of equity.
The returns or EPS under a 100% debt Plan is much higher than other plans. If ABC expects
an EBIT of Rs 6.5 million, it can easily service higher levels of debt.
In the above example, it is quite clear that ABC can benefit from the use of more debt. However, suppose ABC
expects EBIT to fall dramatically over the next few years.
The minimum level of EBIT needed to cover fixed financing charges (debt and preferred shares) under 100%
equity Plan.
1. The minimum level of EBIT needed to cover fixed financing charges (debt and preferred share) under
100% debt Plan.
2. The Indifference Point where EPS is the same under the 100% equity Plan and the 100% debt Plan. The
following formula can be used to calculate the Indifference Point:
EPS: Earnings per Share EBIT: Earnings Before Interest Taxes TR: Tax Rate
PD: Preferred Dividends
If we refer back to Example 1, we can determine that the minimum level of EBIT under the
two financing plans is as follows:
100% equiity: Minimum EBIT to service fixed obligations is Rs 160,000 (Rs 2 million of
existing debt x 8% interest rate)
We need a third intersection point or indifference point where EPS is the same under the two
financing plans (100% equity and 100% debt). We can solve for the EBIT where EPS is the
same:
EBIT = Rs 760,000
At an EBIT of Rs 760,000, we are indifferent to the two financing plans since EPS is the
same. If EBIT were to fall below Rs 760,000, we would favor the equity Plan. If EBIT is
expected to be above Rs 760,000, we would favor the debt Plan. The following calculation
confirms the indifference point:
Summary
One way to understand how to manage capital is to look at the various approaches that can be used for
finding the right capital structure. As we previously indicated, the right capital structure is that mix of
debt and stock that maximizes the value of the firm while at the same time maintains a relatively low
overall cost of capital. Two very different approaches to capital management are the Net Operating
Income Approach and the Net Income Approach.
Net Operating Income Approach: This approach to capital management concludes that it does not
matter how you mix the capital structure. The value of the business is not determined by how you
arrange the right side of the Balance Sheet. Additionally, the overall cost of capital will not change as
you change the mix of capital. Therefore, values are determined by the capitalization of operating
income or EBIT (Earnings Before Interest Taxes).
Example 3 - Calculate Market Value of Business under Net Operating Income Approach to Capital
Management
XYZ Company has Rs 400,000 in outstanding debt at 7% interest. Norton's cost of capital is 12% and
expected operating income or Earnings Before Interest & Taxes (EBIT) is Rs120,000.
Earnings to Shareholders =Rs 120,000 -Rs 28,000 (7% interest on debt) = Rs 92,000.
Total Market Value = Rs 120,000 / .12 = Rs 1,000,000
Market Value of Stock = Rs 1,000,000 - Rs 400,000 = Rs 600,000
Cost of Equity = Rs 92,000 / Rs 600,000 = 15.3%
Net Income Approach: In contrast to the Net Operating Income Approach, the Net Income Approach
concludes that the capital structure of an organization has a major influence on the value of the
organization. Therefore, the use of leverage will change both the cost of capital and the value of the
firm. Net Income is capitalized in arriving at the market value of the firm.
Example 4 - Calculate Market Value of Business under Net Income Approach to Capital Management
Franco Modigliani and Merton Miller have provided some guidance between the Net Operating
Income Approach and the Net Income Approach. Modigliani and Miller concluded that capital
structure is not a major factor in the determination of values. Values are determined by the investment
and operating decisions that generate cash flows. It is cash flows that give rise to values. This approach
to valuation has become a mainstay within financial management. But what about capital structures?
Mike Jenson, founder of the Journal of Financial Economics, may have resolved the answer to this
question. Jenson noted that whenever a company makes a change in its capital structure, it sends a
signal to investors. This signaling effect does in fact result in changes to valuations.
Jenson also noticed that managers have a tendency to guard capital and minimize the distribution of
dividends to shareholders. This follows with the so-called "pecking order" of financing whereby
managers prefer internal sources of capital to external sources of capital. The specific pecking order is
as follows:
Consequently, capital structures can impact valuations due to the so-called signaling effect.
Additionally, the real source of values will reside in cash flows (more specifically free cash flows). Free
cash flows are the excess cash that can be withdrawn from a business after paying everything off. And
in order to generate free cash flows, management must generate returns in excess of the cost of capital.
Test Questions
I. Explain briefly the view of traditional writers on the relationship between capital structure and the value
of the firm,
2. Write a detailed note on Traditional vs. M.M. Approach to capital structure.
3. Explain the position of M.M. theory on the issue of an optimal capital structure. Show as to how home-
made leverage by an individual investor can replicate the same risk and return as provided by the
leveraged .
4. "The basic controversy between 'Traditional Theory' and 'M.M. Theory' comes to an end when
corporate income taxes are assumed to exist:' Explain giving suitable arguments.
5. "The bases of MM Thesis for optimal capital structure are unrealistic assumptions:' Evaluate the
statement.
6. Explain clearly the concept of 'financial risk'. What is the relationship between leverage and cost of
capital? Explain.
7. "The total value of a firm remains unchanged regardless of variations in its financial mix. Discuss this
statement and point out the role of arbitraging and home-made leverage,
"Cost of Capital is the minimum rate of return which a firm requires as a condition for undertaking an
investment proposal."
6.1.1 Concept of Cost Of Capital
Minimum rate for evaluating projects opportunities is opportunity cost of capital = business cost of capital
Cost of capital = opportunity cost of capital
The cost associated with different sources of funds is called the cost of capital. Cost of Capital
represents the rate a business must pay for each source of funds - debt, preferred shares, equity shares, and
retained earnings. Cost of Capital is an important element in taking capital investment decisions. Accurate
measurement of cost of capital is desirable on account of its serious implications on the over-all objective of a
firm, i.e., maximization of shareholders' wealth. Hence, the need for correct definition and measurement of cost
of capital is inevitable.
The term cost of capital refers to the price paid by a firm for obtaining funds from investors through
issuance of a specific type of security. It is, therefore, the minimum rate of return expected by investors.
Thus, in operational terms cost of capital refers to the minimum rate of return which a firm must earn on
its investment in order to satisfy the expectations of its investors and keep the market value of the concern
unchanged. In economic terms, the term 'Cost of Capital' may be defined as the cost of acquiring the
requisite funds, i.e., borrowing rate. Alternatively it may refer , to opportunity cost of funds. i.e., lending
rate. Practically, we use the borrowing rate to indicate the cost of capital. Since a firm borrows funds from
different sources at different rates, the cost of capital indicates the weighted average cost of each
component of capital. Some of the definitions of 'Cost of Capital' are as follows:
According to Solomon Ezra, "The cost of capital is the minimum rate of return or cut-off rate for capital
expenditures,"
According to Hampton John J., "Cost of capital is the rate of return, the firm requires from investment in
order to increase the value, of the firm in the market rate."
According to Milton H. Spencer, "Cost of capital is the minimum rate of return which a firm requires as
a condition for undertaking an investment,"
According to James C. Van Horne, "The cost of capital represents a cut-off rate for the allocation of
capital to investment projects. It is the rate of return on a project that will leave unchanged the market
price of the stock,"
Pricewater house Coopers survey, 14 March 2000
Cost of capital for most Indian companies is generally regarded to be in the 15-20 per cent range. This
when compared with cost of capital for most US companies (believed to be in the 8-12 per cent range),
places Indian companies at a significant competitive disadvantage. The future could, however, see a
general reduction in cost of capital for Indian companies.
According to the survey, a majority of the respondents expect equity market risk premium and risk-free
rate to decline in India over the next three years. This decline, which would lead to a reduction in cost of
equity for Indian companies, is expected on account of improvement in corporate transparency, greater
maturity (thereby reduced volatility) of the equity market, reduction in fiscal deficit, market-determined
returns on government securities, fewer curbs on capital flow and lower transaction costs.
In a common Sense, "The cost of capital is any discount rate used to value cash streams."
Thus, cost of capital is the minimum rate of return from a project, which a firm is expected to earn in
order to discharge its obligations in respect of funds acquired from the investors.
No fixed payments are required to investors; dividends are paid only as earnings are available.
No maturity date on the security, the invested capital does not have to be repaid.
Does not dilute earnings per share or control within the company.
Has a maturity date and the capital invested must be repaid to investors.
The cost of capital comprises an important element in capital investment decisions. It is important not
only from the perspective of capital budgeting decisions but it also constitutes an integral part of capital
structure decisions. The concept of cost of capital is quite relevant in the following managerial decisions.
1. Capital Investment Decisions, The cost of capital represents the cut-off rate in investment decisions.
It is often used as the discount rate for computing the present value of cash in- flows associated with a
capital project. In case of different discounted cash flow methods, such as NPV Method. Profitability
Index Method, Terminal Value Method etc" the cost of capital is employed for discounting the future cash
inflows. In case of the Internal Rate of Return (IRR) Method, the computed lRR is compared with the
cost of capital. Thus, cost of capital constitutes the basis for capital investment decisions. It provides a
yardstick for evaluating capital expenditure proposals, and, thus, serves the role of accept-reject criterion.
Obliviously, the accept-reject rule requires the firm to select only such projects, which give a rate of
return higher than the cost of capital. The cost of capital, therefore, occupies a crucial significance in
capital budgeting decision in- so far as it provides a rational yardstick for making the optimum investment
decisions.
2. Capital Structure Decisions. Besides an accept-reject decision criterion for capital investment
proposal, the cost of capital is also important in designing the balance and appropriate capital structure of
the firm. A firm may raise its financial resources in a number of ways including loans from banks and
other financial institution, public deposits, debts and debentures, equity shares, preference shares, retained
earnings, etc. The cost of capital is influenced by changes in financial leverage or capital structure. Since
the cost of capital has a direct bearing on the firms overall objective: of maximising shareholders' wealth,
the firm will logically attempt to have an optimum capital structure which will minimise cost of capital
and risks associated with raising funds from various sources. Keeping in view the varied costs and risks
involved in different sources of capital, it is inevitable to compute the cost of each type of capital so as to
have an optimum capital structure. Thus, the cost of capital plays a vital role in designing an appropriate
capital structure of a firm, which is absolutely necessary for attaining the firm's overall objective of
shareholders' wealth maximisation by minimising its overall cost of capital and the associated risks.
3. Optimum Resource Mobilisation. The concept of cost of capital is also useful in optimum
mobilisation of resources. A capable financial manager is always aware of the fluctuations in the capital
market, current rates of interest and dividend. This enables him to mobilise the requisite funds from
different sources in such a way as to minimize the composite cost of capital and risk while retaining the
control of the firm in the bands of the existing shareholders. Thus, cost of capital also plays an important
role in optimum mobilization of financial resources from different sources.
4. Evaluation of Expansion Projects and Financial Performance of Top Management. The cost of
capital can be used to evaluate the financial feasibilities of expansion projects. If the marginal rate of
return on investment is higher than the cost of capital, the expansion projects are accepted other wise
rejected. The cost of capital can also be used to evaluate the financial performance of the firm's top
executives. Such an evaluation will involve a comparison of actual profit abilities of the projects with the
projected composite cost of capital and also with the actual cost incurred in raising the required funds.
The cost of capital is also important in many other areas of decision-making, such as comparative study
of alternative financial resources, optimum allocation of financial resources, dividend policy decisions,
working capital management policies, capital budgeting and capital expenditure control, etc.
The concept of cost of capital is not only useful and has considerable practical utility in finance. But it is
also the most controversial topic in the theory of finance; a basic point of dispute regarding long-term
financing is whether a firm's cost of capital depends upon the method and level of financing or its capital
structure. There are two following important approaches in this regard:
1. Traditional Approach. This approach emphasises that a firm's cost of capital hinges upon its capital
structure, and it can change its overall cost of capital by changing its capital structure, i.e., increasing or
decreasing debt-equity ratio. Since the cost of debt capital is cheaper due to lower rate of interest and tax
saving as compared to the cost of equity capital involving relatively higher rate of dividend and foregone
tax benefit, the traditional theorists argue that the weighted average cost of capital will decrease with
every increase in debt content in the total capital structure. However, the debt content in the overall
capital structure should be maintained at a proper level because cost of debt is a fixed burden on the
profits of the firm, and may adversely affect the firm in periods of lower profitability. Further, if the debt
content in the total capital structure is raised beyond a certain point, the investors will expect a higher rate
of return on account of increase in business and financial risks.
2. Modigliani-Miller Approach. According to this approach, the cost is an independent factor and
remains unaffected by changes in the firm's capital structure. In other words, a change in capital structure
or debt-equity ratio does not affect the firm's total cost of capital. This approach is based on the reasoning
that each change ill the debt-equity ratio automatically offsets change in one with the change in the other
due to change in the expectation of equity shareholders. The Modigliani-Miller hypothesis, therefore,
suggests that the market value of the firm and cost of capital is the same for all the firms irrespective of
the proportion of debt included in the capital structure because of the arbitrage in the capital market.
Assumptions of the M.M. Approach. The Modigliani-Miller Approach is based on the following
assumptions:
1. Perfect Capital Market. This implies that the investors are rational persons and have full information
of the capital market. They are free to buy or sell securities. They can borrow without restrictions on the
same terms and conditions as the firm can, and there is no transaction costs.
2. Firms can be classified in Homogenous Risk Classes. Firm with identical risk characteristics may be
grouped in homogenous risk classes. Firms in each class are considered to have the same degree of
business and financial risk. All firms within an industry are assumed to be within the same risk class.
3. Same Expectations of Investors. All investors expect the same net operating income which is used in
evaluation of a firm. The firms distribute all of their net earnings to the shareholders.
4. No Taxes. In the original formulation of this hypothesis, Modigliani and Miller assumed that there are
no corporation taxes. This assumption has been removed later.
This approach is subject to criticisms on account of its basic assumption that capital markets are perfect.
This approach applies only in an equilibrium state, but it is unrealistic to assume the existence of
equilibrium position. Thus, the traditional approach is more realistic.
6.6 Measurement Of Cost Of Capital
As pointed out above, the cost of capital of a firm is the weighted average of the cost of each type of its
capital. If the capital of a firm consists of equity shares, preference shares, debentures, loans and retained
earnings, its cost of capital will be the weighted average of all this sources of financing. Thus, the first
stage in the measurement of a firm's cost of capital is the accumulation of the cost of each specific type of
capital, i.e.., debt capita!, preference share capital, equity share capital and retained earnings.
Once the cost of each specific source of capital is computed, weighted average of all these costs is
calculated to determine the overall cost of capital to the firm. The weight assigned to each type of capital
is the ratio of the market value of each specific component of capital to the market value of the total
capital structure of the firm. In other words, the weights, assigned to each specific component of capital
are in proportion to their respective shares in the total capital structure.
Before proceeding to the computation of cost of each specific component of a firm's capital and its overall
cost of capital, it is pertinent to review the conceptual and practical problems faced by the financial
manager in determining the cost of capital
Problems in determining the cost of capital are briefly summarised as follows:
1. Problem of Controversy regarding Cost Capital. There is a major controversy whether or not the
cost of capital is dependent upon the method and level of financing by the firm. While traditional theorists
maintain that a firm's cost of capital depends upon its capital structure and is subject to changes in its debt
equity mix, the modern theorists argue that the firm's total cost of capital is independent of its capital
structure and changes in debt-equity mix does not affect the firm's overall cost of capital.
1. Problem Regarding Quantification of Shareholders' Expectations. The determination of cost of
equity capital is another problem as it is considered to be the minimum rate of return expected by its
equity shareholders and which will maintain the present market value of the firm equity shares. This
means that the determination of the cost of equity share capital will require the quantification of the firm's
equity shareholders, which is a very difficult task because the equity shareholders value a firm's equity
shares on the basis of a number of factors.
3. Problem Regarding Computation of Cost of Retained Earnings and Depreciation Funds .Since
the cost of capital through these sources will depend upon the approach followed for computing the cost
of equity capital, the finance manager is confronted with the problem of selecting the appropriate
approach because of controversial view regarding cost of capital. .
4. Problem of Weights. Another problem in determining the cost of capital relates to the assignment of
appropriate weights to each component of capital. The finance manager has to make a choice between the
book values and the market values of each type of capital. The cost of capital will be different in each
case.
5. Problem Regarding Type of Cost. It is argued that historical costs are not relevant for decision-
making purposes and only the future costs should be considered. This again creates the problem whether
to consider marginal cost of capital or the average cost of capital.
It is clear from the above discussion that it is quite difficult to determine the accurate cost of
capital. Since the cost of capital; is one of the most crucial factors in managerial decisions, it
should be estimated with a reasonable range of accuracy.
6.7 Determining Component Cost Of Capital
In the following pages we will discuss the methods of computing the component costs of three major
sources of capital: debt, preference shares and equity shares. The investors' required rate of return should
be adjusted for taxes in practice for calculating the cost of a specific source of capital to the firm. In the
investment analysis, net cash flows are computed on an after- tax basis, therefore, the component costs,
used to determine the discount rate, should also be expressed on an after-tax basis.
We could arrive at same results as above by using Equation (1): cash outflow are Rs 15 interest per year
for 7 years and Rs 100 at the end of seventh year in exchange for Rs 100 now. Thus:
15 15 15 15 15 15 15 100
100 = ----------- + ------------ + ---------- + ----------- + ---------+ ------------- +----------- +-----------
(1 +kd) (1 +kd)2 (1 +kd)3 (1 +kd)4 (1 +kd)5 (1 + kd)6 (1 + kd)7 {I + kd)7
7 15 100
100 = ------- +--------
t=1 (1 +Kd)t (1 + Kd)7
100 = 15(PVAF7 .kd) + 100(PVF7.kd)
By trial and error, we find that the discount rate (kd), which solves the equation, is 15 per cent:
100 = 15(4.160) + 100(0.376~ = 62.40 + 37.60 = 100
Clearly, the before-tax cost of bond is the rate, which the investment should yield to meet the outflows to
bondholders.
