Corporate Finance

Time Value of Money

Fundamental Valuation
Importance of Time Value of Money
Reasons
Individuals prefer current consumption to future consumption Investor can profitably employ a rupee received today to get higher returns after certain period of time In inflationary economy, money received today, has more purchasing power than money to be received in future Rupee today, is worth more than a rupee in the future

The Interest Rate

Which would you prefer Rs.10,000 today or Rs.10,000 in 5 years?
Obviously, Rs.10,000 today. You already recognize that there is TIME VALUE TO MONEY!!

Why TIME?
Why is TIME such an important element in your decision? TIME allows you the opportunity to postpone consumption and earn INTEREST.

Future Value Concept

Amount of money that an investment with fixed, compounded interest rate will grow to by some future date. Present Value: Amount today that is equivalent to a future payment of series of payment, that has been discounted by an appropriate interest rate Future Value Amount of money that an investment with a fixed compounded interest rate will grow to by some future date.

Techniques for comparison of cash flows

Compounding-to compute future value Discounting- to compute present value

Compounding Value Concept

Interest earned on the initial principal amount becomes a part of the principal at the end of a compounding period Multiple compounding periods Interest can be compounded for more than once a year A = P(1 + [i/m])mn n: Number of Years m: Compounding Periods per Year i: Annual Interest Rate A : Amount after a period P: Amount in the beginning of the period

Future Value of Series of Cash Flows

Number of transactions in real life are not limited to one.

Compound Sum of Annuity

Annuity is stream if equal cash flows. Annuities involve calculations based upon the regular periodic contribution or receipt of a fixed sum of money

Present Value Concept

Estimation of present worth of a future payment/installment or series of payment adjusted for the time value of money. PV = A / (1+i)n Where PV= principal amount the investor is willing to forego at present
I=Interest rate A=Amount at the end of the period n N=Number of years

Present Value
Present Value of Annuity Individual or depositor may receive only constant returns over the number of years Present Value of a Perpetual Annuity PV = A /i

Doubling Period
Rule of 72 Doubling period(Dp)= 72/I (Interest Rate) Rule of 69 Gives more accurate doubling period Dp= 0.35+69/I (Interest Rate)

Effective v/s Nominal Rate

Effective and nominal rate
Are equal when compounding is done yearly once, but there will be difference Effective rate> Nominal rate for shorter compounding periods Effective rate = (1+I/m)^m -1 Where I = nominal rate of interest m= Frequency of compounding per year

Sinking Fund factor

Estimation of the amount of annual payments so as to accumulate a predetermined amount after future date is important to
Purchase asset, or Pay a liability Formula Ap= FVAn (I/(1+I)n -1) or FVA/FVIFA(I,n)

Loan Amortisation
L1 = PA(I(1+I)n/(1+I) n-1) or L1 = PA/ PVIFA(I,n) where L1 = Loan Installment PA = Principal amount I= Interest rate n= Loan repayment period. PVIFA(I,n) = PV interest factor at loan repayment period at a specified interest rate Shorter Discounting Period PV= CIFn ( 1/1+I/m ) m*n or PV= CIF*PVIFA (I/m, m*n )

Capital Budgeting

Capital Budgeting
Refers to planning the deployment of available capital for the purpose of maximizing the long-term profitability of the firm. Capital Budgeting decisions involves:
Search for new and more profitable investment proposals Making of an economic analysis to determine the profit potential of cash investment proposal.

Features
Exchange of current funds for future benefits Benefit future periods Has effect of increasing the capacity, efficiency, span of life regarding future benefits Funds investigated in long-term activities

Significance
Gross Working Capital
Optimum Investment in Current Assets Financing of Current Assets

Net Working Capital

Maintaining Liquidity Position Decide upon the Extent of Long-term Capital in Financing Current Assets

Capital Budgeting Process

Planning/Idea Generation Evaluation/Analysis Selection Financing of the Project Execution/Implementation Review of the Project

Investment Decision Criteria

Appraisal method should provide the following:
Basis of distinguishing between acceptable and non-acceptable projects Ranking of the projects in order of their desirability Choosing among the alternatives Bigger and early benefits are preferable to smaller ones

Investment Evaluation Criteria

Traditional Techniques
Pay back period Accounting rate of return

Discounted cash flow methods

Net Present Value(NPV) Internal Rate of Return(IRR) Profitability index (Benefit-cost)Ratio

Pay Back Period

Period required to recover the original cash outflow invested in the project Can be calculated by:
Formula (used when cash flow stream is equal in all years) Payback period = Original Investment/Constant Annual Cash flow after taxes or Payback period = Initial investment/Annual cash inflow

Pay Back Period (contd..)