Where Bn is the repayment of debt on maturity and other variable as defined earlier. The above given
equation can be used to find out the cost of debt whether debt is issued at par or discount or premium,
Tax adjustment. The interest paid on debt is tax deductible. The higher the interest charges, the lower
will be the amount of tax payable by the firm. This implies that the government indirectly Jays a part of
the lender's required rate of return. As a result of the interest tax shield, the after-tax cost of debt to the
firm will be substantially less than the investors' required rate of return. The before-tax cost of debt, kd
should, therefore, be adjusted for the tax effect as follows:
After-tax cost of debt = kd(1 - T)
Where T is the corporate tax rate. If the before-tax cost of bond in our example is 16.5 per cent, and he tax
rate is 35 per cent,2 the after-tax cost of bond will be:
kd(1 - T) = 0.1650(1 - 0.35) = 0.1073 or 10.73%
It should be noted that the tax benefit of interest deductibility would be available only when the finn s
profitable and is paying taxes. An unprofitable firm is not required to pay any taxes. It would not gain my
tax benefit associated with the payment of interest, and its true cost of debt is the before-tax cost.
It is important to remember that in the calculation of the average cost of capital, the after-tax cost Jf debt
must be used, not the before-tax cost of debt.
ILLUSTRATION 1 A 7-year Rs 100 debenture of a firm can be sold for a net price of Rs 97.75. The
coupon rate of interest is 15 per cent per year, and b0nd will be redeemed at 5 per cent premium on
maturity. The firm's tax rate is 35 per cent. Compute the after-tax cost of debenture.
The annual interest will be: F x i = Rs 100 x 0.15 = Rs 15, and maturity price will be: Rs 100 (1.05) = Rs
105. We can use Equation (3) to compute the after-tax cost of debenture:
n INT Bn
B0 = ------- t +-------- n
t=1 (1 +Kd) (1 + Kd)
By trial and error, we find kd = 16%:
15(4.038) + 105(0.354) = 97.75
The after-tax cost of debenture will be:
kd(1 - T) = 0.16(1 - 0.35) = 0.104 or 10.4%
Cost of the Existing Debt
Sometime a firm may like to compute the "current" cost of its existing debt. In such a case, the cost of
debt should be approximated by the current market yield of the debt. Suppose that a firm has 11 per cent
debentures of Rs 100,000 (Rs 100 face value) outstanding at December 31, 19XI to be matured on
December 31, 19X6. If a new issue of debentures could be sold at a net realisable price of Rs 80 in the
beginning of 19X2, the cost of the existing debt, using short-cut method, will be:
11+1/5(100-80) 15
kd = ------------------------ = ------------ = 0.167 or 16.7%
½(100-80) 90
ILLUSTRATION 2 A company issues 10 per cent irredeemable preference shares. The face value per
share is Rs 100, but the issue price is Rs 95. What is the cost of a preference share? What is the cost if the
issue price is Rs 105?
We can compute cost of a preference share as follows:
Issue price Rs 95:
PDIV 10
kp = ---------- = ----- = 0.1053 or 10.53%
Po 95
Issue price Rs 105:
PDIV 10
kp = --------- = ------ =0.0952 or 9.52%
Po 105
Redeemable preference share Redeemable preference shares (that is, preference shares with finite
maturity) are also issued in practice. A formula similar to Equation (3) can be used to compute the
cost of redeemable preference share:
n INT Pn
P0 = ------- +--------
t=1 (1 +Kp)t (1 + Kp)n
The cost of preference share is not adjusted for taxes because preference dividend is paid after the
corporate taxes have been paid. Preference dividends do not save any taxes. Thus, the cost of preference
share is automatically computed on an after-tax basis. Since interest is tax deductible and preference
dividend is not, the after-tax cost of preference is substantially higher than the after-tax cost of debt.
It is sometimes argued that the equity capital is free of cost. The reasons for such argument is that it is not
legally binding for firms to pay dividends to ordinary shareholders. Further, unlike the interest rate or
preference dividend rate, the equity dividend rate is not fixed. It is fallacious to assume equity capital to
be free of cost. As we have discussed earlier equity capital involves an opportunity cost; ordinary
shareholders supply funds to the firm in the expectation of dividends (including capital gains)
commensurate with their risk of investment. The market value of the shares determined by the demand
and supply forces in a well functioning capital market reflects the retum required by ordinary
shareholders. Thus the shareholders' required rate of return, which equates the present value of the
expected dividends with the market value of the share, is the cost of equity. The cost of external equity
could, however. be different from the shareholders' required rate of return if the issue price is different
from the market price of the share.
In practice, it is a formidable task to measure the cost of equity. The difficulty derives from two factors:
First, it is very difficult to estimate the expected dividends. Second, the future earnings and dividends are
expected to grow over time. Growth in dividends should be estimated and incorporated in the
computation of the cost of equity. The estimation of growth is not an easy task. Keeping these difficulties
in mind, the methods of computing the cost of internal and external equity are discussed below.
The cost of retained earnings determined by the dividend-valuation model implies that if the firm would
have distributed earnings to shareholders, they could have invested it in the shares of the firm or in the
shares of other firms of similar risk at the market price (Po) to earn a rate of return equal to ke. Thus, the
firm should earn a return on retained funds equal to k, to ensure growth of dividends and share price. If a
return less than k, is earned on retained earnings, the market price of the firm's share will fall. It may be
re-emphasised that the cost of retained earnings will be equal to the share- holders' required rate of return.
ILLUSTRATION 3 Suppose that the current market price of a company's share is Rs 90 and the
expected dividend per share next year is Rs 4.50. If the dividends are expected to grow at a constant rate
of 8 per cent, the shareholders' required rate of return is:
DIV1
ke = -------- + g
Po
Rs 4.50
ke = --------------+0.80 = 0.05 + 0.08 = 0.13 or 13%
Rs 90
If the company intends to retain earnings, it should at least earn a return of 13 per cent on retained
earnings to keep the current market price unchanged.
Supernormal growth Dividends may grow at different rates in future. The growth rate may be very high
for a few years, and afterwards, it may become normal indefinitely in the future. The dividend- valuation
model can also be used to calculate the cost of equity under different growth assumptions. For example, if
the dividends are expected to grow at a super-normal growth rate g" for n years and thereafter, at a
normal, perpetual growth rate of gn beginning in year n + 1, then the cost of equity can be determined by
the following formula:
n DIV0 (1+gs)t Pn
P0 = ------------------ +------------
t=1 (1 +Ke)t (1 + Ke)n
P n is the discounted value of the dividend stream, beginning in year n + 1 and growing at a constant,
perpetual rate gn' at the end of year n, and therefore it is equal to:
DIVn+1
Pn= -----------
Ke-gn
When we multiply Pn by 1/(1 + ke )n we obtain the Present value of P in Year O. Substituting
The above two Equations, we get:
The cost of equity, ke can be computed by solving the above Equation by trial and error.
ILLUSTRATION 4 Assume that a company's share is currently selling for Rs 134. Current dividend,
DIVo are Rs 3.50 per share and are expected to grow at 15 per cent over the next 6 years and then at a rate
of 8 per cent foreve. The company's cost of equity can be found out as follows:
Zero-growth In addition to its use in constant and variable growth situations, the dividend valuation
model can also be used to estimate the cost of equity of no-growth companies. The cost of equity of a
share on which a constant amount of dividend is expected perpetually is given. as follows:
DIV1
ke = ---------
Po
The growth rate g will be zero if the firm does not retain any of its earnings; that is, the firm follows a
policy of 100 per cent payout. Under such case, dividends will be equal to earnings, and therefore
Equation (13) can also be written as:
EPS1
ke = -----------
Po
which implies that/in a no-growth situation, the expected earnings-price (EJP) ratio may be used as the
measure of the firm's cost of equity.
Thus, the shareholders' required rate of return from retained earnings and external equity is the same.
The cost of external equity is, however, greater than the cost of internal equity for one reason. The selling
price of the new shares may be less than the market price. In India, the new issues of ordinary shares are
generally sold at a price less than the market price prevailing at. the time of the announcement of the
share issue. Thus, the formula for the cost of new issue of equity capital may be written as follows:
DIV1
ke= ---------- + g
Io
where Io is the issue price of new equity. The cost of retained earnings will be less than the cost of new
issue of equity if Po> Io.
ILLUSTRATION 5 The share of a company is currently selling for Rs 100. It wants to finance its
capital expenditures of Rs 1.00,000 either by retaining earnings or selling new shares. If the company
sells new shares the issue price will be Rs 95. The dividend per share next year, DIV 1 is Rs 4.75 and it is
expected to grow at 6 per cent. Calculate (i) the cost of internal equity (retained earnings) and (ii) the cost
of external equity (new issue of shares).
Rs 4.75
ke = ---------- +0.06=0.0475+0.06=0.1075 or 10.75%
Rs 100
The cost of external equity can be calculated as follow:
Rs 4.75
ke= ----------+0.06=0.05+0.06=0.11 or 11%
Rs 95
It is obvious that the cost of external equity is greater than the cost of internal equity because of
the under pricing (cost of external equity = 11 % > cost of internal equity = 10.75%).
Market prices are Rs. 1,050 for debts, Rs. 65.00 for equity shares, and Rs. 35.00 for
preference shares. Total market values are calculated as follows:
Since retained earnings have a market value closely tied to equity shares, we will allocate the
equity shares market value between equity shares and retained earnings based on book
values.
Our overall cost of capital is calculated as a weighted average based on the relative market values of
each component of capital. If market values are not available, use %’s derived from the targeted or forecasted
capital structure. If worse comes to worse, you can fall back on book values. In any event, the weighted average
cost of capital is the overall cost of capital that will be used to evaluate capital investments.
In the above graph, we have a total risk free rate of 5%. The addition of business risk increases the
required rate on shares to 10%. When we introduce debt, this adds financial risk and increases the required
return on stock. The final total rate of return on shares with all forms of risk climbs from 12% to 16% over a
range of Debt to Equity Ratios. Since the cost of capital represents the rate that must be paid to investors for the
use of long-term funds, higher risk to investors will increase the cost of capital.
TestQuestions
1. What is Cost of Capital? What is meant by 'explicit cost' and 'real cost' of capital?
2. Define the concept of 'cost of capital'. State how would you determine the weighted average
cost of capital of a company?
3. What is meant by cost of capital for a firm and what relevance does it have in decision-
making? How is it calculated for different types of sources of capital funds? Why is the cost of
capital most appropriately measured on an after tax basis?
4. What is meant by Cost of Capital? What are the components of cost of capital? What is the cost
of retained earnings? How is the cost of new equity issue determined?
5. Explain the problems faced in determining the cost of capital. How is the cost of capital
relevant in capital budgeting decisions and capital structure planning?
6. Explain critically the different approaches to the calculation of cost of equity capital.
7. Explain the various approaches for computing the cost of equity. Discuss the merits and
demerits of each.. '
8. What is the weighted average cost of capital? Explain the rationale behind the use of weighted
average cost of capital.
9. Compare the advantages and disadvantages of using marginal as opposed to historical weights
for calculating weighted average cost of capital. Which of these weights are more consistent
with the company's goal of wealth maximisation?
10. Some people regard retained earnings as a source of capital without any cost. Do you agree
with this view? State how.the cost of retained earnings should be determined.
11. 'Equity capital has also a cost.' Explaining, it discuss the methods of measuring the cost of
equity capital.
12. ABCLtd. wishes to issue 1,000,7% debentures ofRs. 100 each for which the expenses of issue
would be Rs. 5 per debenture. Find out the cost of debenture. [Ans. 7.37%]
13. A company has issued 6% debentures of Rs. 100 each at a discount of 10% repayable after 10
years. Find out the cost of debenture capital. [Ans. 7.37%]
14. rallis Ltd. has issued 1,000 equity shares of Rs. 100 each as fully paid. It has earned a profit of
Rs. 10,000 after tax. The market price of the shares is Rs. 160 per share. Find out the cost of
equity capital. [Ans. 6.25%]
Current Assets:
Cash
Working capital is just like the heart of business. It becomes weak; the business can hardly prosper and
survive. It is an index of the solvency of a concern. Its proper circulation provides to the business the right
account of cash to maintain regular flow of its operations. The following are a few advantages of adequate
working capital funds in the business:
(1) Cash Discount - If proper cash balance is maintained the business can avail of the cash discounts
facilities offered to it by the suppliers.
(2) Liquidity and Solvency - The proper administration of working capital enhances the: liquidity in
funds, solvency and credit-worthiness of the concern.
(3) Meeting Unseen Contingencies-It provides funds for un1ieen emergencies so that a business can
successfully sail through the periods of crisis.
(4) High Morale-The provision of adequate working capital improves the morale of the executives and
their efficiency leads it to higher climax.
(5) Good Bank Relations-Good relations with banks can also be maintained. The enterprise by
maintaining an adequate amount of working capital is able to maintain a sound bank credit; trade credit
and can escape insolvency
(6) Fixed Assets Productivity is Increased-Fixed assets of the firm also cannot work without proper
amount of working capital. Without it-fixed assets are like guns, which cannot shoot as there are, no
cartridges. Somebody has aptly commented that the fate of large-scale investment in fixed assets is
largely determined by the manner in which its current assets are managed.
(7) Research and Innovation Programmes-No research programme, innovation and technical
developments are possible to be undertaken without sufficient amount of working capital.
(8) Expansion Facilitated - The expansion programme of a firm is highly successful, if it is financed
through own working capital.
(9) Profitability Increased-The profitability of a concern also depends, in no small measure, on the right
proportion of fixed assets and current assets. Every activity of the business directly or indirectly affects
the current position of the enterprise; hence, its nee4is should be properly estimated and calculated.
The following diagram illustrates the difference between permanent and variable working
capital:
7.4 Factors determining Working Capital Requirement
There is no set universally applicable rule to ascertaining working capital needs of a business
organization. The factors which influence the need level are discussed below:
* Nature of business: If we look at the Balance sheet of any trading organization, we find major part of
the resources is deployed on current assets, particularly stock-in-trade. Whereas in case of a transport
organization major part of funds would be locked up in fixed assets like motor vehicles, spares and work
shed etc. and the working capital component would be negligible. The service organizations or public
utilities need lesser working capital than trading and financial organizations. Therefore, the requirement
of working capital depends upon the nature of business carried by the organization. .
*Manufacturing Cycle: Time span required for conversion pf raw materials into finished goods is a
block period. The period in reality extends a little before and after the work-in-pr6gress. This cycle
determines the need of working capital.
*Business Cycle Fluctuation: This is another factor which determines the need level. Barring
exceptional cases, there are variations in the demand for goods/services handled by any organization.
Economic boom or recession etc., have their influence on the transactions and consequently on the
quantum of working capital required.
* Seasonal Variations: Variation apart, seasonality factor creates production or even storage problem.
Muster and many other oil seeds are Rabi crops. These are to be purchased in a season to ensure
contu1UOuS operation of oil plant. Further there are woolen garments, which have demand during winter
There are three basic approaches for determining the working capital financing mix:
(A) The Hedging Approach. According to this approach, the maturity of source of funds should match the
nature of assets to be financed. That's why~ it is also known as 'Matching Approach'. It divides total
working capital requirements in two categories- permanent and temporary. The permanent working
capital requirements should be financed by long-term funds while the temporary or seasonal working
capital requirements should be financed out of short-term funds.
(B) The Conservative Approach. This approach emphasizes upon safety. According to this approach, all
requirements of working capital funds should be met from long-term sources. The short-tenn sources
should be used only during emergency times. This approach is less risky but more costly as compared to
hedging approach. It is a 'low risk, low profits' approach.
(C) Trade off Approach. Trade off approach is a mid way between the two extremes-hedging as well as
conservative approaches. However, the level of such trade off will differ from case to ease depending
upon perception of the risk by the persons involved in financial decision-making. However, one way of
determining the trade off is by finding the average of the minimum and the maximum requirements of
working capital during a period. The average working capital so obtained may be financed by long-term
funds and die balance of working capital may be financed by short-term sources.
1.Indigenous Bankers
2. Trade Credit
3. Installment Credit
4. Advances
5. Accounts Receivable Credit or Factoring
6. Accrued Expenses
7. Deferred Incomes
8. Commercial Paper
9. Commercial Banks
1. Indigenous Bankers
Private moneylenders and other country bankers used to be the only source of fmance prior to the
establishment of commercial banks. They used to charge very high rates of interest and exploited the
customers to the largest extent possible. Now a day with the development of commercial banks they have
lost their monopoly. But even today some business houses have to depend upon indigenous bankers for
obtaining loans to meet their working capital requirements.
2. Trade Credit
Trade credit refers to the credit extended by the suppliers of goods in the normal course of business. As
present day commerce is built upon credit, the trade credit arrangement of a firm with its suppliers is an
important source of short-term fmance. The credit-worthiness of a firm and the confidence of its suppliers
are the main basis of securing trade credit. It is mostly granted on an open account basis whereby supplier
sends goods to the buyer for the payment to be received in future as per terms of the sales invoice. It may
also take the form of bills payable whereby the buyer signs a bill of exchange payable on a specified
future date.
When a firm delays the payment beyond the due date as per the terms of sales invoice, it is called
stretching accounts payable. A firm may generate additional short-term finances by stretching accounts
payable, but it may have to pay penal interest charges as well as to forgo cash discount. If a firm delays
the payment frequently, it adversely affects the credit worthiness of the f1rDl and it may not be allowed
such credit facilities in future.
The main advantages of trade credit as a source of short-term finance include:
(i) It is an easy and convenient method of finance.
(ii) It is flexible as the credit increases with the growth of the firm.
(iii) It is informal and spontaneous source of finance.
However, the biggest disadvantage of this method of fmance is charging of higher prices by the suppliers
and loss of cash discount.
3. Instalment Credit
This is another method by which the assets are purchased and the possession of goods is taken
immediately but the payment is made in installments over a pre-determined period of time. Generally,
interest is charged on the unpaid price or it may be adjusted in the price. But, in any case, it provides
funds for sometime and is used as a source of short-term working capital by many business houses, which
have difficult fund position.
4. Advances
Some business houses get advances from their customers and agents against orders and this source i
short-term source of finance for them. It is a cheap source of finance and in order to minimize their
investment in working capital, some firms having long production cycle, specially the firms
manufacturing industrial products prefer to take advances from their customers.
5. Factoring or Accounts Receivable Credit
Another method of raising short-term finance is through accounts receivable credit offered I commercial
banks and factors. A commercial bank may provide finance by discounting the bills or invoices of its
customers. Thus, a firm gets immediate payment for sales made on credit. A factor is a financial
institution, which offers services relating to management and financing of debts arising out of credit sales.
Factoring becoming popular allover the world on account of various services offered by the institutions
engaged in it. Factors render services varying from bill discounting facilities offered by commercial banks
to a total take over of administration of credit sales including maintenance of sales ledger, collection of
accounts receivables, credit control and protection from bad debts, provision of fmance and rendering of
advisory services to their clients Factoring may be on a recourse basis, where the risk of bad debts is
borne by the client, or on a non-recourse basis, where the risk of credit is borne by the factor.
At present, only only a few financial institutions on a recourse basis render factoring in India. However,
the Report of the Working Group on Money Market (Vaghul Committee) constituted by the Reserve Bank
of India has recommended that banks should be encouraged to set up factoring divisions to provide
speedy finance to the corporate entities.
In spite of many services offered by factoring, it suffers from certain limitations. The most critical fallouts
of factoring include; (i) the high cost of factoring as compared to other sources of short-term finance, (ii)
the perception of financial weakness about the firm availing factoring services, and (iii) adverse impact of
tough stance taken by factor, against a defaulting buyer, upon the borrower resulting into reduced future
sales.
6. Accrued Expenses Accrued expenses are the expenses which have been incurred but not yet due and
hence not yet paid also. These simply represent a liability that a firm has to pay for the services already
received by it. The most important items of accruals are wages and salaries, interest, and taxes. Wages and
salaries are usually paid on monthly, fortnightly or weekly basis for the services already rendered by
employees. The longer the payment-period, the greater is the amount of liability towards employees or the
funds provided by them. In the same manner, accrued interest and taxes also constitute a short-term
source of fmance. Taxes are paid after collection and in the intervening period serve as a good source of
finance. Even income tax is paid periodically much after the profits have been earned. Like taxes, interest
is also paid periodically while a firm uses the funds, continuously. Thus, all accrued expenses can be used
as a source of finance.
The amount of accruals varies with the change in the level of activity of a firm. When the activity level
expands, accruals also increase and hence they provide a spontaneous source of fmance. Further, as no
interest is payable on accrued expenses, they represent a free source of fmancing. However, it must be
noted that it may not be desirable or even possible to postpone these expenses for a long period.
Provisions of law and practice in industry determine the payment period of wages and salaries. Similarly,
law governs the payment dates of taxes and delays may attract penalties. Thus, we may conclude that
frequency and magnitude of accruals is beyond the control of managements. Even then, they serve as a
spontaneous, interest free, limited source of short-term financing.
7. Deferred Incomes
Deferred incomes are incomes received in advance before supplying goods or services. They represent
funds received by a firm for which it has to supply goods or services in future. These funds increase the
liquidity of a firm and constitute an important source of short-term finance. However, firm having great
demand for its products and services, and those having good reputation in the market can demand
deferred incomes.
8. Commercial Paper
Commercial paper represents unsecured promissory notes issued by firm to raise short-term funds. It is an
important money market instrument in advanced countries like U.S.A. In India, the Reserve Bank of India
introduced commercial paper in the Indian money market on the recommendations of the Working Group
on Money Market (Vaghul Committee). But only large companies enjoying high credit rating and sound
financial health can issue commercial paper to raise short-term funds. The Reserve Bank of India has laid
down a number of conditions to determine eligibility of a company for the issue of commercial paper.
Only a company, which is listed on the stock exchange, has a net worth of at least Rs. 10 crores and a
maximum permissible bank finance of Rs. 25 crores can issue commercial paper not exceeding 30 per
cent of its working capital limit.
The maturity period of commercial paper, in India, mostly ranges from 91 to 180 days. It is sold at a
discount from its face value and redeemed at face value on its maturity. Hence, the cost of raising funds,
through this source, is a function of the amount of discount and the Reserve Bank of India provides the
period of maturity and no interest rate for this purpose. Investors including banks, insurance companies,
unit trusts and firm to invest surplus funds for a short period usually buy commercial paper. A credit
rating agency, called CRISIL, has been set up in India by ICICI and UTI to rate commercial papers.
Commercial paper is a cheaper source of raising short-term finance as compared to the bank credit and
proves to be effective even during period of tight bank credit. However, only large companies enjoying
high credit rating and sound fmancial health can use it as a source of fmance. Another disadvantage of
commercial paper is that it cannot be redeemed before the maturity date even if the issuing firm has
surplus funds to pay back.
9. Working Capital Finance By Commercial Banks
Commercial banks are the most important source of short-term capital. The major portion of working
capital loans is provided by commercial banks. They provide a wide variety of loans tailored to meet the
specific requirements of a concern. The different forms in which the banks normally provide loans and
advances ; are as follows:
(a) Loans
(b) Cash Credits
(c) Overdraft.,
(d) Purchasing and Discounting of bills.
(a) Loans. When a bank makes an advance in lump sum against some security it is called a loan. In case
of a loan, the bank to the customer sanctions a specified amount. The entire loan amount is paid to the
borrower either in cash or by credit to his account. The borrower is required to pay interest on the entire
amount of the loan from the date of the sanction. A loan may be repayable in lump sum or installments.
Interest on loans is calculated at quarterly rests and where repayments are stipulated in installments, the
interest i~ calculated at quarterly rests on the reduced balances. Commercial banks generally provide
short-term loans up to one year for meeting working capital requirements. But banks also provide now-a-
days term loans exceeding one year. The term loans may be either medium-term or long-term loans.
(b) Cash Credits. A cash credit is an arrangement by which a bank allows his customer to borrow money
up to a certain limit against some tangible securities or guarantees. The customer can withdraw from his
cash credit limit according to his needs and he can also deposit any surplus amount with him. The interest
in case of cash credit is charged on the daily balance and not on the entire amount of the account. For
these reasons, it is the most favourite mode of borrowing by industrial and commercial concerns. The
Reserve Bank of India issued a directive to all scheduled commercial banks on 28th March 1970,
prescribing a commitment charge, which banks should levy on the unutilized portion of the credit limits.
(c) Overdrafts. Overdraft means an agreement with a bank by which a current account-holder is allowed
to withdraw more than the balance to his credit up to a certain limit. There are no restrictions for
operation of overdraft limits. The interest is charged on daily overdrawn balances. The main difference
between cash credit and overdraft is that overdraft is allowed for a short period and is a temporary
accommodation whereas the cash credit is allowed for a longer period. Overdraft accounts can either be
clean overdrafts, partly secured or full secured.
(d) Purchasing and Discounting of Bills. Purchasing and discounting of bills is the most important form in
which a bank lends without any collateral security. Present day commence is built upon credit. The seller
draws a bill of exchange on the buyer of goods on credit. Such a bill may be either a clean bill or a
documentary bill, which is accompanied by documents of title to goods such as a railway receipt. The
bank purchases the bills payable on demand and credits the customer's account with the amount of bill
less discount. At the maturity of the bills, bank presents the bill to its acceptor for payment. In case the
bill discounted is dishonoure4 by non-payment, the bank recovers the full amount of the bill from the
customer along with expenses in that connection.
7.8 Control of Working Capital
The availability of bank credit to industry has been a subject-matter of regulation and control in the recent
years keeping in view the basic objective of ensuring its equitable distribution to various sectors of the
Indian economy. Reports submitted by four important committees are significant in this respect. They are
(i) Dehejia Committee Report, 1969.
(ii) Tandon Committee Report, 1975.
(iii) Chore Committee Report, 1980.
(iv) Marathe Committee Report, 1984.
(v) Chakravaty Committee Report, 1985
(vi) Kannan Committee Report, 1997
Recommendations. The report submitted by the Tandon Committee is a landmark in the history of
financing of working capital by commercial banks in India. The report was submitted on 9th August 1975.
The report included recommendations covering all aspects of lending. The recommendations were
essentially based on three principles:
(i) A proper financial discipline has to be observed by the borrower. He should supply to the banker
information regarding his operational plans well in advance. The banker must carry out a realistic
appraisal of such plans.
(ii) The main function of a banker as a lender is to supplement the -borrower's resources to carry an
acceptable level of current assets. This has two implications: (a) the level of current assets must be
reasonable and based on norms and (b) a part of funds 'requirement for carrying out current assets must be
found from long-term funds.
(iii) The bank should know the end-use of bank credit so that it is used only for purposes for which it is
made available.
The salient features of the recommendations of the committee are being summarised below:
(1) Fixation or norms. An important feature of the Tandon Committee's recommendations relate to
fixation of norms for bank lending to industry. These norms can be divided into two categories.
(i) Inventory and receivables norms. The committee has suggested norms for 15 major industries. The
norms proposed represent the maximum level for holding inventories and receivables. They pertain to the
following:
(i) Raw materials including stores and other items used in the process of manufacture.
(ii) Stocks in process.
(iii) Finished goods.
(iv) Receivables and bills discounted and purchased.
The norms have been worked out according to "the time element". Raw materials
are expressed as so many month's consumption. Stock-in-process are expressed as so many
months' cost of production. Finished goods and receivables are expressed as so many months' cost of
sales and sales respectively.
(ii) Lending norms. The recommendation of the Tandon Committee regarding the "lending norms" has
far-reaching implications. The lending norms have been suggested in view of this realization that the
banker's role as a lender is only to supplement the borrower's resources and not to meet his entire working
capital needs. In the context of this approach, the Committee has suggested three alternative methods for
working out the maximum permissible level of bank borrowings. Each successive method reduces the
involvement of short-term ba:1k credit to finance the current assets.
3. Chore Committee Report, 1980 Having implemented the recommendations of the Tandon
Committee, the Reserve" Bank of India in March, 1979, appointed another committee under the
chairmanship of Shri K.B. Chore. Chief Officer, Department of Banking Operations and Development,
Reserve Bank of India. This Committee was asked to review the working of cash credit system in recent
years with particular reference to the gap between sanctioned limits and the extent of their utilization, It
was also asked to suggest alternative type of credit facilities which should ensure greater credit discipline
and enable the banks to relate credit limits to increase in output or other productive activities.
Recommendations. The important recommendations of the Committee are as follows:
(i) Periodical review of limits. The existing system of three types of lending, namely cash credits, loans
and bills should continue. But wherever possible, the use of cash credit should be supplemented by the
use of loans and bills. The Committee further advised the commercial banks to streamline the existing
cash credit system and also undertake, invariably, a periodical review of the limits already in vogue under
the system. For this purpose, the bank should strictly ensure that review of all the borrower accounts
enjoying working capital credit limits of Rs. 10 lakhs and above from the banking system is made at least
once a year.
(ii) No bifurcation of cash credit accounts. The Reserve Bank's earlier instructions to banks to bifurcate
the cash credit accounts (as per recommendations of the Tandon Study Group) into demand loan
component and cash credit portion and to maintain differential interest rates between these two
components have been withdrawn.
(iii) Separate limits for peak level and non-peak level requirements. The banks have been asked to fix
separate credit limits wherever feasible for the normal non-peak level and for peak-level credit
requirements indicating the periods during which the separate limits would be utilized by the borrowers.
If, however, there is no pronounced seasonal trend, peak-level and normal requirements should be treated
as identical and limits should be fixed on that basis.
Within the limits sanctioned for peak-level/non-peak-level periods, the borrowers should indicate before
the commencement of each quarter the requirements of funds during that quarter (i.e., the operative limit).
The statement so submitted by the borrower should form the basis for quarterly review of the accounts.
The operative limit indicated by the borrower should virtually set the level of drawings in that quarter
subject to a tolerance limit of 10% either way. Excess or under utilization of the operative limit beyond
the tolerance level should be considered as an irregularity in the account indicative of defective planning
by the borrower and the banks should initiate necessary corrective steps, in concert with the borrowers, to
prevent the recurrence of such irregularities in future.
(iv) Submission of quarterly statements. The quarterly statements should be submitted by all borrowers
having working capital limits of Rs. 50 lakhs and above from the entire banking system in place of the
present limit of Rs. 1 crore. In case of default banks were permitted to char6~ penal interest of 1 % p.a. on
the total outstanding for the period of default.
(v) No frequent sanction of temporary limits. Borrowers should be discouraged from approaching
banks frequently for ad hoc or temporary limits in excess of sanctioned limits to meet unforeseen
contingencies. Request for such limits should be considered very carefully and should be allowed only for
predetermined short durations and given through separate demand loan "non-operable" cash credit
account.
(vi) Reduction in overdependence of bank credit. The over dependence on bank credit by
medium/large borrowers is sought to be reduced by requiring them to enhance their contribution towards
working capital. For this purpose, in assessing the maximum permissible bank finance, banks should
hereafter adopt the second method of lending as recommended by the Tandon Committee, according to
which the borrower's contribution from his own funds and term finance to meet the working capital
requirements should be equal to at least 25 per cent of the total current assets.
4. Marathe Committee’s Report
This Committee was appointed by R.B.I. in October, 1982 to review the working of Credit Authorization
Scheme (CAS) from the point of view of operational aspects. The Committee submitted its report in July
1983, which was accepted by R.B.I. with some modifications w.e.f. April 1, 1984. The chief plank of the
recommendations is the concept of 'FAST TRACK' which implies that subject to fulfillment of some
conditions, as given below, the banks can release, without prior approval of R.B.I., 50% of the additional
credit required by borrowers, falling out of the ambit of the CAS, as a result the disbursement of credit is
faster or running on the 'FAST TRACK' than it would have been otherwise. The condition to be complied
with by a borrower is as follows:
(1) Reasonableness of estimate/projections in regard to sales, chargeable current ~ assets, current
liabilities (other than bank borrowings) and net working capital.
(2) Classification of current assets and current liabilities in conformity with the guidelines issued by
R.B.I.
(3) Maintenance of minimum current ratio of 1.33 : 1.
(4) Prompt submission of operating statements.
It is to be ensured that the following periodical statements have been submitted: by the borrower during
the last six months within the prescribed time frame:
(i) Quarterly Information System: Form I. Estimates of current assets and current liabilities (including
short-term bank borrowings) for the ensuring quarter is to be submitted in the week preceding the
commencement of the quarter to which the statement relates.
(ii) Quarterly Information System: Form II. Statement showing the performance for the previous quarter
with current assets and current liabilities to be submitted within six weeks from the close of the quarter to
which the statement relates.
(iii) Half-yearly Operating and Funds Flow Statements: Form III. To be submitted " within two months
from the close of the half-year.
(5) Submission of annual accounts by the borrower to the bank regularly and promptly. Further the bank
is required to review the borrower's account at least once a year.
While forwarding the FAST TRACK cases to RBI, a certificate is to be forwarded by an officer of the
applicant bank.
5.Chakravarty Committee Report
The Reserve Bank of India appointed another committee under the chairmanship of Sukhamoy
Chakravarty to review the working of the monetary system of India. The committee submitted its
report in April 1985. The committee made two major recommendations in regard to the working
capital finance:
(i) Penal Interest for Delayed Payments
The committee has suggested that the government must insist that all public sector units, large
private sector units and government departments must include penal interest payment clause in
their contracts for payments delayed beyond a specified period. The penal interest may be fixed at
2 per cent higher than the minimum lending rate of the supplier's bank.
(ii) Classification of Credit Limit Under Three Different Heads
The committee further suggested that the total credit limit to be sanctioned to a borrower should
be Iii considred under three different heads: (1) Cash Credit I to include supplies to government,
(2) Cash Credit II to cover special circumstances, and (3) Normal Working Capital Limit to cover
the balance credit facilities. The interest rates proposed for the three heads are also different.
Basic lending rate of the bank should be charged to Cash Credit II, and the Normal Working
Capital Limit be charged as below:
(a) For Cash Credit Portion : Maximum prevailing lending rate of the bank.
(b) For Bill Finance Portion : 2% below the basic lending rate of the bank.
(c) For Loan Portion :The' rate may vary between the minimum and
maximum lending rate of the bank.
6. Kannan Committee Report
In view of the ongoing liberalization in the financial sector, the Indian Banks Association (IBA)
Constituted a committee headed by Shri K. Kannan, Chairman and Managing Director of Bank of Baroda
to examine all the aspects of working capital finance including assessment of maximum permissible bank
finance (MPBF). The Committee submitted its report on 25th February 1997. It recommended that the
arithmetical rigidities imposed by Tandon Commit Lee (and reinforced by Chore Committee) in the form
of MPBF computation so far been in practice, should be scrapped. The Committee further recommended
that freedom to each bank be given in regard to evolving its own system of working capital finance for a
faster credit delivery so as to serve various borrowers more effectively. It also suggested that line of credit
system (LCS), as prevalent in many advanced countries, should replace the existing system of
assessment/fixation of sub-limits within total working capital requirements. The Committee proposed to
shift emphasis from the Liquidity Level Lending (Security Based Lending) to the Cash Deficit Lending
called Desirable Bank Finance (DBF). The Reserve Bank of India with has already accepted some of the
recommendations of the committee suitable modifications. The important measures adopted by RBI in
this respect are given below:
(i) Assessment of working capital finallced based on the concept of MPBF, as recommended by Tandon
Committee, has been withdrawn. The banks have been given full freedom to evolve an appropriate system
for assessing working capital needs of the borrowers within the guidelines and norms already prescribed
by Reserve Bank of India.
(ii) The turnover method may continue to be used as a tool to assess the requirements of small borrowers.
For small scale and tiny industries this method of assessment has been extended up to total credit limits of
Rs. 2 Crore as against existing limit of 1 crore.
(iii) Banks may now adopt Cash Budgeting System for assessing the working capital finance in respect of
large borrowers.
(iv) The banks have also been allowed to retain the present method of MPBF with necessary modification
or any other system as they deem fit.
(v) Banks should Jay down transparent policy and guidelines for credit despensation in respect of each
broad category of economic activity.
(vi) The RBI's instructions relating to directed credit, quantitative limits on lending and prohibitions of
credit shall continue to be in force. The present reporting system to RBI under the Credit Monitoring
Arrangement (CMA) shall also continue in force.