Cumulative Cash flow method (applied when Cashflow after taxes are not uniform over the projects life period Payback period = Year before full recovery+( Unrecovered Amount of Investment / Cashflows during the next year)

Accept: Cal PBP<Standard PBP Reject: Cal PBP> Standard PBP Considered: Cal PBP= Standard PBP

Accounting Rate of Return

Uses accounting information as revealed by financial statements, to measure the profitability of the investment proposals. Measured in percentage terms When clearly mentioned as accounting rate of return
ARR= Average annual EAT/Original Investment * 100 Original Investment= Original Investment+ Additional NWC+ Installation Charges+ Transportation

When clearly mentioned as average rate of return

ARR = Average Annual EAT/Average Investment(AI) *100 AI = (Original investment-scrap)1/2+ Add. NWC+ Scrap Value Accept: Cal ARR> Predetermined ARR Reject: Cal ARR< Predetermined ARR Considered: Cal ARR= Predetermined ARR

Net Present Value

Present value of benefits minus present value of costs Steps:
Forecasting of cash inflows of the investment project based on realistic assumptions Computation of cost of capital, which is used as discounting factor for conversion Calculation of cash flows using cost of capital as discounting rate Finding out NPV by subtracting present value of cash outflows from present value of cash inflows

Accept-Reject rule
Accept: NPV>0 Reject: NPV<0 Consider: NPV=0

Internal Rate of Return

Rate at which the sum of Discounted Cash Inflow (DCF) equals the sum of discounted cash outflow
IRR = LDF%+ [ DF+ LDPV OI ]
LDPV-HDPV Where LDF= Discount factor of low trial DF= Difference between low discounting factor and high discounting LDPV= PV of cash flows at low discounting factor trial HDPV= PV of cash inflows at high discounting factor trial OI= Original Investment

Internal Rate of Return

Accept: IRR> Cost of capital Reject: IRR<Cost of capital Consider IRR= Cost of capital

Profitability Index
Ratio of present value of cash inflows at required rate of return to the initial cash outflow f the investment proposal PI measures the present value of future cash per rupee, whereas NPV is based on the difference between present value of cash inflows and cash outflows PI= PV of cash inflows/Initial cash outlay Accept: PI>1, Reject: PI1, Considered PI=1

Capital Rationing
Allocation of limited funds available for financing the capital projects to only some of the profitable projects in such a manner that long-term returns are maximised. Steps:
Ranking of different investment proposals Selection of some of the profitable investment proposals

Sensitivity Analysis
Way of analyzing the changes in NPV or IRR to a given change in one of the variables of capital investment proposal like estimated cash inflows of the project, rate of return or estimated economic life of the project. Steps:
Identification of all variables which have influence on the projects NPV or IRR Determination of mathematical relationship between various variables which affect the projects NPV or IRR Analysis of impact of changes in each of the variables on the projects NPV or IRR.

Working Capital

Determinants of Working Capital

Working capital refers to short-term funds to meet the day-to-day operations Nature of Business Size of Business Production Cycle Process Credit Policy Business Cycle Growth and Expansion Scarce availability of Raw Materials Profit Level Dividend Policy Depreciation Policy Availability of Credit

Concepts of Working Capital

Gross Working Capital (Quantitative Concept)
Investments in short-term assets such as cash, short-term securities, accounts receivable and inventories.