TEST QUESTIONS
A. Objective Type
1. Fill in the gaps:
(i) Net working capital is the excess of………. over ……….;
(ii) Working capital is also known as………….. or………….. , capital.
(iii) The gross working capital is…………. a concern concept.
(iv) The rate of return on investments…………. with the shortage of working capital.
(v) Greater the size of a business unit………… will be the requirements of working capital.
[Ans. (i) Current Assets. Current Liabilities; (ii) revolving. Circulating; (iii) going; (iv) falls; (v) larger]
EXERCISES
1. Traders Ltd. are engaged in large scale retail business. From the following information. You are
requircd to forecast their working capital requirements :
Projected annual sales Rs. 130lakhs
Percentage of Net Profit on Cost of Sales 25%
Average credit period allowed to debtors 8 weeks
Average credit period allowed by creditors 4 weeks
Average stock carrying (in terms of sales requirements) 8 weeks
Add: 10% to computed figures to allow for contingencies.
[Ans. Rs. 26.40 lakhs]
2. The following information has been submitted by a borrower:
(i) Expected level of production 1,20.000 units
(ii) Raw materials to remain in stock on an average 2 months
(iii) Processing period for each unit of product 1 month
(iv) Finished goods remain in stock on an average 3 months
(v) Credit allowed to the customers from the date of dispatch 3 months
(vi) Expected ratios of cost to selling price :
(a) Raw materials-60% (b) Direct wages-IO% (c) Overheads -20%
(vii) Selling price per unit Rs. 10
(viii) Expected margin on sale 10'%
You are required to estimate the working capital requirements of the borrower.
[Ans. Rs. 7.50.000]
Chapter 8 Management Of Earnings
8.1 Introduction
The term management of earnings means how the earnings of a firm are utilised, i.e. how much i to the
shareholders in the form of dividends and how much is retained and ploughed back in the business way
the companies apportion their earnings between-dividends and retention is known as management of
earnings.
In the words of Gerstenberg,'Management of income, in its broadest sense, includes the management of
each phase of the company’s business because, the minutest activity of the business usually involves in,
or expenditure."
Management of earnings is all important tool of business administration. In case of joint stock companies
where ownership and management are in different hands, management of earnings assumes special
importance, Companies, usually, do not distribute the entire amount of earnings to the shareholders in the
form of dividends, but retain a part of it for the future expansion and growth to bear the future risks. A
well established policy regarding management of earnings must be formulated to secure the maximum
benefits to the body corporate and its owners. The prime criterion in this regard is the effect of its policy
decision on the value of the firm, viz, the cost of capital, its growth and the market price of its shares. A
company that pays regular dividends and steadily arguments its future earnings capacity through retention
commands respectable position in the market, Creation of ill planned reserves, unsound depreciation
policy and absence of internal financial control measures are the symbols of defective management of
earnings and may lead to the liquidation of the firm.
The excess of revenues earned over expenses incurred for earning that revenue is known as profits,
Income statement or profit and loss account is prepared to determine the profits. The determination of
correct profits is of immense significance due to the following:
(i) for correct reporting to the shareholders;
(ii) for declaration of dividends, the amount and trend of earnings or profits is the starting point;
(iii) for ascertaining the operating efficiency of the company;
(iv) for deciding about the future expansion and growth ;
(v) for ascertaining the intensive use of capital ;
(vi) for determining creditworthiness of the firm ;
(vii) for payment of correct taxes;
(viii) for determining the basis of mergers and amalgamations; and
8.2.2 Surplus: Meaning and Importance
There are different views regarding the meaning and concept of surplus. According to one school of
thought, the balance remaining after deducting the liabilities and share capital from the total of assets is
known as 'surplus'. In the opinion of the other school, 'surplus' represents the 'undistributed earnings' of a
company, i.e., the balance of profits remaining after paying dividends to the shareholders. Still, there are
others in whose opinion 'surplus' is a left over which represents an addition to assets that is carried over
on the 'equity side'. But, surplus is solely equity of stock-holders and not an asset in any sense of the
word. In simple words, 'surplus' may be described as the net income of the company remaining after
payment of dividend and all other expenses. It is the difference between the book value of the assets and
the sum of liabilities and capital.
Surplus is considered to be a sort of a blanket covering of many corporate purposes. It is not merely a
source of dividend, but has various other functions as well. It is regarded as a welcome sign by the
management. It reflects upon the sound earning capacity of a firm. It enables a company to follow a stable
dividend policy. A company can pay stable dividends even in the years when there are no sufficient
profits. Surplus acts as a cushion to absorb the shocks of economy and business such as depression for the
company. A company with large surplus can withstand the shocks of trade cycles and the uncertainty of
the market with comfort, preparedness and economy.
8.2.2.1 Kinds And Sources of Surplus
The various kinds of surplus and their sources are discussed as below:
1. Earned surplus. In the mind of a layman, surplus always implies earned surplus. The use of the term
surplus as accumulation of past earnings accounts for its common identification with earned surplus. The
main sources of earned surplus are:
Sometimes the companies hide their surplus for the various reasons, such as:
In general, the term 'reserve' refers to the amount set aside out of profits. The amount may be set aside
to cover any liability, contingency, commitment or depreciation in the value of assets. Reserves mean,
therefore, amounts, which belong to the owners over and above, the capital contributed by them. If
amounts equal to reserves are invested in outside investments, the reserve is called 'Reserve Funds'.
Technically speaking, the amount set aside out of profits may be either (i) a 'provision' or (ii) a’ reserve.
A 'provision' means amount set aside as a charge against profits to meet:
(a) depreciation, renewals or diminution in the value of assets; and
(b) any known liability the amount of which cannot be known as yet, e.g., provision for doubtful debts,
provision for repairs, etc.
The term 'reserve' also includes other surpluses, which are not designed to meet any known liability,
contingency, commitment or diminution in the value of assets. Such a reserve is not a charge against
profits, but an appropriation of profits. In the modem days, the term reserve is used only in connection
with a restriction on, or appropriation of retained earnings. Such an appropriation is made on account of
the following:
(i) to prevent the distribution of surplus in the form of dividends;
(ii) to provide additional capital, i.e., ploughing back of profits;
(iii) to provide for rainy days;
(iv) to enable equalisation of dividends; and
(v) to supplement other reserves
The 'Ploughing Back of Profits' is a technique of financial management under which all profits of a
company are not distributed amongst the shareholders as dividend, but a part of the profits is retained or
reinvested in the company. This process of retaining profits year after year and their utilisation in the
business is also known as ploughing back of profits.
It is actually an economical step, which a company takes, in the sense, that instead of distributing the
entire earnings by way of dividend, it keeps a certain percentage of it to be re-introduced into the business
for its development. Such a phenomenon is also known as 'Self-Financing’; 'Internal Financing’; or
'Inter- Financing'. A part of profits is ploughed back or re-employed into the business and is regarded as
in ideal source of financing expansion and modernisation schemes as there is no immediate pressure to
pay a return on this portion of stockholders' equity. Under this method, a part of total profits is transferred
to various reserves such as General Reserve, Replacement Fund, Reserve Fund, and Reserve for Repairs
and Renewals, etc. Sometimes 'secret reserves' are also created without the knowledge of the
shareholders. From all the practices of financial management, this system of ploughing back of profits is
considered desirable as it helps in the financial and economic stablisation of the concern.
It is sometimes argued that retained earnings do not involve any cost because a firm is not required to pay
dividends on retained earnings. However, the shareholders expect a return on retained profits. Retained
earnings accrue to a firm only because of some sacrifice made by the shareholders in not receiving the
dividends out of the available profits. The cost of retained earnings may be obtained by investing the
after-tax dividends in alternative opportunity of equal qualities. It is, thus, the opportunity cost of
dividends foregone by the shareholders. Cost of retained earnings can be computed with the help of
following formula:
K = D + Gr
NP
where, K, = Cost of retained earnings
D = Expected dividend
NP = Net proceeds of share issue
G = Rate of growth
Further, it is important to note that shareholders, usually, cannot obtain the entire amount of retained 1
profit by way of dividends even if there is 100per cent pay-out ratio. It is so because the shareholders are l
required to pay tax on their dividend income. So, some adjustment has to be made for tax. However, tax
adjustment in determining the cost of retained earnings is a difficult problem because all shareholders do
not I fall under the same tax bracket. Moreover, if the shareholders wish to invest their after-tax dividend
income in alternative securities, they may have to incur some costs of purchasing the securities such as
brokerage. Hence, the effective rate of return realised by the shareholders from the new investment will
be somewhat lesser than their present return from the firm. To make adjustment-in the cost of retained
earnings for tax and costs of purchasing new securities, the following formula may be adopted:
WHAT IS DIVIDEND PROBLEM Dividend is the amount paid out to the shareholders out of the
earnings for equity shareholders. That part of the total earnings, which is not paid out as dividend, is the
retained earnings (RE), which is ploughed back or reinvested in the business. The higher the amount of
dividend, the lower the RE and vice versa. Retained profit increases the long-term capital base of the
company and thus increases the potential of future earning capacity. On the other hand, the higher the
dividend, the higher the earnings of the equity shareholders at present. The question is what is the trade-
off between present earnings and higher future earnings; what is the optimum dividend policy. As in other
matters, that dividend policy is optimum, which maximises the net wealth of equity shareholders. The
issue before dividend policy is to determine the best distribution of profit between dividend per share
(DPS) and retained earnings per share (RES). There are a number of models all of which revolve around
the question: how does dividend affect market value of equity shares. These are:
I) Earnings capitalisation model
2) Walter's model.
3) Gordon's model
4) Graham and Dodd model:
8.4.1 Earnings capitalisation model
Under the approach:
Market value (MY) per equity share = EPS or DPS + RES
ke ke
It is clear that under this approach, dividend has no effect on market value (MY) of equity shares as
shown in illustration 1 below.
Illustration 1. EPS = Rs. 4, ke = 10%, calculate market value per equity share under 3 dividend, payout
ratios (DP ratios) namely 25%, 50% and 75%.
Solution. . The required market values per share will be as follows:
(DP ratio 25%) MV per equity share = DPS + RES = Re. I + Rs. 3 = Rs.40
ke 10%
Thus under this model, dividend cannot affect market value of equity shares.
This model slightly modifies the Earnings Capitalisation approach for valuation of equity shares as
follows:
Market value per equity share = DPS + (RES X AR/NR)
ke
(4.3) When AR = NR, higher dividend would have the effect of reducing the total earnings of the equity
shareholders. With increased dividend, the shareholders would get more cash as dividend and if they
reinvest it in the companies earnings normal rate actual rate of the company, it would reduce the total
earnings of the equity shareholders. Therefore, the market value per equity share decreases.
8.4.3 Gordon's Model (continuing dividend growth valuation model)
Under this model, market value per equity share is affected by:
(a) current dividend per share (DPS)
(b) expected increase in dividend per share.
This model regards that retained earnings, RE, is a growth factor i.e. RE invested now increases the future
DPS. RE by itself is not involved but only its expected future earnings affect DPS.
Definition of terms
(1) CR act or AR = actual capitalisation rate = E/P ratio
= EPS
MV/equity share
Illustration 3 :
5% 50%
10% 50%
10% 60%
Calculate the growth factors.
Solution
Growth factor (first case) = CRact (5%) x RE (50%) = 2.5%
Growth factor (second case) = 10% x 50% = 5%
Growth factor (third case) = 10% x 60% = 6%
Illustration 4: A company has 10% CR act dividend payout ratio = 50% and present dividend
per share = Re. 1. Normal capitalisation rate = 12%. Find the market value per equity share under
Gordon's model. :
Illustration 5: X Ltd. has dividend per share of Rs. 1.50, earnings per share = Rs. 3, normal P/E ratio is
20. Find the market value per equity share.
c) the balance of reserves after such drawl shall not fall below 15% of the paid up capital.
d) Dividends cannot be declared for past years for which accounts have been closed.
e) Dividends cannot be declared out of reserves created by revaluation of assets.
8.5.8 Procedural aspects
The payment of dividend requires the following procedural formalities:
a) Approval of the Board of Directors by a resolution in a formal meeting.
b) The resolution of the Board should be approved by the shareholders in the Annual General Meeting.
c) The dividend is payable only to members whose names appear in the Register of Members on the
record date.
d) Once the dividend is declared, the dividend warrants must be posted within 42 days. Within 7 days
after the expiry of 42 days, the unpaid dividends should be transferred to a special account opened with a
scheduled bank. Any amount remaining unpaid or unclaimed for three years from the date of transfer shall
be transferred to the general revenues of the central government, and such shareholders may prefer their
claim directly to the Government.
8.5.9 Bonus Shares
Bonus shares (or stock dividends in US parlance) are shares issued to existing shareholders as a result of
capitalisation of reserves (including share premium account). In the wake of a bonus issue, the
shareholders proportionate ownership remains unchanged. The book value per share. The EPS and the
market price per share will decrease, but the number of shares (stock outstanding) will increase.
The underlying reasons for issue of bonus shares are as follows:
a) The accumulated reserves created out of transfers from profits earned represent an increase in the
shareholder’s wealth, which legitimately, belongs to them.
b) The bonus issue tends to bring the market price per share within a realistic range.
c) It increases the number of shares outstanding, and promotes more active trading.
d) The nominal rate of dividend decreases, which dispels the impression of profiteering from the minds of
the public at large. ,
e) The bonus issue decision is taken consciously only when the management feels confident about
"servicing" the increased equity, i.e. maintaining the rate of dividend in the long run, and hence
shareholders regard the bonus issue as an indication of the financial health of the company.
t) The issue of bonus shares can be a prelude to issue of convertible debentures when the firm is ready
with attractive investment opportunities.
The important regulatory provisions governing the issue of bonus shares are as follows:
a) The bonus issue can be made only out of free resources built up out of genuine profits, or share
premium collected in cash.
b) The residual reserves after proposed capitalisation shall be at least 40% of the increased paid up
capital.
c) 30% of the average profits before tax of the company for the previous three years should yield a rate of
dividend on the expanded capital base of the company of not less than 10%.
Chemical "Our dividend policy is to pay a fixed rate of dividend and issue bonus shares when we
are eligible to. The purpose is to ensure that shareholders retain shares to enjoy capital
gains."
Automobile "We like to maintain a dividend rate of 15 per cent. This seems to be a fair return to
investors."
Shipping "In the past when the going was good, we paid good dividends and issued bonus shares
periodically. The last few years were rough. We had to suspend dividend for some time.
We are now recovering. We will try to follow the past policies, provided business
conditions are good."
Leasing "We would like to declare as high a dividend as we can. If share prices rise due to that,
we can raise relatively easily more funds by issuing convertible debentures."
Diversified "We regard shareholders as partners. They deserve handsome returns. We give good
dividend and periodic bonus issues."
Diversified "We have a very conservative dividend policy. Our dividend rate, which used to be 10 per
cent four years ago, has now been raised to 15 per cent. We won't probably consider a
change for the next few years." '.
Truck' "The company follows a conservative dividend policy which aims at protecting the
interests of the shareholders and the company by (a) providing a consistent and
reasonable return to the shareholders, and (b) ploughing back profits to take care of
contingencies and to improve the equity base."
Pharmaceuticals "We distribute about 30 per cent of our earnings. We maintain our dividend around 18
Percent. When the reserves position permits and the earnings potential justifies, we issue
bonus shares."
Diversified "We don’t have a specific dividend policy. When the profits are good and liquidity
satisfactory we give 12% to 15% as dividends."
Textiles "Due to drop in profits we have skipped dividends. We will try to restore it- when I don't
know." '
Storage "We have been paying steadily about 20 per cent as dividends. Batteries Of course, our
bonus record is poor. In the foreseeable future there may be very little change."
Diversified "The investor is the king. Unless he is rewarded, we can't get the funds for our growth.
So, we try to benefit him by dividends, bonus issues, and rights issue."
Consumer "We paid good dividends as profits were high, We will try to maintain the Electronics
same. Of course, profitability will be the key factor."
Diversified "We have, if you permit me to say, an obsession with 20 per cent dividend rate. We don't
want to raise it to 25 per cent or 30 per cent as this connotes super profits--but we would
like to' declare bonus shares. Our planning revolves around this compelling goal-
dominant goal."
Some Types.
On the basis of the above responses we find that most of the firms pursue three types of policies:
1. Generous Dividend and Bonus Policy Firms, which follow these policy reward shareholders
generously by stepping up total dividend payment over time. Typically, these firms maintain the dividend
rate at a certain level (15 to 25 per cent) and issue bonus shares when the reserves position and earnings
potential permit. Such firms naturally have a strong shareholder orientation.
2. More or Less Fixed Dividend Po/icy Some firms have a target dividend rate, which is usually in the
range 10 per cent to 20 per cent which they consider as a reasonable compensation to equity shareholders.
Such firms normally do not issue bonus shares. Infrequently, may be once in few years, the dividend rate
may be raised slightly to provide somewhat higher compensation to equity shareholders to match the
higher returns from other forms of investment.
3. Erratic Dividend Po/icy Firms, which follow this dividend policy, seem to be indifferent to the welfare
of equity shareholders. Dividends are paid erratically whenever the management believes that it will not
strain its resources.
TEST QUESTIONS
9.1 Introduction
THE PRIMARY TASK OF A LENDING INSTITUTION BEFORE GRANTING A TERM LOAN IS TO
assure itself that the anticipated rise in the income of the borrowing unit would materialise, thus providing
the necessary funds for repaying the loans according to the terms of amortization. The liquidity of term
loans depends not so much on the short-run sale ability of the goods and commodities as on the increased
Term loan income of borrowing units resulting from a higher level of utilisation of existing installed
capacity. For assessing the risks involved in term lending, the normal criteria used for judging the
soundness of short-term loans are often unreliable and inadequate. The methods of analysis and the
standard to be adopted for appraisal of term loans are more similar to investment decisions than to short-
term lending. Appraisal of term-loans requires a dynamic approach involving, inter alia, a projection of
future trends of output, sales, and estimates of costs, returns and flow of funds. Appraisal of term loans
depends to a large extent on estimates of forecasts. Its purpose is not to set down a categorical statement
of the long-range prospects of an industrial unit but only to provide broad guide outlines to the financial
institutions.
The practice of making an appraisal of term loan applications on modern scientific lines has not made
much progress in India. This is partly due to the fact that mainly the larger banks give such loans to
highly credit-worthy constituents and hence no elaborate enquiry is considered necessary. The need for
such appraisals is now being increasingly felt with the expansion of term lending. There cannot be a fixed
or standardised approach to appraisal. Numerous and diverse elements enter into the process. It is difficult
to have a cut and dried formula with the help of which a loan proposal can be considered; straightaway as
acceptable or unacceptable. While the same set of factors is taken into consideration in the scrutiny of
individual applications. The weightage given to the several factors varies from case to case. The more
important factors among these are: the type of organisation and activity of the borrowing unit, the nature
of its' product and its market potentiality, its size, the quality of its management, soundness of financial
position, the amount and, term of the loan required and its repayment schedule.
Financial institutions are usually inclined to adopt the criterion of profitability rather than that of'
‘development' in extending term loans. In other words, they are concerned mainly with the commercial
profitability of a project as determined by the level of prospective profits and its ratio to invested capital
of the borrowing unit and not with its broad economic significance or importance in the development of
the resources of the economy. Commercial profitability could sometimes be more apparent than real. The
extent of State support and the manner in which it is made available in the form of import controls,
protective duties, subsidies, tax rebates and other concessions have I considerable bearing on the profit
prospects of certain industries. To the extent that the profitability of a project is conditional in the
continuance of such support, appropriate allowance has to be made by the lending institution in the
appraisal of the project. A number of other aspects of the State policy such as transport rates, prices and
wage limits, export promotion, exchange regulations require due attention of the lending institutions
while appraising term loam.
Economic feasibility. This aspect relates to the determination of the extent of absorption of the output of
the new unit or the additional production from an established unit at given prices. In other words, it takes
account of the total output of the product concerned and the existing demand for it with a view to
establishing whether there is an unsatisfied demand for the product. Two general indicators of the
existence of unsatisfied demand are the price level and the prevalence of controls. It is necessary to know
specifically whether the unsatisfied demand is ephemeral or genuine. The study goes beyond immediate
prospects. Possible future changes In the volume and pattern of supply and demand will have to be
estimated in order to assess the long-run prospects of the industry as well as earning capacity of the unit.
Projection or forecasting of demand is a complicated matter though of vital importance. The demand for
a product is affected by a variety of factors and it may be difficult to take account of all these. If
information concerning the demand for a product in the past is available, projections of demand over a
period of years can be made on the basis of assumptions concerning future trend of all prices and
incomes, particularly in the case of consumer goods industry. The projection of demand for intermediate
goods (goods used as inputs for further production) and capital goods is more complicated because the
demand for such goods is affected by changes in incomes and prices only indirectly. Often intermediate
and capital goods have multiple uses, being needed in several lines of production, and hence it is
necessary to take into account inter-industry relationships also.
Estimations of demand can never be wholly accurate or absolutely reliable; they can at best be considered
as approximations.
Managerial competence. The confidence of the lending institution in repayment prospects of a loan is
largely conditioned by its opinion of the borrowing unit’s management. It has, therefore, been remarked
that appraisal of management is the touchstone of term credit analysis. Where the technical competence,
administrative ability, integrity and resourcefulness of the management are well established, the loan
application gets the most favorable consideration.
Financial feasibility. The financial appraisal, by and large, is designed to seek answers to the following:
(a) Whether the estimates of the cost of the project fully cover all items of expenditure and are realistic.
(b) Whether the sources of finance contemplated by the sponsors of the project will be adequate and the
necessary finance will be available during the period of construction as per their schedule. (c) What is the
likely impact of the project on the level of production, sales, net earnings, borrowings, costs, etc. of the
borrowing unit? Or, when can the project be expected to break-even (with offsetting expenditure) and
start yielding profit? (d) What time should be fixed for starting of repayment over a period to be
determined in the light of the financial capacity of the borrowers " arising from increased output and
income?
The magnitude of the available surplus and other cash accruals to meet the interest and principal
repayments (called as debt service coverage) is an essential point for investigation in deciding the period
of amortization.
The financial position of the concern has to be examined during the currency of the loan. For having a
proper perspective of the financial position of the concern, it is not sufficient to consider a single year's
performance as revealed in the balance sheet and profit and loss account. On the other hand, a: dynamic
view has to be taken of the organisation in the next few years.
Term lending institutions follow different methods in obtaining the financial data. Some use
comprehensive application form calling for particulars of different aspects of the projects presented for
financing, others use a simple preliminary application form to judge whether the schedule of the
application is prima facie feasible and later on follow-up by a comprehensive form. Quite often, the
lending institutions adopt the interview method for eliciting as many details and particulars of the
schedule as possible.
The basic data required for a financial analysis can be grouped under the following heads:
1 Cost of the project (Exhibit I).
2 Cost of production and profitability (Exhibit 3).
3 Cash-flow estimates during the currency of loan (Exhibit 4).
4. Pro-forma balance sheets (Exhibit 2),
Term lending institutions have to critically analyse the data obtained from the borrowers with a view to
ensuring that: (i) the estimated cost of the project is reasonable and the project has a fair chance of
materialising; (ii) the financial arrangement is comprehensive without leaving any gaps and ensures cash
availabilities as and when needed; (iii) the estimates of earnings and operating costs are as realistic as
circumstances permit; and (iv) the borrower's repaying ability, as judged from the project operations,
exists with a reasonable margin of safety .
Exhibit 1 Cost of the Project Period Required for completion
Total
Already incurred To be incurred
Rupees and
In In
In Rupee In Rupee Rupee
Rupees Rupees
equival equiva Equivalent
ent lent
of of
foreign foreig
exchan n
ge excha
nge
Land (including
development expenses)
Buildings
Machinery and Plant
Spare Parts
Insurance, freight
duty and
transportation to
site
Erection Charges
Technical know how/
consulting engineering fees
Intangibles
Preliminary expenses
Pre – operative expenses
(upto start of normal
production)
Interest during construction
Allowance for unforeseen
costs
Total
Grand Total
Note:- (1) Details and / or supporting documents may be required to be furnished wherever possible.
Note:- (2) Information may be furnished on the phasing of the expenditure on the project over a period of
years in a separate statement, if necessary.
Exhibit 2 Pro – Forma Balance Sheet Estimates
Construction Operation
Second Third First Second Third
First
Year Year Year Year Year
Year
(2) (3) (4) (5) (6)
(1)
Rs. Rs. Rs. Rs. Rs. Rs.
Total
Assets
Gross fixed assets
Less: Depreciation
Current assets
Investments
Intangible assets
Others
Total
Current ratio:
Exhibit 3 Cost of Production and Profitability
Construction Operation
Second Third First
First
Year Year Year
Year
(2) (3) (4)
(1)
Rs. Rs. Rs. Rs.
Raw materials (separately for each item of raw material indicating also
the quantity required per unit of finished product and price
at which it will be obtained)
Power and Fuel
Consumable Stores
Repair and Maintenance
Labour
Factory Supervision and Overheads
Administrative overheads (viz. office salaries, insurance, rent,
travelling and other expenses etc.)
Selling and advertising expenses
Cost of Production
Operating profit
Less
Taxation
Net Profit
Construction Operation
Second Third First
First
Year Year Year
Year
(2) (3) (4)
(1)
Rs. Rs. Rs. Rs.
Source of funds:
Net Profit (before taxes with interest added back but
after depreciation and development rebate reserve)
Depreciation provisions
Other (specify)
Total
Application of Funds:
Fixed assets and capital expenditure
Current assets (such as book debts, closing stock,
bills receivable, etc).
Repayment of long – term borrowing s
(Including deferred payments)
Interest
Other assets
Taxation
Other expenses
Total
Opening balance of cash
Surplus / deficit between sources and application of
funds
Closing balance of cash
Debt service coverage ratio
Test Questions
. Redeemable and Irredeemable Preference Shares Subject to an authority in the articles of association,
a public limited company may issue redeemable preference shares to be redeemed either at a fixed date or
after a certain period of time during the life time of the company. The Companies Act, 1956 prohibits the
issue of any preference share which is irredeemable or is redeemable after the expiry of a period of
twenty years from the date of issue.
10.4-2 Advantages and Disadvantages - The major advantages to the issuing company are:
- The obligation to pay fixed rate of interest on the security is not binding in the same way as it is with
debentures.
- Preference shares enable the company to avoid dilution of equity capital which occurs when additional
ordinary shares are issued.
- They also permit a company to avoid sharing control through participation in Voting.
- Since many preference shares are irredeemable, they are more flexible than debentures.
The major disadvantage is that dividends paid to preference shareholders are not tax-deductible;
consequently the true cost to a company of preference shares is far greater than the cost of debentures.
As a hybrid security, the use of preference shares is favored by circumstances that fall between those
favouring the use of ordinary shares and those favouring the use of debentures. The costs of preference
share financing follow interest rate levels more than ordinary share prices; in other words, when interest
rates are low, the cost of preference shares is also likely to be low. Companies sell preference shares when
they seek the advantage financial gearing but fear the dangers of the fixed charges on debt in the face of
potential fluctuations in income. If debt ratios are already high or the costs of equity financing are
relatively high, the case for using preference shares will be strengthened.
10.5 Deferred/Founders Shares
A private company may-issue what are known as deferred or founder's shares. Promoters and directors of
the company normally hold such shares. That is why they are usually called founders shares. These shares
are usually of a smaller denomination, say one rupee each. However they are generally given equal voting
rights with equity shares which may be of higher denomination, say Rs. 10 each.
Thus, by investing relatively lower amounts, the promoters may gain control over the management of the
company. As regards the payment of dividends to holders of such shares, the articles usually provide that
these shares will carry a dividend fixed in relation to the profits available after dividends have been
declared on the preference and equity shares. It is because of this deferment of the dividend payment that
these shares are; also called deferred shares. The promoters, founders and directors tend to have a direct
interest in the success: of the company they will receive dividends on these shares only if the profits are
high enough to leave a balance of after paying dividends to preference and equity shareholders. Besides,
greater the profits of the company, the higher will be dividends paid on these shares. Non-voting Shares
10.6 Non voting shares (NVS) as an innovative instrument for raising funds, although prevalent in many
developed countries for years, it only recently introduced in our country by the new union budget 1996-
97. In India, the concept of NVS is not a novel idea. The Companies Bill, 1993 that was scrapped
subsequently, had proposed NVS instrument for raising funds. The Pherwani study group, Constituted by
the Government on 27-3-1991 strongly recommended the concept of NVS. ;
The non-voting shares are closely akin to preference shares, which do not carry any voting
rights, nor is the dividend payable pre-determined. However, unlike preference capital, non-
voting shares do not carry a predetermined dividend. The pay-off to the investor for the
assumption of higher risk levels and the compensation for loss of control is high rate of
dividends payable to them.
10.6-1 Advantages and Disadvantages - NVS can be found useful by companies, which are shy of
exposure over leveraged companies, new companies and closely held companies. It may find favour with
small investors, non-resident Indians, overseas corporate bodies, mutual funds etc. The investor gains in
terms of higher dividends purchase at advantageous low price, liquidity and capital appreciation.
10.7 Sweat Equity Shares
Under Section 79Aof the Companies Act, 1956,a company can issue sweat equity shares to its employees
or directors at discount or for consideration other than cash for providing know-how or making available
from rights in the nature of intellectual property rights or value additions etc. on the following conditions:
- Issue of sweat equity shares of a class of shares already issued.
- Such issue must be authorised by a special resolution passed by the company in General meeting.
- Not less than one year has, at the date of the issue, elapsed since the date on which the company was
entitled to commence business.
- The equity shares of the company must be listed in recognised stock exchange.
10.8 Stock Options
Stock options is defined as the right to buy a designated stock at the option of the holder at a>1y time
with a specified period at a determinable price. It can also represent the right to sell designated stocks
within an agreed period at a determinable price.
These options are often granted to management and key employees as a form of incentive compensation.
It is to be distinguished from stock right available to all shareholders. The' Stock option’ is used when the
rights are issued other than pro rata to all-existing shareholders.
10.9 Stock Splits
According to section 94 of the Companies Act, 1956 a company can alter its share capital by sub-division
of all or part of its capital into shares of small amounts. The following illustration will explain how the
stock split will have impact on the capital structure of a company.
10.10 Buy Back of Shares (Shares Repurchase)
Buy back is described as the procedure which enables a company to go back to the holders of its shares
and offer to purchase from them the shares that they hold.
Section 77(1) of the Companies Act provides that a company limited by shares or a company limited by
guarantee having a share capital cannot buy its own shares. The restriction is applicable to all companies
having share capital, whether public or private. However, the Companies (Amendment) Act, 1999 vide
sections 77A, 77AA and 77B and the guidelines issued by SEBI in this regard allow companies to
purchase their own shares or other securities subject to certain conditions.
10.10.1 Reasons for Buy-back - There are three reasons why a company would opt for buy-back:
* To improve shareholder value, since buy back provides a means for utilising the companies surplus
funds which have unattractive alternative investment options, and since a reduction in the capital base
arising from buy-back would generally result in higher earnings per share (EPS).
*It is used as a defense mechanism, in an environment where the threat of corporate takeovers has
become real; buyback provides a safeguard against hostile take-over by increasing promoter’s holdings.
* It would enable corporate to shrink their equity base thereby injecting much needed flexibility.
* It improves the intrinsic value of the shares by virtue of the reduced level of floating stock.
* It would enable corporate to make use of the buy-back shares for subsequent use in the process of
mergers and acquisitions without enlarging their capital basis.
*Buy-back of shares is used as a method of Financial Engineering.
* It is used for signaling the effect of buy-back on the share price.
10.11 Debentures
According to section 2(12) of the Companies Act, a "Debenture" includes debenture stock, bonds and any
other securities of a company, whether constituting a charge on the assets of the company or not. From
this definition it is not very clear what a debenture is. A debenture has been defined as "acknowledgement
of debt, given under the seal of the company and containing a contract for the repayment of the principal
sum at a specified date and for the payment of interest at fixed rate per cent until the principal sum is
repaid and it may or may not give the charge on the assets to the company as security of the loan. A
debenture is a kind of document acknowledging the money borrowed containing the terms and conditions
of the loan, payment of interest, redemption of the loan and the security offered (if any) by the company.
Debentures are bonds issued, by a company. Such bonds embody terms and conditions of loans, payment
of interest, and repayment of the loan etc.
10.12 Kinds of Debentures. Debentures may be of the following kinds:
Bearer Debentures: Bearer debentures are similar to share warrants in that they too are negotiable
instruments, transferable by delivery. The interest on bearer debentures is paid by means of attached
coupons. On maturity, the principal sum is paid to the bearers.
Registered Debentures: These are debentures which are payable to the registered holders i.e., persons
whose names appear in the Register of debenture holders. Such debentures are transferable in the same
way as shares.
Perpetual or Irredeemable Debentures: A debenture which contains no clause as to payment or which
contains a clause that it shall not be paid back is called a perpetual or irredeemable debenture. These
debentures are redeemable only on the happening of a contingency or on the expiration of a period,
however long. It follows that debentures can be made perpetual, i.e., the loan is repayable only on
winding up or after a long period of time.
Redeemable Debentures: These debentures are issued for a specified period of time. On the expiry of
that specified time the company has the right to pay back the debenture holders and have its properties
released from the mortgage or charge. Generally, debentures are redeemable.
Debentures Issued as Collateral Security for a Loan: The term collateral security or secondary security
means, a security which can be realised by the party holding it in the event of the loan being not paid at
the proper time or according to the agreement of the parties. At times, the lenders of money are given
debentures as a collateral security for loan. The nominal value of such debentures is always more than the
loan. In case the loan is repaid, the debentures issued as collateral security are automatically redeemed.
Naked Debentures: Normally debentures are secured by a mortgage or a charge on the company's assets.
However debentures may be issued without any charge on the assets of the company. Such debentures are
called 'Naked or unsecured debentures: They are mere acknowledgement of a debt due from the
company, creating no rights beyond those of unsecured creditors.
Secured Debentures: When any particular or specified property of the company is offered as security to
the debenture holders and when the company can deal with it only subject to the prior right of the
debenture holders, fixed charge is said to have been created. On the other hand, when the debenture
holders have a charge on the undertaking of the company i.e., on the whole of the property of the
company, both present and future, and when it can deal with the property in the ordinary course of
business until the charge crystallizes i.e., when the company goes into liquidation or when a receiver is
appointed, the charge is said to be a floating charge. When the floating charge crystallizes, the debenture
holders have a right to be paid out of the sale proceeds of the assets subject to the right of the preferential
creditor but prior to making any payment to unsecured creditors.
10.13 Convertible Debentures (CDs) - A company may also issue CDs in which case an option is given
to the debenture holders to convert them into equity or preference shares at stated rates of exchange, after
a certain period. Such debentures once converted into shares cannot be reconverted into debentures.
CDs may be fully or partly convertible. In case of fully convertible debentures, the entire face value is
converted into shares at the expiry of specified period(s).1n case of partly convertible debentures only the
convertible portion is converted into shares at the end of the specified period and non-convertible portion
is redeemed at the end of certain specified period. Non-convertible debentures do not confer any option
on the holder to convert the debentures into shares and are redeemed at the expiry of specified period(s).
CDs, whether fully or partly convertible, may be converted into shares at the end of specified period or
periods in one or more stages. The company should get a credit rating of debentures done by credit rating
agency. CDs are listed on stock exchanges.
The Partly Convertible Debentures (PCDs) offers more flexibility to both companies and investors. It has
been claimed to be better than fully convertible debentures as it does not automatically entail a large
equity base, particularly in case of new companies. Experience shows that servicing of a large base of
capital is not easy in case of new projects, especially if the company runs into rough weather due to
marketing difficulties. As such, the non-convertible portion of the debenture keeps the equity of a
company within manageable limits.
The instrument of PCD also has been usual advantages of a convertible debenture - the security offered
on the non-convertible portion as well as the prospects of capital appreciation and higher dividends on the
convertible portion. Further the non-convertible portion is unlikely to be quoted at a discount for a fair
part of the life of the debenture on account of the equity entitlement. Finally, the interest cover is lower
than normal debt on account of the debt is being reduced over time with conversion into equity.