Significance:
Optimum Investment in Current Assets Financing of Current Assets

Net Working Capital (Qualitative Concept

Excess of current assets over current liabilities. Helps creditors and investors to judge the financial soundness of a firm Significance:
Maintaining liquidity position Decide upon the extent of Long-term capital in Financing current assets

Need of adequate Working Capital

Dangers of Excessive Working Capital
1. Unnecessary accumulation of inventories 2. Indication of defective credit policy and slack in collection policy 3. Managerial efficiency 4. Speculative profits

Dangers of Inadequate Working Capital

1. 2. 3. 4. 5. Stagnates growth Difficult to implement operating plans Operating inefficiencies Inefficient utilisation of fixed assets Loses its reputation

Operating Cycle
Conversion of cash into raw materials Conversion of raw materials into work-in progress Conversion of work-in-progress into finished goods Conversion of finished goods into sales[debtors and cash] Conversion of debtors into cash

Cash Conversion Cycle

CCC = OC- APP Where OC= Operating Cycle APP= Accounts Payable Period OC = AAI+ ARP AAI= Average Age of Inventory ARP = Average Collection Period AAI = Average Inventory Cost of Goods Sold/365 ARP= Average Accounts Receivable Annual Sales/365 APP= Average Accounts Payables Cost of Goods Sold/365

Determinants of Working Capital

Estimation of working capital
1. Estimation of cash cost of the various current assets required by the firm. 2. Estimation of spontaneous current liabilities of the firm 3. Compute net working capital by subtracting the estimate current liabilities 4. Add some percentage of net working capital, if there is any contingency or safety working capital required.

Financing of Working Capital Needs

Short-term Financing Long-term Financing Spontaneous Financing
Automatic sources of short-term funds arising in the normal course of a business. Sources include trade credit and outstanding expenses.

Cash Management

Cash Management
Motives for holding cash
Transaction motive Necessity of having cash for various disbursements Precautionary Motive Firms require cash for the payment of unexpected disbursements Speculative Motive Advantage of opportunities, which present themselves at unexpected moments, which are outside the normal course of business

Objectives of Cash Management To meet Cash Payments To maintain minimum Cash Balance

Aspects of Cash Management

Cash Inflows and Cash outflows Cash flow within the firm; and Cash balances held at the point of time Cash management strategies
Cash Planning Cash flow management Determination of optimum cash balance Investment of surplus cash

Cash Budget
Preparation of Cash Budget
Selection of period of time Selection of factor that has bearing on cash flows
Operating Cash Flows Financial Cash Flows

Factors Determining Cash Needs

1. Synchronisation of Cash Flows 2. Short Costs
1. 2. 3. 4. 5. Cost of Transaction Cost of Borrowing Cost of Deterioration Cost of Loss of Cash Discount Cost of Penalty Rates

3. Surplus Cash Balance Costs 4. Management Costs

Computation of Optimum Cash Balance

Baumol Model(Inventory Model) Used when the cost flows are predictable. Assumptions:
1. 2. 3. Firm knows its cash needs with certainty Cash payment occurs uniformly over a period of time Opportunity cost of holding cash is known and will remain stable over time Transaction cost if known and remains stable

4.

Elements of Total Cost

a) Conversion Cost= C[F/M] where F= Expected cash need for future period M=Amount of marketable securities sold in each sale a) Opportunity Cost (O) = I(M/2) where I=Interest Rate that could have been earned M/2= Average Cash balance Total Cost = Conversion Cost+ Opportunity Cost

Baumol Model(Inventory Model) (contd)

Economical(optimal) Conversion lot size: ECL= 2CF/O where ECL= Economic Conversion Lot F= Expected cash needed for future period C= Cost per conversion O= Opportunity cost

Miller and Off Model

Makes Baumol model more elastic with regards to the pattern of periodic changes in cash balance Provides 2 control limits:
Upper control limit and lower control limit Cash balance fluctuates between UPL and LCL

The Miller-Orr Model - Target Cash Balance (Z)

3

Z(Rp)=

3 x TC x V 4xr

+L

where: TC = transaction cost of buying or selling securities V = variance of daily cash flows r = daily return on short-term investments L = Lower control limit

Receivables Management

Receivables Management
Accounts Receivables Management, means making decisions relating to the investment in current assets as n integral part of operating process. Main objectives:
Maximising the value of the firm Optimum Investment in Sundry Debtors Control the cost of Trade Credit