10.14 New Debt Instruments
In the fast changing financial scenario, it has become imperative for the corporate sector to device new
debt instruments for raising funds from the market. A brief discussion is made here about the new
instruments of finance.
10.15 Zero Interest Bond (ZIB) - ZIB refer to those bonds which are sold at discount from their eventual
maturity value and have zero interest rate. These certificates are sold to the investors for discount. The
difference between the face value of the certificate and the acquisition cost is the gain to the investors.
The investors are not entitled to any interest and are entitled to only repayment of principal sum on the
maturity period.
The individual investors prefer ZIB because of lower investment cost and low rate of conversion to equity
if ZlBs are fully or partly convertible bonds. This is also a means of tax planning because the bonds do
not carry any interest, which is otherwise taxable. Companies also find ZIB quite attractive because there
is no immediate interest commitment. On maturity the bonds can be converted into equity shares or non-
convertible debentures depending on the requirement of capital structure of a company.
10.15.1 Secured Premium Notes (SPN) - The SPN is a tradable instrument with detachable warrant
against which the holder gets equity share(s) after a fixed period of time. The SPN have feature of
medium to long-term notes.
With each SPN, a warrant may be attached to it, which will give the holder the right to apply for and get
allotment of equity shares after certain period of time by which the SPN will be fully paid-up.
The investor can plan his tax affairs to minimise tax burden. It will be possible to spread interest income
evenly over the life of the investment and that the premium as capital gains. For example, those who
retire after fifth year of investment can opt for low premium to reduced tax liability.
10.15.2 Deep Discount Bond (DDB) - The IDBI for the first time issued Deep Discount Bond (DDB).
For a deep discount price of Rs. 2,700 an investor gets a bond with a face value of Rs. I lakh. The DDB
appreciates to its face value over the maturity period of 25 years. The unique advantage of DDB is the
elimination of investment risk. It allows an investor to lock-in the yield to maturity or keep on
withdrawing from the scheme periodically after five years by returning the certificate.
The main advantage of DDB is that the difference between the sale price and original cost of acquisition
will be treated as capital gain, if the investor sells the bonds on stock exchange. The DDB is safe, solid
and liquid; instrument. Investors can take advantage of these new instruments in balancing their mix of
securities to minimise risks and maximize returns. 16.15-5 Zero Coupon Convertible Note - It is an
instrument which can be converted into common stock of the issuer. If investor chooses to convert they
will be required to forego all accrued and unpaid interest. Zero coupon can generally be put to the issuer.
This allows the issuer to obtain the advantages of convertible debt without too much dilution of common
stock. Like any zero coupon bond the issuer gets a tax deduction for imputed interest, even though no
cash is paid until maturity. Investors are also benefited since they have the opportunity to participate in
the underlying stock appreciation. If the appreciation does not materialise investors still have the regular
scheme of interest income. There are risk considerations also in view of the fact that prices of zero
coupon bonds are much more sensitive ~o changing interest rates than coupon bonds. In case if the
proposal does not seem to be advantageous to convert, the investor will be left with a relatively low yield
to maturity. Since zero coupon convertibles often can be put to the issuer, the issuer may be forced to
refinance the debt at a disadvantageous time.
10.15.3 Debt for Equity Swap - This instrument is an offer from an issuer of debt securities to its debt
holders to exchange the debt for the issuer common or preferred stock. The issuer who wishes to offer
debt for equity swaps does so with a view to increasing equity capital for the purposes of improving its
debt-equity ratio and also enhances its debt raising capacity. It also helps issuers to reduce their interest
expenses and enables them to replace it with dividends on stock that are payable at their discretion.
Investors get attracted because of the potential appreciation in the value of the stock. There are risk
considerations in view of the fact swaps may dilute earnings per share of issuer. In addition, dividends are
not tax deductible while interest on tax securities is taxable. Further, potential appreciation in the value of
the stock may not materialise and in the process investors may have to suffer. Debt for swaps instrument
has not been used in Indian situations and there arc markets may be able to diversify and after they are
well established, the other instruments recommended by the Pherwani committee may find place in the
portfolios of the investors.
10.15.4 Multi-option Secured Redeemable Convertible Debentures - Where a debenture gives the
holder thereof two or more different options, it may be called a multi-option debenture. It is a species of
debenture. It is essentially a debenture in character and is secured redeemable and convertible into equity
shares. Its chief feature is the multi-options available to the investor.
10.15.5 Callable Bond - A callable bond is a bond, which the issuer has the right to call in, and payoff at
a price stipulated in the bond contract. The price the issuer must pay to retire a callable bond when it is
called is termed as 'call price'. The main advantage in callable bond is the issuers have an incentive to call
their existing bonds if the current interest rate in the market is sufficiently lower than the bond's coupon
rate. Usually the issuer cannot call the bond for a certain period after issue.
10.15.6 Option Tender Bonds - The option tender bonds are bonds with put option which give the
bondholders the right to sell back their bonds to the issuers normally at par. Issuers with puts are aimed
both at investors who are pessimistic about the ability of interest rates to decline over the long-term and at
those who simply prefer to take a cautious approach to their bond buying.
10.15.7 Guaranteed Debentures - Some businesses are able to raise long term money because their
debts are guaranteed, usually by their parent companies. In some instances the State Governments
guarantee the bonds issued by the State Government undertakings and corporation like Electricity Supply
Board, Irrigation Corporation etc.
10.15.8 Subordinated Debentures - A subordinated debenture is an unsecured debt which is junior to all,
other debts i.e., other debt holders must be fully paid before the subordinated debenture holders receives
of conversion into ordinary shares. Subordinated debt is often called Mezzanine finance because it ranks
between equity and standard debt.
10.15.9 Floating Rate Bonds - The interest paid to the floating rate bondholder’s changes periodically
depending on the market rate of interest payable on the gilt edged securities. These bonds are also called!
adjustable interest bonds or variable rate bonds.
10.15.10 Junk Bonds - Junk bonds are a high yield security which because a widely used source of
finance i in takeovers and leveraged buyouts. Firms with low credit ratings are willing to pay 3 to 5 per
cent more than the high-grade corporate debt to compensate for the greater risk.
10.15.11 Indexed Bonds - Fixed income and fixed sum repayments are uneconomic in times of rapid
inflation. Indexed bond is a financial instrument which retains the security and fixed income of the
debenture but which also provides some safeguard against inflation.
10.15.12 Stepped-up Debentures- The terms of issue of stepped up debenture contains that instead of
making I conversion at one go at the end of the tenure, it has designed the instrument in such a way that
the equity component is augmented gradually. For example, the stepped up debenture has been priced at
the face value of Rs. 50, with a coupon of 1896 p.a. (interest payable half yearly) and tenure of three
years. The debt component will be converted into equity in a phased manner over a period of three years
from the date of the issue. The conversion will be done at par value, at the rate of 2096 at the end of first
year and 4096 each at the end second and third years. As the scale of business increases, via funding
through borrowings, proportional increases in equity should also be brought in.
A debt instrument with interest rates that either ascends or descends, ratcheting up to the highest or lowest
level in the terminal year.
Test Questions
The sources of finance available to industries may be considered under three board classifications:
(a) Long-term Sources;
(b) Short-term sources:
(c) Internal sources (self-financing).
Long-term sources include individual investors, corporate and institutional investors like banks, insurance
companies, investment trusts, Government agencies, financial corporation "Sales and Leaseback" and hire
purchase arrangements and international financing institutions.
Short-term sources include private firms and money-lending operative societies, mercantile creditors and
commercial banks.
Internal sources include plaguing back of profits and depreciation earned on assets used in the business.
General Insurance Companies in. India also subscribes to or purchase shares and debentures and thus
contributes directly to the long-term needs of industry. By investing in shares and debentures of other
banking and financial institutions, they also indirectly participate in long-term financing of industries.
The Life Insurance Corporation of India, which came into existence on 1st September, 1956 under the
Life Insurance Corporation Act, enjoys the exclusive right to carryon Life Insurance business in India. It
is one of the institutions in India which mobilizes a vast amount of personal savings. The Corporation
now occupies an important place in the Capital Market of India. The Corporation not only takes an active
interest in underwriting operations but also invests in shares and debentures of companies. The
Corporation is permitted to invest up to 30 per: cent of the subscribed share capital of a company. The
Corporation provides loan to co-operative sugar factories, industrial estates, and improvement trusts, State
Electricity Boards and companies on a long-term basis.
11.5 Unit Trust of India:
The Unit Trust of India, established under the Unit Trust Act, 1963, came to operation on 1st February
1964. It has an initial capital of Rs. 5 crores contributed by the Reserve Bank of India. The Life Insurance
Corporation of India. The State Bank of India and its subsidiaries, scheduled banks and other specified
financial institutions. With this capital, it has already built up a balanced portfolio of investment in
securities of diverse types giving an average yield of over 1 per cent. The Trust offers to small investors
the advantages of a reasonable return and expects management. The Trust enjoys exemption from
payment of income tax, and super tax other taxes on income. With the significant tax concessions and
other advantages offered to investors, the Unit Trust is expected to mobilize the financial resources of
numerous small investors and channelise them to the corporate sector.
The loans sanctioned for the purchase of tools, equipment and machinery are normally paid by the
Government directly to the suppliers of such machinery etc. ~very loan granted under these schemes is
secured by a mortgage upon specified assets of the business." The rates of interest charged on those loans
are very concessional ones. The period for the repayment of the loans may extend up to 22 years.
The object of this scheme, which came into force on 1st July, 1960, is to enlarge the supply of
institutional credit to small-scale industrial units by ensuring a degree of protection to the lending
institutions against possible losses in respect of the advances granted by them to there small-scale
industries. The Reserve Bank of India may give guarantee under this Scheme to the approved credit
institution. Though, initially, such guarantees applied only to loans for periods not exceeding seven years,
this limitation has now been re]axed so that the period of the loans can extend beyond 7 years from the
date of the first disbursement of the advances.
I.F.C.I. can extend financial assistance to any public limited company or co-operative society engaged in,
or proposing to engage in, one of the following activities:
(b) Shipping;
(c) Mining;
(d) Hotel industry; and
(e) Generation or distribution of electricity and gas. I.P.C.I. finance is not available to:
(a) Small-scale industrial units; and
(b) Proprietary concerns, partnerships or private limited companies.
Any public limited company ,or a co-operative society incorporated and registered in India which is
engaged in, or is proposing to engage in the manufacture, preservation or processing of goods, or in
shipping, mining, hotel industry or in the generation or distribution of electricity or any other form of
power, is eligible for financial assistance from the lFCI. Public sector projects which are set up as public
limited companies are also eligible for assistance by the IFCI on the same basis as projects in the private
sector, within the framework of Government policies.
In case of many projects, the Corporation undertakes joint financing with other all-India financial
institutions. For this purpose, they have an inter-institutional approach.
Terms for advancing loans:
The loans are generally secured by a first legal mortgage on the block, i.e., fixed assets of the industrial
concern, both existing and those to be acquired in future. In the case of projects which require joint
financing, pari passu charge on the mortgaged assets is conceded in favour of other institutions. Raw
materials, stocks in process, finished goods, and consumable store and book debts are not included in
IFCI's security. This is because the same can be pledged for working capital loans with the banks. In the
case of existing concerns which are undertaking schemes of expansion or renovation. IFCI's assistance is
up to about half the total capital cost of expansion and renovation or the written down value of the
existing block. In special cases, the IFCI may advance more than 5°% of the total cost. In the case of co-
operative enterprises, the IFCI may finance up to 65% of the capital cost of projects, provided the loans
are guaranteed by the Central State Government; similarly; a higher percentage of total cost can be given
as loans if the project is in a backward area.
The loans are normally repayable by semi-annual instalments over a period of 7 to 10 years. The
corporation generally allows a grace period of up to 3 years after the initial disbursement of the loan.
To remove regional imbalances in the economy, the Corporation extends sizeable financial assistance on
concessional terms to industrial undertakings in less developed State/areas. It also encourages the growth
of new entrepreneur- ship and special consideration is given to applications for financial assistance for
projects promoted by technocrats and professionally qualified persons. The Corporation is also extending
substantial assistance to industrial co-operatives.
The Corporation is authorised to undertake the following activities to achieve these objects: (i) granting
loans over a period of year. (ii) subscription to equity and preference share capital, normally in the form
of underwriting of public issues, (iii) guaranteeing of rupee payments required, for instance, in the case of
deferred payments, (iv) advancing loans in foreign technical and administrative assistance to Indian
industry. Generally, the Corporation treats Rs. 5 lakhs as the lower limit for its assistance. The upper limit
for assistance is Rs. 1 crore. In 1969, the Corporation decided to provide foreign currency loans to
partnership and proprietary firms also to strengthen entrepreneurship in small concerns.
11.12 The National Industrial Development Corporation (NIDC):
The National Industrial Development Corporation (NIDC) was incorporated in 1954 as a Private Limited
Company. Its primary objects are-"the promotion and establishment of industries for the manufacture and
production of plant, machinery, implements and goods of any description likely to promote industrial
development and to aid and assist any industrial undertaking owned by the private companies also, with
capital and other resources for establishing new industries or for running their business."
Therefore, it can render assistance to any type of industrial organisation, i.e., public or private sector
enterprise. Company, firm or individual. The assistance may also take any form such as providing capital,
credit, machinery and equipment, loans and advances, subscriptions to or underwriting of shares and
debentures and guaranteeing of loans and advances. The NIDC is intended mainly to be an agency of the
Government for developing industries with no profit motive.
The NIDC started with Rs. 10 lakhs of capital. Its financial requirements are met by the Government by
an annual grant for the purpose of study, investigation and formulation of projects and building up
technical and managerial staff. and by loans to be made as and when projects are taken up.
It undertakes financing of industries only in so far as it is incidental to such development. It gives priority
to establishments for the manufacture of capital goods, machinery and equipment for other industries. It
takes up the study and investigation of industrial schemes, and implementing them, tries to secure,
wherever possible, the maximum use of industrial equipment, experience; and skill available in the
private sector. In other case, it may itself set up industries which may, in their turn, lead to the growth of
ancillary industries in the private sector.
NIDC can render assistance to any type of industrial undertaking. The assistanced can be provided in the
shape of capital, credit, machinery, or any other type of facility. However, the Corporation has made slow
progress in the field of setting up new industries because it has been undertaking large projects
simultaneously.
11.13 The Industrial Development Bank of India (IDBI):
The Industrial Development Bank of India was established under the Industrial Development Bank Act
1964. It is a wholly owned subsidiary of the Reserve Bank of India. The development Bank is enable to
finance all types of industrial enterprises both in the public and private sectors which incorporated under
the Companies Act or any other law.
The assistance that can be rendered by the Development Bank can take diverse forms. These may include-
(a) granting loans and advances;
(b) subscribing to, purchasing or underwriting the issue of stocks, shares, bonds or debentures;
(c) guaranteeing~ deferred payments due from industrial concerns, loans raised by them in the open
market or from scheduled banks etc.
(d) taking under writing obligations;
(e) accepting, discounting or rediscounting bonafide commercial bills or promissory notes of industrial
concerns;
(f) refinancing;
(i) term-loans to industrial concerns repayable between 3 and 25 by I.F.C., the Financial Corporation and
other financial year’s institutions notified by the Government for the purpose;
(ii) term-loans repayable between 3 and 10 years given by schedule banks or State Co-operative Banks;
and
(iii) export credit maturing between 6 months and 10 years granted by the specified financial institutions;
(g) augmenting the resources of the I.F.C., State Financial Corporation and other financial institutions
notified for the purpose by subscribing to their stocks, shares, bonds or debentures.
The Act also makes provision for a separate "Development Assistance Fund" intended to provide
assistance for industries which may not be able to obtain funds in the normal course but may nevertheless
be of such importance as to justify special assistance. This fund is to be created out of an appropriate
initial grant from the Central Government supplemented by loans, gifts, grants, donations etc., from
Government and other sources. Assistance from this fund is subject to prior approval of the Central
Government.
The Development Bank can also undertake promotional activities such as marketing and investment
research, surveys and techno economic studies and provide technical and administrative assistance to
industrial enterprises for promotion, management or expansion.
To begin with, the Development Bank will have capital fund of Rs. 10 crores. It will be supplemented by
an interest free loan from the central Government of Rs. 10 crores for a period of I5years repayable in 15
equal annual installments. It can also borrow other funds from the Central Government and Reserve Bank
of India. It can also take loans foreign currency from any bank of financial institution in any other country
with the approval of Central Government.
The Refinance Corporation for Industry has since been merged with the Development Bank. As important
landmark in the history of industrial finance in the country was the establishment of the Industrial
Development Bank in July, 1964. The Bank is intended to serve as a reservoir from which the existing
financial institutions can draw. It seeks to cover the gaps left by the numerous State institutions working
in the field of industrial finance. The Bank has a measure of flexibility in its scope and operations which
is essential for the organisation of capital market on a sound footing. It promotes the establishment of new
enterprises especially in key industries and assists projects both in the private and the public sectors.
The Bank is expected to combine commercial promotion and re-financing activities. To the end, it
performs the following important functions:
(a) Refinancing: The Bank refinance: (i) loans for term between 3 and 25 years granted by the I.F.C., &
S.F.Cs., or other financial institutions. (ii) loans repayable between 3 and 10 years granted by any
schedule bank or state co-operative bank to an industrial concern, and (iii) export loans, given by any
schedule bank of state co-operative bank or any other approved institution, repayable between six months
and ten years.
(b) Short term accommodation: The Bank is empowered to accept, discount or re-discount commercial
paper (Bills of Exchange, Promissory Note etc.) of industrial concerns.
(c) Direct subscriptions: The Bank subscribes to Or buys stocks, shares bonds or debentures of the I. F.
C., S. F. Cs. or any other notified financial institution.
(d) Lending and underwriting: The Bank grants loans and advance to industrial concerns. It can also
underwrite the issue of shares or debentures by any industrial concern.
e) Guaranteeing: The Bank can guarantee deferred payment due from any industrial concern. It can also
guarantee loans floated by an industrial concern in the market or raised from a scheduled bank or I.F.C or
S.F.C., or any other financial institution.