Modes of Payment
Cash Mode Open Account
Credit Period Cash Discount

Bills of Exchange Letter of Credit Consignment

Factors influencing the size of Investment in Receivables

Volume of credit sales Credit Policy of the Firm Trade Terms Seasonality of Business Collection Policy Bills Discounting and Endorsement

Credit Policy
Lenient Credit Policy Stringent Credit Policy Credit Policy Variables
Credit Standards Credit Terms Collection Policy

Credit Evaluation of Individual Accounts

Monitoring Accounts Receivable

Receivables Turnover

Average Collection Period

Inventory Management
Sum of total of those activities necessary for the acquisition, storage, disposal or use of materials. Components:
Raw materials Work-in-progress Finished goods Stores and Spares

 Optimum level of inventory will lie between the two danger points of excessive and inadequate inventory
Consequences of Excessive Inventory Consequences of Inadequate Inventory 1. Opportunity Costs of funds 1. Interruption in Production tied up in inventory 2. Excessive stock out costs 2. Excessive carrying costs such as storage costs, handling costs, Insurance etc. 3. Risk of liquidity

Cost of holding inventories

Ordering Costs Carrying Costs

Costs incurred for acquiring inputs. Costs includei. Cost of placing an order ii. Cost of transportation iii. Cost of receiving goods iv. Cost of inspecting goods

Costs incurred in maintaining a given level of inventory. Costs includei. Cost of storage space, ii. Cost of handling materials, iii. Costs of Insurance iv. Cost of deterioration v. Cost of store staff

Inverse relationship between order size and Positive relationship between order size ordering cost. and carrying costs

Larger the order size, lower the ordering costs because of fewer orders
Smaller the order size, higher the ordering costs because of more orders

Larger the order size, higher the carrying costs because of high average inventory
Smaller the order size lower the carrying costs because of low average inventory.

Cost of holding inventories (contd..)

Shortage costs
Costs that arise due to shortage Shortage of raw materials
Firms to pay some higher prices, connected with immediate procurements Compulsorily resort to some different production schedules, which may not be as efficient and economical

Shortage of finished goods

May result in dissatisfaction of the customers and will lead to loss of rules

Risks of Holding Inventory

Price decline Product deterioration Product obsolescence

Tools and Techniques of Inventory Management

ABC Classification
Class A
5 15 % of units 70 % of value

Class B
30 % of units 20 % of value

Class C
50 60 % of units 5 10 % of value

EOQ
Level of inventory at which the total cost of inventory is minimum. EOQ =2AO/CC where A= Annual usage O= Ordering cost per order CC= Carrying cost per unit CC= Price per unit* Carrying cost per unit in percentage

Assumptions
Demand for the product is constant and uniform throughout the period Lead time is constant Price per unit of product is constant Inventory holding cost is based on average inventory Ordering cost are constant All demands for the product will be satisfied

 Different types of stock levels:

Minimum level
Determination of minimum stock level, lead time, consumption rate, the material nature must be considered Minimum stock level= Re-order level-[Normal level* Average delivery time]

EOQ

Reorder level
Level of inventory in weeks, which an order should be placed for replenishing the current stock of inventory Reorder Level= Lead time(in days) * Average Daily usage Assumption: Consistent daily usage and Fixed lead-time

Maximum level
Level of stock beyond which a firm should not maintain the stock. Maximum Stock Level= Reorder Level+ Reorder Quantity(Minimum Usage* Minimum Delivery Time)

EOQ
Average stock level
Average Stock Level= Minimum Level+ [Reorder Quantity/2]

Danger level
Levels of materials beyond which materials should not fall in any situation Danger Level= Average Usage*Minimum Deliver Time [ for emergency purchase]

Two Bin
Used to control C category inventories Stock divided into two piles, bins or groups:
First: Stock enough to last from the date a new order is placed until it is received for inventory. Second: Stock enough to meet the current demand over the period of replenishment.

VED
Inventories grouped on the basis of the effect of production Inventories grouped into
V: Vital E: Essential D: Desirable Vital category items are stocked high and Desirable items are maintained at minimum level

HML
Classification based on the unit value and not on the annual usage value. Three categories:
High Medium Low

Inventory should be listed in the descending order of unit value Management can set limits for three categories Useful in keeping control over consumption at department levels, deciding frequency of physical verification and for controlling purchases

SDE
Classification made based on availability of materials
S: Scarce D: Difficult E: Easy to acquire

FSN
Classification based on movement of inventories from stores.
F: Fast moving S: Slow moving N: Non moving

Involved in inventory useful for avoiding obsolescence. Determination of fast moving:

Date of receipt or last date of issue, whichever is later taken, which has lapsed since the last transaction Taken for the period of 12 months

Ordering Cycling System

Periodic reviews are made of each item of inventory and orders are placed to restore stock to prescribed supply Frequency depends on the criticality of inventory Approaches:
Fixed Order Quantity System(Q): Fixed order is placed once the stock level reaches the re-order level
When reaches re-order level- EOQ

Fixed Order Periodic System (P): Stock review is periodic and the frequency depends on company and importance of materials

Just In Time
Applied to either raw materials purchase or producing finished goods Also, known as Zero Inventory Production System, Zero Inventories, Materials as Needed or Neck of Time.

Leverage

Capital Structure
Capital Structure is that part of financial structure, which represents long-term sources Optimum capital structure is that capital structure at that level of debt-equity proportion where the market value per share is maximum and the cost of capital is minimum.

What is Leverage?
The firms ability to use fixed cost assets or funds to magnify the returns to its owners. James Horne has defined leverage as The employment of an asset or funds for which firm pays a fixed costs or fixed return. 2 types of fixed costs: Fixed operating costs = Rent, Depreciation. Fixed financial costs = Interests costs from debt.

Types of Leverages :
Operating leverage Financial leverage Composite leverage

Operating leverage
Is present any time, a firm has operating costs regardless of the level of production fixed costs do not vary with sales. Must be paid regardless of the amount of revenue available. Firms ability to use operating costs to magnify the effects of changes in sales on its earnings before interest and taxes Associated with investment activities Operating leverage is function of three factors:
The amount of fixed costs The contribution margin The volume of sales

Operating leverage = Contribution ( C ) Operating Profit (OP) Contribution= Sales-Variable costs Degree of operating leverage= % Change in EBIT % Change in sales

 According to Lawrence:

Financial Leverage

Ability of the firm to use fixed financial charges to magnify the effects of changes in EBIT on the firms earning per share

Use of fixed interest/dividend bearing securities such as debt and preference capital along with the owners equity in the total capital structure. When capital structure consists of equity shares and debt Financial Leverage = EBIT/Operating Profit (OP) EBT or Taxable Income

Degree of Financial Leverage (DFL) = % change in EPS % change in EBIT

Combined Leverage
% change in EBIT * % change in EPS % change in Sales % change in EBIT = % change in EPS % change in Sales Contribution * EBIT = Contribution EBIT EBT EBT

Combination of operating and financial leverage and effect of combination

Operating Leverage High Low Financial Leverage High Low Combined Effect Should be avoided Cautious policy and is not assuming risk

High
Low

Low
High

Adverse effect of operating leverage, taken care of by financial leverage

Combination is ideal situation. Company can follow aggressive debt policy

Cost of Capital

Concepts
From Investors perspective Firms point Capital Expenditure Point

Cost of Equity
Cost of Retained Earnings
Cost involved is opportunity cost
Formula: Kre = Ke [ (1-Ti ) * 100
(1-T b Where Ke Ti ) = Cost of Equity capital [ D/P or E/P +g] = Marginal tax rate applicable to the individuals concerned T b = Cost of purchase of new securities D= Expected dividend per share NP= Net proceeds of equity share/market price g = Growth rate in (%)

Approaches to Calculate the Cost of Capital

Dividends Capitalisation Approach (D/Mp Approach) Ke = D/CMP or NP where, Ke = Cost of equity D=Dividend per share CMP=Current market price per share NP= Net proceeds per share

Approaches to Calculate the Cost of Capital (contd)

Earnings Capitalisation Approach (E/MP) More useful than Dividend capitalisation approach due to:
It acknowledges earnings after payment of fixed dividend to preference shareholders Determining the market price of equity shares is based on earnings.

Approaches to Calculate the Cost of Capital (contd)

Dividend Capitalisation plus Growth rate Approach [(D/MP)+ g] Better than Dividend Capitalisation Approach since it considers the growth in dividends Ke= D +g NP or CMP where D=Dividend per share NP= Net Proceeds per share CMP= Current market price per share g = Growth rate (%)

Approaches to Calculate the Cost of Capital (contd)

Bond Yield Plus Risk Premium Approach Ke= Yield on long-term bonds+ risk premium Realised Yield Approach It takes into consideration the actual average rate of returns realised in the past few years along with the gain realised at the time of sale of share Capital Asset Pricing Model Approach (CAPM) Developed by William F Sharpe. Ke= Rf+ (Rmf-Rf)* Beta where Rf= Rate of return required on risk free security Beta= Beta coefficient Rmf= Required rate of return on market past folio of assets

Cost of Preference Shares

Cost of irredeemable preference shares
Kp= D/CMP or NP D= Dividend per share CMP= Market price per share NP= Net Proceeds With tax Kp (with tax)= D(1+ Dt)/NP * 100 Dt= tax on preference dividend

Cost of Debentures
Cost of Irredeemable Debenture
Pre tax cost

Kdi= I/P( Principal amount) or NP (Net sale proceeds)

Post-tax cost Kdi= I(1-t)/P ( Principal amount) or NP(Net sale proceeds)

 Cost of redeemable debentures Kd= LDF+ [ (HDF-LDF) LDFPV-NP]

LDFPV-HDFPV Where LDF= Lower Discounting factor HDF= Higher Discounting factor LDFPV= Lower discounting factor present value HDFPV= Higher dicounting factor PV PVCIF= Present value of cash inflows NP= Net proceeds

WACC
Steps
Determine the type of funds to be raised and their individual share in the total capitalisation f the firm Computation of cost of specific source of funds Assign weights (based on book value or market value) to specific weights Multiply the cost of each source by appropriate assigned weights Dividing the total weighted cots by total weights to get overall cost of capital

Marginal Cost of Capital

Company may raise additional funds for expansion. Cost is involved in raising it. Cost of additional funds is marginal cost of capital Weighted average cost of new capital using the marginal weights is marginal cost of capital

Capital Structure

Capital Structure Theories

These explain the relationship between capital structure, cost of capital and value of the firm There is a viewpoint that strongly supports the argument that financing leverage has major impact on the shareholders wealth. While others believe that financial structure is irrelevant as regards maximisation of shareholders wealth. Four theories: Net Income (NI) Approach Net Operating Income (NOI) Approach Modigilani-Miller (MI) Approach, and Traditional Approach

Assumptions
The firm employs only two types of capital-debt and equity. There are no corporate taxes The firm pays 100% of its earnings as dividend The firms total assets are given and they do not change. The firms total financing remains constant. The EBIT are not expected to grow The business risk remains constant and is independent of capital structure and financial risks The firm has a perpetual life.

Net Income Approach

According to NI approach both the cost of debt and the cost of equity are independent of the capital structure; they remain constant regardless of how much debt the firm uses.

As a result, the overall cost of capital declines as the leverage

ratio increases and the firm value increases with debt. Suggested by David Durand

Cost

According to the approach, capital structure decisions is ke, ko relevant in the valuation of the firm This approach has no basis in reality; the optimum capital structure would be 100 per cent debt financing under NI approach. Assumptions:
Debt kd

ke

ko kd

No corporate taxes Cost of debt is less than cost of equity or equity capitalisation rate Debt does not change the perception of the investors

Net Income Approach

The value of the firm on the basis of NI Approach can be ascertained as follows: V=S+B Where V= Value of firm S= Market Value of Equity B= Market Value of Debt S= NI/ke Where S= Market value of equity NI= Earnings available for equity shareholders; ke= Equity Capitalisation Rate.

Net Operating Income Approach

Net Operating Income Approach -- A theory of capital structure in which the weighted average cost of capital and the total value of the firm remain constant as financial leverage is changed.
Assumption: 1. Ko remains constant for all degrees of debt-equity mix or leverage 2. Market capitalises the value of the firm as a whole and therefore, the split between debt and equity is not relevant 3. There are no corporate taxes 4. Use of debt having low cost increases the risk of equity shareholders resulting in increase in equity capitalisation rate. Advantage of debt is set off exactly by increase in the equity capitalisation rate.

Net Operating Income Approach

V= NOI= (V=B+S) ko where V=value of capital k=Overall cost of capital
Assume: Net operating income equals 1,350 Market value of debt is 1,800 at 10% interest Overall capitalization rate is 15%

Traditional Approach
Traditional Approach -- A theory of capital structure in which there exists an optimal capital structure and where management can increase the total value of the firm through the judicious use of financial leverage. Optimal Capital Structure -- The capital structure that minimizes the firms cost of capital and thereby maximizes the value of the firm.

 Traditional approach is a mid-way between the two approaches. It partly contains the features of both the approaches as given below:
1. The traditional approach is similar to NI approach to the extent that it accepts that the capital structure or leverage of the firm affects the cost of capital and its valuation. However, it doesnt subscribe to the NI approach that the value of the firm will necessarily increase with all degree of leverages. 2. It advocates to the NOI approach that beyond a certain degree of leverages, the overall cost of capital increases resulting in decrease in the total value of the firm. However, it differs with NOI n the sense that the overall cost of capital will not remain constant for all degree of leverages.

Optimal Capital Structure: Traditional Approach

Traditional Approach
.25 ke ko

.20
Capital Costs (%) .15

kd .10 Optimal Capital Structure .05 0

Financial Leverage (B / S)

Summary of the Traditional Approach

The cost of capital is dependent on the capital structure of the firm.
Initially, low-cost debt is not rising and replaces more expensive equity financing and k declines. Then, increasing financial leverage and the associated increase in ke and ki more than offsets the benefits of lower cost debt financing.

Thus, there is one optimal capital structure where k is at its lowest point. This is also the point where the firms total value will be the largest (discounting at k).

Total Value Principle: Modigliani and Miller (M&M)

Advocate that the relationship between financial leverage and the cost of capital is explained by the NOI approach. Provide behavioral justification for a constant k over the entire range of financial leverage possibilities. Total risk for all security holders of the firm is not altered by the capital structure. Therefore, the total value of the firm is not altered by the firms financing mix.

Modigliani and Miller Approach

Assumptions: 1. Capital markets are perfect. This meansa) Investors are free to buy and sell securities b) Investors can borrow without restriction on the same terms on which the firm can borrow c) The investors are well informed d) The investors behave rationally; and e) There are no transaction costs.

2. The firms can be classified into homogenous risk classes 3. All investors have the same expectation of a firms EBIT with which to evaluate the value of any firm. The dividend pay-out ratios is 100% There are no corporate taxes.

Modigliani and Miller Approach

Basic Propositions 1. Overall cost of capital (ko) and the value of the firm (V) are independent of the capital structure 2. Cost of equity is equal to capitalisation rate of a pure equity stream plus a premium for the financial risk. 3. Cut-off rate for investment purposes is completely independent of the way in which an investment is financed.

Proposition
Proposition I The market value of any firm is independent of its capital structure and is given by capitalising its expected return at the rate appropriate to its risk class. Proposition II The expected yield on a share of stock is equal to the appropriate capitalisation rate (ko ) for a pure equity stream in the class, plus a premium related to financial risk equal to the debt-equity ratio times the spread between WACC ko and cost of debt kd

Arbitrage and Total Market Value of the Firm

Two firms that are alike in every respect EXCEPT capital structure MUST have the same market value. Otherwise, arbitrage is possible. Arbitrage -- Finding two assets that are essentially the same and buying the cheaper and selling the more expensive.

Corporate Tax Example: Company ND

Valuation of Company D (Note: has no debt)
Vi= Vu+Bt Vi= Value of levered firm Vu= Value of the unlevered firm B= Amount of debt T=Tax rate

Dividend

Concept of Dividend
Portion of the companys net earnings that is paid out to the equity shareholders Inverse relationship between retained earnings and payment of cash dividends

Forms of Dividend
Cash Dividend Scrip Dividend
Shareholders are issued transferrable promissory notes for a shorter maturity period that may or may not be interest bearing

Bond Dividend
Bond dividend has a longer maturity

Property Dividend
Payment of dividend takes place in the form of property

Stock Dividend(Bonus Shares)

Payment of additional shares of common stocks to the ordinary shareholders.

Factors affecting the dividend payout

Funds requirement Liquidity Availability of external sources of financing Shareholder preferences Difference in the cost of external equity and retained earnings Control Taxes

Types of Dividend Policies

Residual Dividend Approach Stable Dividend Policy Payment of certain amount of dividend regularly Three forms:
1.
2.

Constant Dividend per share e.g. (Rs. 2 as a dividend on the face value of share of Rs. 10)
Constant Payout Ratio
Constant percentage of net earnings.

3.

Stable Rupee Dividend plus Extra Dividend:

Minimum Dividend per share

Target Payout Ratio:

What percentage of earnings it wishes to pay out through dividends

Shares Repurchases Either to increase the value of shares or to eliminate any threats by shareholders

Relevance of dividends
Dividend decisions to be an active variable in determining the value of a firm. Supporting two theories:
Walters Model Gordons Model

Walters model
Assumptions of the model:
Financing through retained earnings Internal rate of return(R) and cost of capital (K) of the firm remains constant Firms earnings are either distributed as dividends or invested internally Firm has a infinite life. No change in the key variables EPS,DPS

Formula P= D+ r (E-D)
k (Cost of capital)
K (Cost of capital)

Where P = prevailing market price of share D =dividend per share E = earnings per share r = The rate of return on the firms investment

Relationship between R and K

Growth Firms( R>K) Optimum payout for Growth firm is 0% Normal Firms (R=K) All the payout ratios are optimum Declining Firms (R<K) Earnings optimum payout ratio for declining firms is 100%

Criticisms of the model

Assumption of investments financed by retained earnings would only be applicable to only equity firms R changes with the investment k is affected by the risk complexion of the firm

Overall the model ignores the effect of risk on the value of the firm

 Assumptions:

Gordons model

Firm is an all equity firm No external financing and all investments are financed exclusively by retained earnings R and ke are constant Firm has perpetual life Retention ratio is constant, once decided upon Thus, growth rate (g =br) is also constant ke >br Corportate tax doesnt exist

Formula P= Et(1-b) k- br Where P= Price per share, K=Cost of Capital, E=Earnings per share, b=retention ratio,(1-b)= payout ratio, g=br=growth rate (r=internal rate of return)

Interpretation
R>K price per share increases as the dividend payout ratio decreases R<K price per share increases as the dividend payout ratio increases R=K price per share remains unchanged in response to the change in the payout ratio

Irrelevance of dividend
Valuation of firm is unaffected by the distribution of dividends and is determined by the earning power and risk of its assets. Theories supporting it:
Modigliani and Miller(MM) Hypothesis

MM hypothesis
Dividend policy has no effect on the share price of the firm Investment policy is of prime importance Assumptions:
Perfect capital market No taxes and flotation cost Investment policy of firm doesnt change All information is available to all the investors No transaction cost and no time lag

Criticisms of theory
Tax effect Flotation Costs Transaction Costs Diversification Uncertainty Informational content of dividend

Long term sources of finance

Long-term sources of Finance

Purpose
To finance fixed assets To finance the permanent part of working capital To finance growth and expansion of business

Sources
Shares
Equity Preference

Debentures Public deposits Retained earnings Term loans from banks Loans from financial institutions

Ordinary Shares
Features
Permanent Capital Residual Claim on Income Residual Claim on Assets Voting right Pre-emptive Right Limited Liability

Types
Sweet Equity Shares Par-value shares No-par value shares

Primary Market-Mechanics
Public issue through Prospectus Book building Offer for sale Private placement Rights issue

Preference Shares
Features
Claim on Assets Claim on Income Accumulation of dividend Redeemable Fixed rate of dividend Convertible Participation in profits Voting rights

Debentures
Features
Fixed rate of interest Maturity Redemption Call and put option Debenture indenture Security interest Convertibility

Types of debentures
Bearer Registered Secured Unsecured Redeemable Perpetual Convertible Participating

Other sources
Loans from Venture Capital Mezzanine Debt Overseas ADRs/GDRs and ECBs

Lease Financing
Characteristics
The parties Asset Agreement Period Rent Use

Types
Operating Service Financial

Thank You