(f) Formation: The Bank can arrange technical or administrative assistance for any industrial concern or
person for promotion, management or expansion of any industry. It will also plan, promote and develop
industries to cover the gaps in the existing capital structure.
(g) Miscellaneous: The Bank may undertake research and surveys for evaluation of dealing' with
marketing of investments. It can form subsidiaries for carrying out its functions and will do any other
kind of business which the Central Government on the recommendation of the Reserve Bank of India,
may authorise.
11.14 Industrial Rehabilitation Bank of India
The IRBI originated in April, 1971 as a public limited company was known as the Industrial
Rehabilitation Corporation of India Ltd. (IRCI). It was established as an adjunct to the development
institutions already functioning in the country. The need for setting up the IRCI was felt in the context of
the all round depression in industry arising from recession combined with adverse factors like
management, unsatisfactory labour relations and critical raw material position which led to the closure or
sickness of many industrial units. The position was particularly critical in West Bengal. The IRC[ was
established by the Reserve Bank of India at the instance of the Central Govt. with the object of reviving
and revitalizing the sick and closed industrial units. Though it is all-India insti- tuition, it has paid special
attention to West Bengal; this is because of the particularly serious condition of industry in that State. In
1984, IRCI was re-constituted as a subsidiary of IDBI to be known as Industrial Rehabilitation Bank of
India (IRBI), L.I.R.B.I. functions not merely as a lending institution, but as a reconstruction agency which
concerns itself with the diagnosis and the removal of the problems and shortcoming which might have led
the sick unit to its present unfortunate condition. It helps in the management by providing managerial
guidance, and acts as a catalyst in securing assistance for banks and financial institutions and government
agencies.
The assistance given by IRBI has taken the form of soft loans and guarantees, Reconstruction loans are
granted for meeting essential capital expenditure and repayment of pressing liabilities as also for
providing liquid (i.e. cash) resources. In regard to working capital, the IRBI provides the margin money
on the strength of which the assisted units can obtain finance from banks. The margin money is essential
to have before a borrowing concern is able to get assistance from banks. It becomes a kind of security for
the advance taken.
Generally IRBI has been issuing guarantees to banks in respect of margin money for working capital.
However, in some cases It had to provide cash payment for the margin money.
Limited companies, co-operatives, partnership, or proprietary concerns are all eligible for assistance from
IRBI. In practice, however, IRBI generally suggests conversion of partnership and proprietary concerns
into limited companies. IRBI does not ordinarily assist cases where more than 50% shares are held by a
State or the Central Government.
Normally, it charges interest at 8i% p.a. with half yearly rests on its term loans. For units in the small-
scale group, the interest rate is 7%t and for units located in backward areas, a concessional rate of 7% is
charged by way of interest. For guarantees, charges are limited to I % per annum.
The repayment of loans normally depends upon the facts of each case. It has varied between 4 and 12
years. Moratorium periods of different durations have been granted with regard to payment to principal
and/or interest. This means that IRBI postpones its dues for a certain period over which the weak or sick
units will not be required to pay the principal or the interest. For providing reconstruction assistance, the
IRBI asks for a first charge on all the fixed assets of the assisted units.
11.15 State Financial Corporation:
State Government have been empowered by the State Financial Corporations Act, 1951 to establish
financial corporations in their respective States, Each of the States in India has got its own financial
corporation nearly all of them were established under the State financial Corporation Act, 1958 except the
one in Madras, which was established under the Companies Act.
State Financial Corporation can render financial assistance not only to private public limited companies
but also to limited companies partnership firms and proprietary concerns. The assistance can be in anyone
or more of the following forms:
(a) Granting loans or advances or subscribing to debentures Or industrial concerns, repayable within 20
years;
(b) Guaranteeing loans raised by industrial concerns, on such terms and condition as may be mutually
agreed upon, which are repayable within 20 years; and
(c) Underwriting the stocks, shares, bonds and debentures subject to their being diposed of in the market
within 7 years.
They cannot, however, subscribe directly to the shares or stock of any limited liability company except
for underwriting purposes or grant any loan or advance on the security of their own shares. The loan or
advance granted to any single enterprise cannot exceed 10 per cent of the paid-up capital of the
Corporation or Rs. 10 lakhs, whichever is less. The loans are to be property secured by pledge, mortgage,
and hypothecation or otherwise. I
The capital structure of any State Financial Corporation may range between Rs. 50 lakhs and Rs. 5 crores.
They can issue bonds and debentures to supplement their financial resources and may accept deposits
from the public. They can also get medium-term credit facilities from the Reserve Bank of India.
To sum up, the State Financial corporations have been established in all the State under the Financial
Corporations Act, 1951, a central legislation, to serve the needs of medium and small-scale industries on a
regional basis. In Tamil Nadu, the Tamil Nadu Industrial Investment Corporation Ltd., functions on the
lines of a State Financial Corporation. In structure and mode of operation, SFCs are broadly, similar to the
Industrial Finance Corporation. They grant loans to corporate and non-corporate industrial units including
proprietary. and partnership concerns, generally against the first charge by way of legal mortgage on fixed
assets, such as land, buildings, plant and equipment with a margin of about 50% on the net value of the
security. However, the margins differ with the unit and the nature of business.
""'
For the proper co-ordination of their activities, the Industrial Finance Corporation and the State Financial
Corporation observe a convention under which the Industrial Finance Corporation does not normally
entertain applications for loans for amounts less than Rs. 30 lakhs to anyone borrower.
11.16 Foreign Financial Participation:
The Government of India has invited, foreign assistance in cases where sufficient capacity for the
manufacture of a particular item does not exist in the.- country and where it is considered desirable to
secure technical knowledge from leading foreign firms. Several incentives (including tax concessions)
have been offered to foreign investors in order to attract foreign capital which will supplement the
country's capital resources. The participation of foreign capital and management however, is regulated in
the national interest. Normally, it is ensured that the major interest in ownership and control is in Indian
hands and that suitable Indian personnel are trained for eventually replacing foreign experts.
Foreign investment in the equity of Indian industrial projects can be a significant source of long term
finance for these projects which may take the form of patents, licenses, technical know-how, machinery or
cash or a combination of more than one of these forms.
11.17 Foreign Private Loans:
The Major sources of foreign private loans for Indian industries are the suppliers of machinery and
services. Many such firms are prepared to give credit for duration of or more years. 'Often these credits
are financed by their own Government agency to encourage exports, (e.g., The Export Credit ~ Guarantee
Department-U.K.)
Test Questions
Q1 Discuss broadly the structure of financial institutions in India.
Q2 Describe the ways in which financial institutions provide direct financial assistance.
Q3 Explain how the IDBI bill-rediscounting scheme works.
Q4 Explain how the ICICI suppliers credit scheme works.
Q5 “Financial Institutions in India have come up of age.” Comment.
Chapter 12 Lease financing
12.1 Introduction
A lease is a contractual arrangement whereby one party (i.e., the owner of an asset) grants the other party
the right to use the asset in return for a periodic payment. A lease is essentially the renting of an asset for
some specified period. The owner of the assets is called the lessor while the other party that uses the
assets is known as the lessee. A lessee can be an individual. a firm or a company interested in the use of
the assets without owning it, while the lessor may be the seller, supplier, a finance company or the
manufacturer who can finance the purchase of the assets. Under the lease contract, the ownership of the
assets remains with the lessor whereas the use of the assets is available to the lessee. In return, the lessee
has to pay a fixed periodic amount to the lessor. This periodic payment is known as the lease rental.
Generally, the lease rental is fixed and the amount and timing of its payments are a matter of agreement
between the lessor and the lessee.
The terms and conditions regulating the lease arrangement are given in the lease contract. At the end of
the lease period, the assets generally revert to the lessor, who is the real owner of the assets. As a legal
owner, the lessor is also entitled to claim depreciation on the assets. Acquiring an asset by a business firm
under a lease arrangement is a recent phenomenon, particularly in India. Gradually, it is gaining
popularity and has emerged as a significant source of long term financing over recent years.
The concept of leasing can be understood by comparing the lease to the purchase of a specific asset. If a
firm wishes to obtain the service of a specific asset, it has two alternatives: Purchase or Lease. To
purchase the asset, the firm must payout a lump sum or agrees to some type of installment plan that
involves incurring a long term liability. Leasing the assets, on the other hand, provides the firm with
asset's services without necessarily incurring any capital liability. Leasing is a source of financing as it
enables the firm to obtain the use of assets in exchange for agreeing to pay lease rentals. The present
chapter discusses various aspects of lease financing from the point of view of both the lessor and the
lessee.
12.2 Lease, Hire-purchase and Installment Sale:
In case of leasing, as already stated, the asset is handed over by the lessor to the lessee in return for a
lease rental. The ownership and the title to the assets remain with the lessor. The lessor, however, recovers
the cost of the assets as well as a reasonable return in form of rental income. The lessor also gets the
deduction in taxable income for the depreciation of the assets (though not using the assets). The lessee
gets the opportunity of using the assets in its entirety without owning it. Further, the rental, paid by the
lessee gets fully deducted from the taxable income of the lessee.
In case of hire purchase, the seller hands over the assets to the buyer but the title to goods are not
transferred. The buyer becomes the owner of the goods and acquires the title to the goods only when he
makes the payments of all the installments. In case of default in payment by the buyer, the seller can
repossess the goods. The buyer treats the installments already paid by the buyer up to the date of
repossession, in such a case, as ‘hire’ towards using the assets. The hire-purchaser shows the assets in his
balance sheet and can claim depreciation from taxable income, although he may not be the owner at that
time. The interest part of the installment can also be claimed as deduction from the taxable income.
In case of installment sale, the title to goods is immediately transferred to the buyer though the payment
of price is to be discharged in future. This is just like a credit sale. In case of default, the seller has no
option but to claim the money in the court of law. The seller cannot repossess the goods, a facility which
is available in leasing as well as in hire” purchase.
12.3 Types Of Lease Arrangements
From the point of view of the lessee, leasing involves obtaining the use of specific assets without
acquiring the title to the assets. In exchange for the use of the assets the lessee pays the lessor a ed
periodic payment which is normally agreed in advance and is made in the beginning of each the lease
period. As the lease is, basically, a contract between the lessor and the lessee and they can agree for any
set of terms and conditions, there can be different types of lease arrangements. Broadly speaking, the
lease may be classified as a finance lease or an operating lease.
FINANCE LEASE: A finance lease, also called a capital lease, is one which usually covers the full useful
economic life of the assets or a period that is close to the economic life. The lessor receives: lease rentals
during the lease period so as to recover fully not only the cost of the assets but also a reasonable return on
the funds used to buy the assets. The finance lease is usually a non-cancelable and the lessee provides for
the maintenance of the assets. The lease payment under financial lease is a payment for the use of the
assets only and the responsibility for the repair d maintenance of the assets generally lies with the lessee.
Since the term of a finance lease is normally closely aligned with the economic life of the assets, the
lessee's position is quite similar that of an owner; and the cost of maintaining is in its hands. At the end of
the lease period, the assets may be returned to the lessor or handled as per the lease contract.
From the point of the view of the lessee, the finance lease ensures him an uninterrupted use the assets. For
him a finance lease is essentially a form of borrowing for the purpose of acquiring an asset. The lessor
may not be involved in dealing with the assets. The lessee may select the assets according to his
requirement, may even negotiate the price, the delivery schedule etc., with supplier and get the delivery
also. The payment however, is made by the lessor to the supplier. This arrangement is concurrent to the
signing of the lease contract. There may be different types finance lease depending upon how the lessee
acquires the asset. Some of these are as follows:
Direct Lease: This is the most straight forward type of finance lease. The lessor itself purchases the asset
and hands it over to the lessee. A manufacturer can also act as a lessor and can deliver the assets to the
lessee under the lease agreement (instead of delivering under the sale agreement). In other words, the
lessee will normally specifies the manufacturer, the model number and other relevant characteristics of
the asset it wishes to lease and the lessor will procure for the lessee.
Leveraged Lease: A leveraged lease is an arrangement where the lessor borrows a portion of the
purchase price from some lender/financial institutions. This loan is secured by the assets and the lease
rentals. The loan is repaid out of the lease rentals either directly by the lessee or the lessor. The surplus
(i.e., the difference between the lease rental and the repayment portion of it) then goes to the lessor. So,
under the leveraged lease, the lessor acts as an equity participants supplying only a part of the cost of the
assets and the lender supplies the balance. The lease rentals are distributed first to the lender to satisfy the
scheduled debt service payments; any surplus then going to the lessor. If lease payments are less than the
debt service, the lessor or the lessee (as the contract may provide for) will have to make up the difference.
The lease payment must be large enough to meet the debt repayment, interest payment to the lender as
well as provide a return to the lessor. The leveraged lease may generally be adopted in case of costly
assets.
Sale and Lease Back: Under both the direct lease and the leveraged lease, the lessee ac- quire the assets
after the lease arrangement. However, in case of sale and lease back, the situation is different. The lessee
is already the owner of the assets. He, under the lease agreement, sells the assets to the lessor who, in
turn, leases the assets back to the owner (now the lessee). Under the sale and lease back, the lessee not
only retains the use of the assets but also gets funds from the 'sale' of the assets to the lessor. The sale and
lease back is usually preferred by firms having fixed assets but shortage of funds. The Following Figure
depicts the mechanism of sale and lease back.
Manufacture
Sales of Assets
User/Lessee
Positive Negative
IIl"stration 12.3
A person wishing to take on lease an office premises, has been given two options by the landlord. The
options are:
Option I: Lease period 18 years,
Initial non-refundable deposit of Rs. 2, 00, 000.
A yearly rent of Rs. 60,000 to be increased by 10% every 5th year of tenancy
Option II: A yearly rent of Rs. 1,00,800 to be increased by 10% every 5th year of tenancy. Lease
period - 18 years
You are required to give your views on the alternatives from the point of view of the tenant. The rate of
discount is to be taken at 18%. The present value of Re. I payable at the end of the each year at 18%
starting from year I to year 18 are as follows: 1.0, 0847458,0.718184,0.608631',
0.515789,0.437109,0.370432,0.313925, 0.266038, 0.225456, 0.191064, 0.161919, 0.137220, 0.116288,
Test Questions
1. Right short notes on:
a) Finance Lease.
b) Sale and Lease back.
2. What is Lease? How is it different from installment sale?
3. Explain the concept of leasing. What are its advantages and limitations?
4. Explain the difference between leasing and hire-purchase.
5. What do you understand by the finance lease? Explain the difference between finance lease
and operating lease. '
6. Differentiate between leveraged lease and sale and lease-back.
7. What is lease-buy decision? What is the difference in lease ~buy decision from the point of'
view of the lessor and the lessee.
8. How are lease payments timed? What effect might advance payment have on the cash out- flows and
the tax benefits associated with the lease?
9. Leasing is often called hedge against obsolescence. Under what conditions is it true?
10. What are the similarities and differences between lease financing and debt financing? In what cases,
lease may be preferred?
P12.1 A company is considering to lease an equipment which has a purchase price of Rs. 3,50,000. The
equipment has an estimated economic life of 5 years. As per the Income Tax Rules a written down
depreciation at 25% is allowed. The lease rentals per year are Rs. 1,20,000. The company's marginal tax
rate is 50%. If the before-tax borrowing rate for the company is 16%, should the company lease the
equipment?
![Answer: The purchase option is better.]
P12.2 ABC Company Ltd., has two financial options in respect of procuring an Equipment for j
ulitising the same for 5 years costing Rs. 10,00,000. The two options are:-
Option I: Borrow Rs. 10,00,000 at an interest rate of 15%. The loan is repayable at 5 year-end
instalments. The equipment could be sold at the end of its 5 year economic life at a realisable value
ofRs.1,00,000.
Option 11: Lease-in the asset for a period of 5 years at yearly rental of Rs. 3,30,000 I payable at year-end.
The rate of depreciation allowable on the equipment is 15%. The company has to pay Income Tax @ 50%
and has a discounting rate of 16%. Capital gain or loss is to be ignored. Evaluate the two options and give
your opinion.
[Answer: PV of outflow of buying option is Rs. 5,78,164 and of leasing option is Rs. 5,40,210. So,
leasing is better.]
P12.3 ABC Machine Tool Company is considering the acquisition of a large equipment to set
up its factory in a backward region for Rs. 12,00,000. The equipment is expected to have an economic
useful life of 8 years. The equipment can be financed either with an eight: year term loan at 14% interest,
repayable in equal instalments of Rs. 2,58,676 per year, or by an equivalent amount of lease rental per
year. In both cases, payments are due at the end of the year. The equipment is subject to the straight line
method of depreciation. Assuming no salvage value, and 50% corporate tax rate. Which of the financing
alternatives should it select?
[Answer: The PV of outflows in buying option is Rs. 7,52,088 and in leasing option i.
Rs.7,72,277.So,thebuyingoptioni~better.]
The term take-over is used to denote the acquisition, which is hostile in nature and the company, which is
being taken-over, may put resistance and oppose the take-over bid. Two companies i.e., DCM Ltd. and
Escorts Ltd. successfully resisted the take-over bid on their companies by the Caparo Group of the U.K.
Recently, ICI Ltd. has acquired 9% (approx.) equity share capital of Asian Paints Ltd. (from one of its
major shareholder in order to acquire controlling interest in the latter).
Another form of acquisition may take place in the form of holding-subsidiary relationship between two
companies. A company is called a holding company if it controls the composition of the Board of
Directors of the other company, or holds more than half in nominal value of the equity share capital of the
other company. The other company in such a case is known as the subsidiary company. Both holding and
the subsidiary company, maintain their individual identity in the eyes of law as well as in practice.
Generally, the relationship between holding and subsidiary companies takes place at the time of
incorporation of the latter. Reliance Petro Chemical Ltd. was incorporated as a subsidiary of Reliance
Industries Ltd. and later it was merged into the holding company. Hindustan Lever Chemical Ltd.
(erstwhile Stepan Chemical Ltd.) is a subsidiary of Hindustan Lever Ltd. In most of the cases, subsidiary
companies are small in size and operate as an investment or financing arm of the holding company.
The Accounting Standard, AS-14, issued by the Institute of Chartered Accountants of India has defined
the term amalgamation by classifying (i) Amalgamation in the nature of merger, and. (ii) Amalgamation
in the nature of purchase.
Amalgamation in the nature of Merger: As per AS-14, an amalgamation is called in the nature of merger if
it satisfies all the following conditions:
i) All the assets and liabilities of the transferor company should become, after amalgamation, the assets
and liabilities of the other company.
ii) Shareholders holding not less than 90% of the face value of the equity shares of the transferor
company (other than the equity shares already held therein, immediately before the amalgamation, by the
transferee company or its subsidiaries or their nominees) become equity shareholders of the transferee
company by virtue of the amalgamation.
iii) The consideration for the amalgamation receivable by those equity shareholders of the transferor
company who agree to become equity shareholders of the transferee company is discharged by the
transferee company wholly by the issue of equity share in the transferee company, except that cash may
be paid in respect of any fractional shares.
iv) The business of the transferor company is intended to be carried on, after the amalgamation, by the
transferee company.
v) No adjustment is intended to be made in the book values of the assets and liabilities of the transferor
company when they are incorporated in the financial statements of the transferee company except to
ensure uniformity of accounting policies.
An amalgamation which does not fulfill any of the conditions mentioned above, is known as
amalgamation in the nature of purchase. It may be noted that the difference between amalgamation in the
nature of merger and amalgamation in the nature of purchase (as envisaged by the AS- 14) is relevant
particularly from the point of view of the accounting treatment of the merger trans- action in the books of
the transferee company.
Reverse Merger: It is a merger of a prosperous and profit making company into a loss making company,
which is generally a sick company and having eroded a substantial portion of its net worth. In the context
of the Companies Act, 1956, there is no difference between the regular merger and the reverse merger. It
is like any other merger. However, if one of the merging companies is a sick company under the Sick
Industries Companies Act, then such merger should take place through the Board\ of Industrial and
Financial Re-construction (BIFR). The reverse merger automatically makes the transferee company
entitled for the concessions and rebates under the Income Tax Act, 1961.
Difference types of merger and acquisitions can also be classified on the basis of the functional
relationship between two companies and the economic impact of the merger on their operations. The
merger may take place in any of the following situations:
1. Horizontal Merger: It is a case of merger of two or more companies that compete in the same
industry. It is a merger with a direct competitor and hence expands the firm's operations in the same
industry. Horizontal mergers are designed to produce, primarily, substantial economies of scale and result
in decrease in the number of competitors in the industry. The merger of Tata Oil Mills Ltd. with the
Hindustan Lever Ltd. was a horizontal merger.
In case of horizontal merger, the top management of the company being merged is generally, replaced by
the management of the transferee company. One potential repercussion of the horizontal merger is that it
may result in monopolies and restrict the trade.
2. Vertical Merger: It is a merger, which takes place upon the combination of two companies, which are
operating, in the same industry but at different stages of production or distribution system. If a company
takes over its supplier/producers of raw material, then it may result in backward integration of its
activities. On the other hand, forward integration may result if a company decides to take 'over the retailer
or customer company. Vertical merger may result in many operating and financial economies. The
transferee firm will get a stronger position in the market, as its production/distribution chain will be more
integrated than that of the competitors. Vertical merger provides a way for total integration to those firms,
which are striving for owning of all phases of the production schedule together with the marketing
network (i.e., from the acquisition of, raw materials to the retailing of final products).
3. Conglomerate Merger: It is a merger of two or more firms operating in different and unrelated
industries. It is an expansion of a company into areas unrelated to existing lines of business. In this case,
the company may not get the operating economies such as those, which may arise in case of horizontal or
vertical merger. In fact, the conglomerate merger results in portfolio of lines of business. There may
neither be increased concentration in anyone particular industry (as in horizontal merger), nor new control
of raw material etc., (as in case of vertical merger). But there is an increase in total economic activities of
the firm.
The conglomerate merger may be called pure when the activities of two firms being merged are totally
unrelated e.g., merger of an automobile company with textile company. It may be called congeneric
merger if the companies being merged are engaged in activities which are complementary but not direct
competitive e.g., merger of a car manufacturer with a scooter manufacturer. The conglomerate mergers do
not reduce the number of competitors in an industry but may result in some operating and financial
economies to the company.
Irrespective of the type of merger, there are at least two firms involved. One, the buying company that
acquires the other company, and survives after merger. This firm is known as an acquiring firm or
transferee company. The other is the company, which is merged and loses its identity in the process. This
is called the acquired company, or Transferor Company or the target firm. There are various modes in
which the acquiring firm can attempt a merge~' move and therefore, merger can also be classified on the
basis of initiative style or the procedure adopted by the acquiring firm. These are as follows:
a) Negotiated Merger: It is also called friendly merger. In this case, the management/owners of both the
firms sit together and negotiate for merger. The acquiring firm negotiates directly with the management of
the target firm. So, the willingness of the management of the target firm is implied here. If the two firms
reach an agreement, the proposal for merger may be placed before the shareholders of the two companies.
However, if the parties do not reach at an agreement, the merger proposal stands terminated and dropped
out. The merger of ITC Classic Ltd. with ICICI Ltd., and merger of Tata Oil Mills Ltd. with Hindustan
Lever Ltd. were negotiated mergers. However, if the management of the target firm is not agreeable to the
merger proposal, then the acquiring firm may go for other procedures i.e., tender offer or hostile take-
over.
b) Tender Offer: A tender offer is a bid to acquire controlling interest in a target firm by the acquiring
firm by purchasing shares of the target firm at a fixed price. The acquiring firm approaches the
shareholders of the target firm directly to sell their shareholding to the acquiring firm at a fixed price. This
offered price is generally, kept at a level higher than the current market price in order to induce the
shareholders to disinvest their holding in favor of the acquiring firm. The Acquiring firm may also
stipulate in the tender offer as to how many shares it is willing to buy or may purchase all the shares that
are offered for sale.
In case of tender offer, the acquiring firm does not need the prior approval of the management of the
target firm. The offer is kept open for a specific period within which the shares must be tendered for sale
by the shareholders of the target firm. Consolidated Coffee Ltd. was taken- over by Tata Tea Ltd. by
making a tender offer to the shareholders of the former at a price, which was higher than the prevailing
market price. In India, in recent times, particularly after the announcement of new take-over code by
SEBI, several companies have made tender offers to acquire the target firm. A popular case is the tender
offer made by Sterlite Ltd. and then counter offer by Alcan to acquire the control of Indian Aluminium
Ltd.
c) Hostile Take-over Bid: The acquiring firm, without the knowledge and consent of the management of
the target firm, may unilaterally pursue the efforts to gain a controlling interest in the target firm, by
purchasing shares of the later firm at the stock exchanges. Such case of merger/acquisition is popularity
known as 'raid'. The Caparo Group of the U.K. made a hostile take-over bid in 1988 to take-over DCM
Ltd. and Escorts Ltd. Similarly, some other NRl's have also made hostile bid to take-over some other
Indian companies. The new take- over code, as announced by SEBI deals with the hostile bids.
d) Arranged Mergers: In India, the Board for Industrial and Financial Reconstruction has also been
active for arranging mergers of financially sick companies with other companies under the package of
rehabilitation. These merger schemes are framed in consultation with the lead bank, the target firm and
the acquiring firm. These mergers are motivated and the Lead bank takes the initiative and decides terms
and conditions of merger. The recent take- over of Modi Cements Ltd. by Gujarat Ambuja Cement Ltd.
was an arranged take-over after the financial reconstruction of Modi Cement Ltd.
13.3 Defence against Tender Offer and Hostile Take-over Bids: A firm having all or any of the
following features may provide a temptation to an acquiring firm to take-over the former:
a) The target firm has under performed other shares and the overall market in terms of retutn the
shareholders in the preceding years.
b) The target firm has been less profitable than other firms, and
c) The promoter/owner group has lower shareholding in the target firm and the public has a, higher
portion.
If an acquiring firm makes an offer for negotiated merger to the management of the target firm, it is up to
the latter to accept or not to accept the offer. The target firm may not find the offer to be attractive and
hence it may reject the offer. However, the acquiring firm may still persists with the idea either by making
a tender offer or attempting a hostile take-over bid. In such a case, it is the responsibility of the
management of the target firm to take defensive measures to thwart away any bid for take-over. The
management has a fiduciary position in the company and should take decisions in the best interest of the
shareholders. Moreover, the existence of the management of the target firm is also uncertain, as there is
an all likely chance of change of management of the target firm, if the take-over bid is successful.
What the present management can do in such circumstances? One obvious but impractical solution is that
promoter should increase their shareholding so as to have 51 % plus holding. This may require a public
offer, which is not only expensive but will also expose the company to a counter bid. Such a situation is
not consistent with the concept of a listed company where substantial public funds are used. Alternatively,
the promoter and the existing management have three options before it as measures against the hostile
take-over bid. These are first, those which can ~e taken prior to the bid, second, those which are taken up
when the bid is in progress, and third, which can be taken up after the completion of the bid. The
management of the target firm should adopt tactics and fight away the take-over bid. The following are
some of the strategies that may be adopted to avoid/fight away the take-over bid.
i) Legal Strategy: The target firm cat} take a legal action by moving a court of law for grant-
Ing injunction against the offer. Relevant provision of Securities Contracts (Regulations) Act, 1956 and
the Companies Act, 1956 may be referred to. Lawsuits may be initiated to block or at least delay the
tender offer. Refusal to transfer registration of shares is the vintage and one of the most successful of
measures. Undoubtedly, the application of this measure is made at the time when the shares are lodged for
the transfer by the bidder. However, adequate preparation in advance also needs to be made to ensure that
such refusal is successful and is finally upheld in the court of law.
ii) Tactica1 Strategy: The management of target firm can adopt different types of tactical moves to
thwart away the take-over bid. The firm can mount a media campaign against the tender offer. However,
the campaign must be based on facts and figures. The firm can also send letters etc., to the shareholders
explaining them about the defects of the tender offer. The directors may explain that the consideration
being offered by the acquiring firm is not ad- equate; and that the merger/takeover does not make any
economic sense and the performance of the firm may be adversely affected by the take-over.
The management of the target firm may also persuade their business associates, directors, and employees
etc., to purchase the shares of the target firm from the market. This may result in reduction of floating
stock of the target firm and thus making it difficult for the bidder firm to acquire the controlling interest.
Another way to thwart away the take-over bid is to find out a 'White Knight' who offers a higher bid for
the share of the target firm. With the higher bid offered by the White Knight, the take-over may not
remain a viable and profitable proposition to the original bidder. However in this case, the target firm still
loses its independence to the White Knight, but may get a better deal.
Further that the present management can increase the stake in the target firm by the issue of warrants or
convertible preference shares or convertible bonds etc., at a relatively low price. This is a good strategy to
fight away the expected take-over bid, however, the provisions of the new take-over code regarding
pricing of preferential issues must be taken-care of.
iii) Defensive Strategy: The target firm may take some action to destroy the attractiveness of the firm. It
may sell, mortgage, lease or otherwise dispose off some of its precious assets. The target firm, if having
large liquidity, may dispose of its liquidity by acquiring some as- set or other firm. This strategy is also
known as "Poison Pill". For example, if a hostile bid is made, the target firm takes on exorbitant and
expensive debts, which make it unattractive. While such a measure is not easily available in India in view
of the legal restrictions, this may be considered only as a theoretical strategy.
iv) Offensive Strategy: It is also known as 'Pac man' Strategy. The target firm in turn, may launch a
counter take-over bid on the acquiring firm. For example, firm A makes a tender offer before the
shareholders of firm B. As a strategy, the firm B may also make a tender offer to acquire the shares of
firm A. However, this strategy can be adopted only in case when the target firm is quite big and
financially sound. As a variant, the target firm may also buy-off the acquirer by placing a lucrative offer
before the management of the acquiring firm. The management of the target firm may also offer to pay a
higher price for the shares in the target firm already purchased by the acquiring firm. It is quite possible
that in view of such a move from the target firm, the acquiring firm may not pursue the take-over bid.
13.4 Motives and Reasons Behind Mergers: A number of motives have been often cited as the reason
for mergers. The simplest rationale is the under valuation of the target firm. An under valued firm (by the
financial market) will be a target for acquisition by other firms. However, the fundamental motive for the
acquiring firm to take-over a target firm may be the desire to increase the wealth of the shareholders of
the acquiring firm. This is possible only if the value of the new firm is expected to be more than the sum
of individual value of the target firm and the acquiring firm. For example, if A Ltd. and B Ltd. decide to
merge into AB Ltd. then the merger is beneficial if
Value of AB Ltd. > Value of A Ltd. + Value of B Ltd.
A merger, which results in meeting the test of in9reasing the wealth of the shareholders, is said to contain
synergistic properties. Synergy is the increase in value of the firm combining two firms into one entity
i.e., it is the difference value between the combined firm and the sum of the value of the individual firms.
There may be various sources for this extra value arise i.e., the in- crease in wealth of the shareholders as
a result of merger. Some of these are:
1. Operating Economies: The key to the existence of synergy is that the target firm controls a specialized
resource that becomes more valuable when combined with the bidding firm's re- sources. The sources of
synergy of specialized resources will vary depending upon the merger.
In case of horizontal merger, the synergy comes from some form of economies of scale, which reduce
costs, or from increased market power, which increases profit margins and sales. There are several ways
in which the merger may generate operating economies. The firm might be able to reduce the cost of
production by eliminating some fixed costs. Eliminating similar research efforts and repetition of work
already done by the target firm will also substantially reduce the research and development expenditures
in the new set up. The management expenses may also come down substantially as a result of corporate
reconstruction.
The selling, marketing and advertisement department can be streamlined. The marketing economies may
be produced through savings in advertising (by reducing the need to attract each other's customers), and
also from the advantage of offering a more complete product line (if the merged firms produce different
but complementary goods), since a wider product line may provide larger sales per unit of sales efforts
and per sales person. When a firm having strength in one functional area acquires another firm with
strength in a different functional area, synergy may be gained by exploiting the strength in these areas. A
firm with a good distribution network may acquire a firm with a promising product line, and thereby can
gain by combining these two strength. The argument is that both firms will be better off after the merger.
A major saving may arise from the consolidation of departments involved with financial activities e.g.,
accounting, credit monitoring, billing, purchasing etc.
Thus, when two firms combine their resources and efforts, they will be able to produce bet- ter results
than they were producing as separate entities because of savings in various types of operating costs. These
resultant economies arc known as synergistic operating economies. There is no denying the fact that there
is a potential for operating synergy, in one form or the other, in most of take-over. Some disagreement
exists however, over whether synergy can be valued, and if so, how much that value should be. Some
argue that the synergy is too nebulous to be valued and that any attempt to do so requires so many
assumptions that it is point less. Although valuing synergy requires assumptions about future cash flows
and growth, the lack of precision in the process does not mean that an unbiased estimate of value cannot
be made. The synergy can be valued by answering fundamental questions: What form is the synergy
expected to take? Will it reduce costs as a percentage of sales and increase profit margins? Will it increase
future growth?
2. Diversification: Diversification into new areas and new products can also be a motive for a
firm to merge an other with it. A firm operating in North India, if merges with another firm
operating primarily in South India, can definitely cover broader economic areas. Individually
these firms could serve only a limited area. Moreover, products diversification resulting from
merger can also help the new firm fighting the cyclical/seasonal fluctuations. For example, firm
A has a product line with a particular cyclical variations and firm B deals in product line with
counter cyclical variations. Individually, the earnings of these two firms may fluctuate in line
with the cyclical variations. However, if they merge, the cyclically prone earnings of firm A
would be set off by the counter cyclically prone earnings of firm B. Smoothing out the earnings
of a firm over the different phases of a cycle tends to reduce the risk associ ated with the firm. The
figure 30.1 depicts the effect of counter-cyclical diversification.
The above figure shows that through the diversification effects, merger can produce benefits to all firms
by reducing the variability of firm’s earnings. If firm A's income generally rises when B's income
generally falls, and vice-a-versa, the fluctuation of one will tend to set off the fluctuations of the other,
thus producing a relatively level pattern of combined earnings. Indeed, there will be some diversification
effect as long as the two firm's earnings are not perfectly correlated (both rising and falling together). This
reduction in overall risk is particularly likely if the merged firms are in different lines of business.
The diversification motive is based on the proposition that if two risky projects are combined, then the
risk of combination will be less than the weighted average of the risk of these two projects. The greatest
benefit from diversification can be obtained by continuin5 firms from different industries i.e.,
conglomerate mergers, where two firms with poorly correlated cash flows merged to create a portfolio of
a firms (a conglomerate can be viewed as a portfolio of firms.
Sometimes, doubts are raised for considering diversification as a motive for merger. The real question is
whether the firm should create a portfolio of firms or the shareholders themselves can do the same by
diversifying their portfolios. In both the cases, the total risk of the shareholders is reduced. But portfolio
of firms in a conglomerate merger is costly as the acquisition of firms is a costly exercise. On the other
hand, a shareholder can easily create a diversified portfolio of firms merely by holding the shares of
diversified companies. This is much easier and cheaper than creating a portfolio of firms in conglomerate
merger.
3. Earnings Per Share (EPS): Increasing the EPS of the firm can also be a motive for the merger. A firm
can increase its EPS by acquiring another firm, which is profitable and has a low Price Earning (PE)
Ratio. Suppose, firm A and firm B have the following particulars.
Firm A Firm B
Earnings Rs.10,00,000 Rs.3,00,000
Number of shares 10,00,000 2,00,000
EPS Re.l.00 Rs.l.50
Market price Rs.20 Rs.12
PE Ratio 20 8
Now the firm A decides to acquire firm B and for this purpose evaluates three options of price offer: (i)
Rs. 12 per share of firm B (i.e., the market price); (ii) Rs. 30 per share of firm B (i.e., the EPSxExlsting
PE Ratio of firm A); and (iii) Rs. 35 per share of firm B (i.e., a price higher than EPS of B x Existing PE
Ratio of firm A). The effects of these three price options have been presented in the following table: