Financial Management

The Management of Business Finance

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Understanding The Core Concept of Financial
Management
To understand the core concept of the subject, we have to define the
following three terminologies:
• Business.
• Finance.
• Management.

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Business
• Business refers to any legal busyness for earnings. In other words
business is the summation of all legal economic activities. All illegal
and non economic activities are excluded from the scope of business.

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Forms of Business Organization
• Sole Proprietorship.
• Partnership.
• Corporation

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Types of Business
• Merchandise Business. (Trading)
• Manufacturing Business. (Industry)
• Commerce.
• Profession

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 6

FINANCE
Finance is the combination of seven functions that can be explained
with the help of components contained in the spelling of this
terminology.

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The first “F” of Finance.
This covers the following areas:
1:Financial Planning so as to determine the financial objectives of the proposed project.
2:To determine the required amount of capital for the achievement of objectives.
3:To determine the sources of capital.
4:To devise capital structure so as to procure the capital.

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The “I” of finance.
• It refers to investment decision.
• Investment decision refers to the selection of assets for the business.
• Assets fall mainly into two categories:
1:Current Assets.
2:Fixed Assets.

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The “I” of Finance (Contd.)
• Current Assets: Those assets that are either in cash form or convertible into cash within
one accounting period. The normal duration of an accounting period is one year. The
examples of currents asset are:
• Cash.
• Accounts Receivable.
• Inventory.
Current Assets are managed through the management of working capital.

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The “I” OF Finance (Contd.)
• Fixed Assets: Assets that are used in business operations and not exhausted in one
accounting period, such as:
• LAND.
• Building.
• Plant and Machinery.
• Motor Vehicle.
• Furniture, etc.
To handle long lived assets, Capital budgeting process is carried out.

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The “N” of Finance.
Taking investment decisions is not an easy job in today’s complex and competitive business world.
Therefore, such decisions will never be taken in isolation. To have positive and fruitful investment
decisions, we will have to go a step ahead in finance that is “N” .
This function refers to negotiation and consultation with other departmental heads and executives
regarding investment decisions. As two heads are better than one, therefore, this function
ensures the combination of skills and judgment in the process of decisions making.

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The “A” of Finance.
• Allocation of funds among the assets selected through negotiation
and consultation.
• To allocate funds among the selected assets, optimization must be
ensured so as to multiply ultimate profitability and value of the firm
by maximizing stockholders wealth.

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The second “N” of Finance.
• It refers net results determination.
• In other words “Standards/Targets Setting” such as:
• Out Put.
• Costs.
• Quality, etc.

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The “C” of Finance.
• This function refers to control process.
• Controlling refers to a persistent comparison of actual performance with the pre determined
standards.
• As it is a continuous process that highlights any deviation (Variance) from the standard well in
time.
• The variances highlighted by the control process are then analyzed so as to determine that either
they are favorable or unfavorable.
• Then favorable variances are retained by making certain adjustments in standards and remedial
measures are taken against unfavorable variances.

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The last “E” of Finance.
• This function refers to Evaluation Process.
• As change is an unchangeable law of nature– Changes were, Changes are and Changes
will be, we can’t stop changes.
• Keeping in view the fact, we will have to manage the change.
• Evaluation process provides the “WHAT, WHY,HOW, BY WHOM and WHEN” of the
change management.

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MANAGEMENT—A Preface.
Every human being has several needs and wants, but no individual can fulfill all his desires himself. Therefore, people
work in organized groups to achieve what they cannot achieve individually. There are several types of organized
groups, e.g., a family, a cricket team, a school, a business firm, a government, etc. Whenever there is an organized
group of people working towards a common goal, some type of management becomes essential. Group efforts
become productive only when they are effectively managed. Every organization makes use of money, materials,
machinery, and manpower. Management is required to assemble and coordinate these resources in the best
possible manner for the achievement of desired objectives.

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The Concept of Management.
The term management can be defined in several ways:
1: As a body of individual, management refers to all those persons who are concerned with getting things done
through and with people in formal groups. The prime Minister of a country is as much a manager as the Manager
Director of a company, and the commander of an army.
2:As a subject of study, management implies that branch of knowledge which is concerned with the study of
principles and practice of administration.
3: As process, management refers to the functions which are performed to make productive use of material and
human resources to achieve the desired objectives

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Conclusion of the concept of Management
0f the various interpretations, the meaning of management as a process is most popular.
Thus management may be defined as the sum of total activities which are undertaken to
plan, organize, direct and control the efforts of a formally organized group of people in
order to serve the interests of all. It involves the coordination of human efforts and
physical resources towards the achievement of organizational, social and individual
objectives.

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The concrete definition of Financial
Management
After the thorough study of the aforesaid terminologies, now we are in a position to
present a comprehensive definition of the subject.
Financial Management refers to the managerial process that plan, organize, assemble,
direct, coordinate and control the financial resources of an organization, so that not only
to ensure the well planned procurement of required resources, but also their best
utilization for the achievement of organizational goals.

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Scope of Financial Management
• Scope refers to the range of application or jurisdiction.
• The scope of financial management can be highlighted by two
different angles:
• 1:- The scope of financial management as a subject of study.
• 2:- The scope of financial management as a field of specialization.

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Scope of Financial Management
• Scope of financial management as a subject of study is extended to
the coverage of all topics given in the table of contents of any book of
financial management.

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Scope of Financial Management
• Scope of financial management as a field of specialization refers to the jurisdiction of the practice
of financial management. It refers to the range of application of the knowledge of financial
management. So as a field of specialization, financial management covers the following decisions
areas.
• Which projects to take? (Investment decisions)
• How to finance these projects? (Financing decisions)
• How much to return to investors? (Dividend decisions)
• • How to manage working capital and its components? (Liquidity decisions)

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Financial markets
and Institutions

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CONTENTS

• FINANCIAL MARKETS
• FINANCIAL INSTITUTIONS

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AN OVERVIEW OF FINANCIAL
SYSTEM

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What is Financial system?
Financial system (FS) – a framework for describing set of markets,
organisations, and individuals that engage in the transaction of
financial instruments (securities), as well as regulatory institutions.
- the basic role of FS is essentially channelling of funds within the
different units of the economy – from surplus units to deficit
units for productive purposes.

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I. AN OVERVIEW OF FINANCIAL MARKETS

• What are Financial Markets?

• Structure of Financial markets?
• Instruments traded in Financial markets?
• Functions of Financial markets

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1. Financial Markets?
• Financial markets perform the essential function of channeling
funds from economic players that have saved surplus funds to
those that have a shortage of funds
• At any point in time in an economy, there are individuals or
organizations with excess amounts of funds, and others with a
lack of funds they need for example to consume or to invest.

• Exchange between these two groups of agents is settled in

financial markets
• The first group is commonly referred to as lenders, the
second group is commonly referred to as the borrowers of
funds.

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1.1 Financial Markets?
We will start our discussion on financial markets with some
basic definitions:
• There exist two different forms of exchange in financial markets.
The first one is direct finance, in which lenders and borrowers meet
directly to exchange securities.
• Securities are claims on the borrower’s future income or assets.
Common examples are stock, bonds or foreign exchange
• The second type of financial trade occurs with the help of financial
intermediaries and is known as indirect finance. In this scenario
borrowers and lenders never meet directly, but lenders provide
funds to a financial intermediary such as a bank and those
intermediaries independently pass these funds on to borrowers

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1.2 Structure of Financial Markets
Financial markets can be categorized as follows:

• Debt vs Equity markets

• Primary vs Secondary markets
• Exchange vs Over the Counter (OTC)
• Money vs Capital Markets

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 Debt vs Equity

• Financial markets are split into debt and equity markets.

• Debt titles are the most commonly traded security. In these arrangements,
the issuer of the title (borrower) earns some initial amount of money (such
as the price of a bond) and the holder (lender) subsequently receives a
fixed amount of payments over a specified period of time, known as the
maturity of a debt title.

• Debt titles can be issued on short term (maturity < 1 yr.), long term
(maturity >10 yrs.) and intermediate terms (1 yr. < maturity < 10 yrs.).

• The holder of a debt title does not achieve ownership of the borrower’s
enterprise.

• Common debt titles are bonds or mortgages.

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 Debt vs Equity

• Equity titles are somewhat different from bonds. The most common equity
title is (common) stock.

• First and foremost, an equity instruments makes its buyer (lender) an

owner of the borrower’s enterprise.

• Formally this entitles the holder of an equity instrument to earn a share of

the borrower’s enterprise’s income, but only some firms actually pay
(more or less) periodic payments to their equity holders known as
dividends. Often these titles, thus, are held primarily to be sold and resold.

• Equity titles do not expire and their maturity is, thus, infinite. Hence they
are considered long term securities.

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PRIMARY MARKETS Vs SECONDERY MARKETS

Markets are divided into primary and secondary markets

• Primary markets are markets in which financial instruments are

newly issued by borrowers.

• Secondary markets are markets in which financial instruments

already in existence are traded among lenders.

• Secondary markets can be organized as exchanges, in which titles

are traded in a central location, such as a stock exchange, or
alternatively as over-the-counter markets in which titles are sold in
several locations.

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 MONEY MARKETS VS CAPITAL MARKETS

Finally, we make a distinction between money and capital markets.

• Money markets are markets in which only short term debt titles are
traded.

• Capital markets are markets in which longer term debt and equity
instruments are traded.

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 1.3 INSTRUMENTS TRADED
IN THE FINANCIAL MARKETS

• Most commonly you will encounter:

• Corporate stocks are privately issued equity instruments, which
have a maturity of infinity by definition and, thus, are classified as
capital market instruments

• Corporate bonds are private debt instruments which have a certain

specified maturity. They tend to be long-run instruments and are,
hence, capital market instruments

• The short-run equivalent to corporate bonds are commercial

papers which are issued to satisfy short-run cash needs of private
enterprises.

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 1.3 INSTRUMENTS TRADED
IN THE FINANCIAL MARKETS

• Most commonly you will encounter:

• On the government side, the most commonly used long-run debt
instruments are Treasury Bonds or T-Bonds. Their maturity exceeds ten
years.

• Short-run liquidity needs are satisfied by the issuance of Treasury Bills or

T-Bills, which are short-run debt titles with a maturity of less than one year.

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 Functions of Financial markets

• Borrowing and Lending

• Financial markets channel funds from households, firms,
governments and foreigners that have saved surplus funds to those
who encounter a shortage of funds (for purposes of consumption
and investment)

• Price Determination
• Financial markets determine the prices of financial assets. The
secondary market herein plays an important role in determining the
prices for newly issued assets

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 Functions of Financial markets

• Coordination and Provision of Information

• The exchange of funds is characterized by a high amount of incomplete and
asymmetric information. Financial markets collect and provide much
information to facilitate this exchange.

• Risk Sharing
• Trade in financial markets is partly motivated by the transfer of risk from
borrowers to lenders who use the obtained funds to invest

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 Functions of Financial markets

• Liquidity
• The existence of financial markets enables the owners of assets to
buy and resell these assets. Generally this leads to an increase in the
liquidity of these financial instruments

• Efficiency
• The facilitation of financial transactions through financial markets
lead to a decrease in informational cost and transaction costs, which
from an economic point of view leads to an increase in efficiency.

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 2.FINANCIAL INSTITUTIONS
• What are Financial Institutions?
• Financial Institutions and their function
• Types of Financial Institutions

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2.1What are Financial Institutions ?

• Financial intermediaries are firms that collect the funds from lenders and
channel those funds to borrowers (Mishkin)
• Financial intermediaries are firms whose primary business is to provide
customers with financial products and services that can not be obtained
more efficiently by transacting directly in securities markets (Z.Bodie
&Merton)

• Any classification of financial institutions is ultimately somewhat arbitrary,

since financial markets are subject to high dynamics and frequent
innovation. Thus, we roughly use four categories:
• Brokers
Engage in trade in securities
• Dealers
(direct finance)
• Investment banks
Engage in financial asset
• Financial intermediaries
transformation (indirect
finance)
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2.1What are Financial Institutions? (Cont)

• Brokers are agents who match buyers with sellers for a desired
transaction.

• A broker does not take position in the assets she/he trades (i.e. does not
maintain inventories of those assets)

• Brokers charge commissions on buyers and/or sellers using their services

• Examples: Real estate brokers, stock brokers

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2.1What are Financial Institutions? (Cont)

• Like brokers, dealers match sellers and buyers of financial assets.

• Dealers, however, take position in their assets, their trading.

• As opposed to charging commission, dealers obtain their profits from

buying assets at low prices and selling them at high prices.

• A dealer’s profit margin, the so-called bid-ask spread is the difference

between the price at which a dealer offers to sell an asset (the asked
price) and the price at which a dealer offers to buy an asset (the bid price)

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2.1What are Financial Institutions? (Cont)

• Investment Banks

• Investment banks assist in the initial sale of newly issued securities (e.g.
IPOs)

• Investment banks are involved in a variety of services for their customers,

such as advice, sales assistance and underwriting of issuances

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2.1What are Financial Institutions? (Cont)
• Financial Intermediaries

• Financial intermediaries match sellers and buyers indirectly through the

process of financial asset transformation.
• As opposed to three above mentioned institutions. they buy a specific kind
of asset from borrowers –usually a long term loan contract – and sell a
different financial asset to savers –usually some sort of highly-liquid
short-run claim.
• Although securities markets receive a lot of media attention, financial
intermediaries are still the primary source of funding for businesses.
• Even in the United States and Canada, enterprises tend to obtain funds
through financial intermediaries rather than through securities markets.
• Other than historic reasons, this prevalence results from a variety of
factors.

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2.2 Function of Financial Intermediaries:
Indirect Finance
• Lower transaction costs
• Economies of scale
• Liquidity services
Since transaction costs are reduced, financial intermediaries are able to provide
customers with additional liquidity services, such as checking accounts which can be
used as methods of payment or deposits which can be liquidated any time while still
bearing some interest.
• Reduce Risk
• Risk Sharing (Asset Transformation)
• Diversification
• Through the process of asset transformation not only maturities, but also the risk of
an asset can change: A financial intermediary uses funds it acquires (e.g. through
deposits) and often turns them into a more risky asset (e.g. a larger loan). The risk
then is spread out between various borrowers and the financial intermediary itself.
• The process of risk sharing is further augmented through diversification of assets
(portfolio-choice), which involves spreading out funds over a portfolio of assets
with different types of risk.

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 2.2 Functions of Financial Intermediaries: Indirect Finance

• Reduce Asymmetric Information

• Asymmetric Information in financial markets - one party often does not know
enough about the other party to make accurate decisions.
• Adverse Selection (before the transaction)—more likely to select risky borrower
• Moral Hazard (after the transaction)—less likely borrower will repay loan
=> Financial intermediaries are important in the production of information. They help
reduce informational asymmetries about some unobservable quality of the
borrower for example through screening, monitoring or rating of borrowers, Net
worth and collateral.

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2.2 Functions of Financial Intermediaries: Indirect Finance

• Finally, some financial intermediaries specialize on services such as

management of payments for their customers or insurance contracts
against loss of supplied funds.

• Through all of these channels financial intermediaries increase market

efficiency from an economic point of view.

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 2.3TYPES OF FINANCIAL
INTERMEDIARIES

• There are roughly three classes of financial intermediaries:

• Depository institutions accept deposits from savers and transform
them into loans (Commercial banks, savings and loan associations,
mutual savings banks and credit unions)

• Contractual savings institutions acquire funds at periodic intervals on

a contractual basis (insurance and pension funds)

• Investment intermediaries serve different forms of finance. They

include finance companies, mutual funds and money market mutual
funds.

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 Commercial Bank

Savings and Loans Associations (S&L)

Depository
Institutions Mutual Saving Banks

Credit Unions

Specialized Banks

Financial Contractual
Intermed savings Insurance Companies
iaries Institutions
Pension Funds

Finance Companies
Investment
Intermedarie
s Mutual Funds (Investment Funds)

Money market Mutual Funds 50

COST OF CAPITAL
What is cost of capital?
• Cost of capital is the minimum required rate of earning or the cutoff
rate for capital expenditure.
• It is also referred to as a “hurdle” rate because this is the minimum
acceptable rate of return.
• Any investment which does not cover the firm’s cost of funds will
reduce shareholder wealth (just as if you borrowed money at 10% to
make an investment which earned 7% would reduce your wealth.)
What is cost of capital?
• Cost Of Capital • “ The minimum rate of return that the firm must
earn on investment so that the market value of the company’s equity
share does not fall”
• Importance of the cost of capital
• – Importance from the capital budgeting decisions
• The NPV is calculated using the cost of capital as the discount factor
• The IRR calculated is compared with the minimum rate of return
while selected and rejecting the project
Explicit cost
• The explicit cost of capital is associated with the raising of funds.
• Implicit cost:
• For example: I have Rs. 100,000, I can deposit it in bank and earn
Rs.3500 as bank interest but I did not invest it in saving bank account
and invested in the shares of XYZ company. So, my implicit cost of
investment in shares will equal to the bank interest.
 Cost of capital

Cost of Debt Cost of

Preference Cost of Equity
Share

Retained
Redeemable Irredeemable Normal Equity earnings

Irredeemable Redeemable
Cost of DEBT Capital
FORMULA FOR THE AFTER TAX COST OF DEBT

• ATKd=Kd(1-T)
• Where: Kd = The before tax cost of debt
• T = The firm’s marginal tax rate
• Consider that ABC Ltd’s before tax cost of debt is 10 percent and its
marginal tax rate is 40 percent. The after tax cost of debt is:
• ATKd=Kd(1-T) =.10(1-.40)
• .10 x .60
• .06 or 6%
 Cost of Debt Capital
Practice Question—Cost of Debt

• Jules’ Security Company can issue new bonds with a market interest rate of 14 %. Jules’ marginal
tax rate is 32%. Compute the after tax cost of debt, ATKd, for this company.
• Solution;
• ATKd= Kd(1-T)
• Kd= 0.14
• T = 0.32
• Put the values in the equation
• ATKd= 0.14(1-0.32) =0.14 x 0.68 =0.0952 = 9.52%-
Cost of Debt

• – Irredeemable
• AT Par
• AT Discount/Premium
• – Redeemable
• AT Par
• AT Discount/Premium
Cost of Irredeemable Debt( issued at par)

• kd= (1-T) X I
• k = cost of capital ( to be calculated)
• T= tax rate
• I= annual interest rate to be paid to the creditor ( in percentage)
• Example: A company has issued debentures worth Rs 1,00,00 of par value
of Rs 1000.The coupon rate is 9%.What is the cost of debt. Tax rate is 50%
• There is no mention of the maturity date
• Thus this is the case of irredeemable debt
• kd= (1-T)I
• Kd = 0.5X9% = 4.5%
Cost of Irredeemable Debt( issued at
Premium or Discount)

Kd = (1-T) X I
Net Proceeds

• k = cost of capital ( to be calculated)

• T= tax rate
• I= annual interest rate to be paid to the creditor( in Rs)
• Net Proceeds = Total amount raised by the company by issuing the debentures ( in Rs)
• Incase of par --- It is equal to the par value
• In case of discount --- it is less than par value
• In case of premium--- it is more than the par value
Cost of Irredeemable
Debt(Par/Discount/Premium)
• Example : A company issues the debentures worth Rs 1,00,000 at coupon rate 10%.The company is
in the tax bracket of 55%.Calculate the cost of debt if the debentures are issued
• At PAR
• At a discount of 10%
• At a premium of 10%
Kd = (1-T) X I
Net Proceeds

• I = Rs 10,000
• T= .55
• In case of Par Net proceeds = Rs1,00,000
• Kd = 4.5% –
• In case of Discount Net Proceeds = Rs 90,000
• Kd = 5%
• In case of Premium Net Proceeds = Rs1,10,000
• Kd= 4.09%
Cost of Redeemable Debt

• In the previous case we have assumed that the bonds are not
maturing and thus are continuously going on
• In case the bond matures after the certain period of time then it is
called redeemable debt
• The formula to be used is kd (before tax) =I +(P-Net Proceed)/n
• (P+ Net Proceed)/2
• I = annual interest payment ( in RS)
• Net Proceeds = Total amount raised by the company by issuing the
debentures ( in Rs)
• P = Par value of debenture (the value that the creditor gets at maturity) (in Rs)
• n = Maturity period of the bond
• Example
• • A firm issues debenture of Rs 1,00,000 but is able to realize only 98,000 due to
2% commission to the broker. The debentures carry an interest rate of 10%The
debentures are due for maturity after 10 years. Calculate the cost of capital
• Kd(Before Tax) = I + (P-Net Proceeds)/n
• (P + Net Proceeds)/2
• – I = 10,000,
• P= 1,00,000,
• NP =98000, n= 10
• Kd( before Tax) = 10.30%
• kd (after tax) =( 1-T) X kd (before tax)
• Calculate after tax cost of capital if the firm is in the tax bracket of 55%
Cost of PREFERRED Capital
FORMULA FOR COST OF PREFERRED STOCK

Kp = Dp
• Pp
• Where: Kp = The cost of the preferred stock issue; the expected return.
• Dp = The amount of expected dividend.
• Pp = The current price of the preferred stock.
• Assume that ABC Ltd issued preferred stock that has been paying dividends of Rs.2.50 and is
expected to continue to do so indefinitely. The current price of its preferred stock is Rs.20 a
share. So the cost of firm’s preferred stock is ;
• Kp = Dp / Pp = Rs. 2.50 / Rs. 20 =.125 or 12.50%
Cost of Preference Capital
• – Cost of Irredeemable Preference Capital
• Kp = Dp/Np
• Dp= Total Preference dividend to be given
• Np = Net proceeds generated by the firm
• Example: A company raises the capital of Rs 1,00,000 by issuing 10000
preference share of Rs 10 each. The dividend rate on the preference share is
10%. Calculate the cost of preference share when
• Preference shares are issued at par
• Preference shares are issued at 10% premium
• Preference share are issued at 10% discount
Cost of Preference Capital ( Irredeemable)

• Kp = Dp/Np
• Preference shares are issued at 10% premium
• Dp = Rs 10,000
• Np = 1,10,000
• Kp = 9.09%
• Preference share are issued at 10% discount
• Dp = Rs 10,000
• Np = 90,000
• Kp = 11.11%
Cost of Preference Capital ( redeemable)
• Kp = D + (P-Net Proceeds)/n
• (P+ Net Proceeds)/2
• D = Dividend on preference shares
• P = Principal to be paid to the creditors
• – Net Proceed= Amount actually received by the firm
• – n = Maturity period
• Example: A firm has issued preference share of Rs 100 each
generating a proceed of Rs 1,00,000.The dividend rate is 14%.The
Preference shares will be redeemed after 10 years. Floatation cost is
about 5%.Determine the cost of preference share.
Cost of Preference Capital ( redeemable)
• Kp = D + (P-Net Proceeds)/n
• (P+ Net Proceeds)/2
• Kp= 14000 +(100000-95000)/10 = 14500/97500 = 14.87%
• (100000 + 95000)/2
Cost of Preference Capital ( redeemable)
• Example 2: A firm 10 % redeemable shares of Rs 1,00,000, redeemable at
the end of 10 years. The underwriting cost is about 2 %.Calculate the
preference share cost
• Kp = D + (P-Net Proceeds)/n
• (P + Net Proceeds)/2
• D ( Dividend to be paid ) = 10% of 1,00,000 = RS 10,000
• P = Principal to be paid to the creditors = 1,00,000
• Net Proceed= 98,000
• n = 10
• Kp = 10,200/99000 X 100 =10.30 %
Cost of Equity Capital

• Very difficult to calculate as there is no apparent cost involved as compared

to the cost of debt
• Some people argue that equity capital does not have any cost , since it is
not legally binding on them to pay dividends, but this argument is wrong
• People invest in the equity with an expectation of
• Getting the dividends
• Increase in the price of the share
• If a firm is not able to meet the expectation of share holders the price falls
• Thus cost of equity is defined as the “ rate of return” that the share holders
expect to earn on their investment
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Cost of Equity Capital
FORMULA FOR COST OF COMMON STOCK EQUITY

• Ks = D1 + g
Po
• Where: Ks = The required rate of return per period on this common stock investment.
• D1 = The dollar amount of the common stock dividend expected one period from now.
• Po =The current price of the common stock.
• g= The annual growth rate of dividends.
• Assume that ABC Ltd’s common stock is selling for Rs. 40 a share. Next year common stock dividend is
expected to be Rs. 4.20 and the dividend is expected to grow at a rate of 5% per year indefinitely. Given
these conditions, the cost of common stock is:
• Ks = D1 + g = .Rs.4.20 + 0.05
Po Rs.40
• = 0.105 + 0.05 = 0.155 or 15.5%
Cost of Equity Capital

Cost of Equity
Dividend Price
Approach

Without Growth in
Dividends With Growth in
Dividends

New Issue of Already Existing

Equity Equity
Already existing
New Issue of equity
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Cost of Equity Capital
• Approaches to finding the Cost of Equity
• Dividend Price Approach
• Without growth in dividends
• New issue of equity
• Already existing Equity
• With growth in dividends
• New issue of equity
• Already existing Equity
•

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 Cost of Equity Capital
•Dividend Price Approach
•Without growth in dividends (New issue of equity)
Ke = D
Np
•Ke = Cost of Equity
•D= Dividend Given
•Np = Net proceeds
Example : A company offers for public subscription the shares of Rs 10 at a
premium of 10%.The commission cost for the company is 5%.The
dividend rate is 20 % .Calculate the cost of equity.

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Cost of Equity Capital
• Dividend Price Approach
• – Without growth in dividends (New issue of equity)
• Ke = D X 100 %
Np
• Ke = To be calculated
• D= Rs 2
• Np = 11- (5% of 11) = Rs 10.45
• Ke = (2/10.45)X 100 = 19%

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Cost of Equity Capital
• Existing Share ( No Dividend Growth)
• Example : A company s share face value is Rs 10,has a market value
of Rs 15.The expected dividend to be paid is 20% of the face value.
Calculate the cost of equity.
• Ke = D X 100 %
Mp
• D = Dividend given
• Mp = Market Price of the share
• = Rs 2/15 = 0.133 or 13.3%
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Cost of Equity Capital
• Dividend Price Approach
• – With growth in dividends (New issue of equity)
• Ke = D + g
Np
• Ke = Cost of Equity
• D= Dividend
• Np = Net proceeds
• g = expected growth in dividends
• Example: A company issues new equity with each share at Rs
• 150. The underwriting cost is 2%. Following is the dividend history of the
company. The expected dividend on the new share is Rs 14.10 .Find the cost of
equity.
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Cost of Equity Capital
Year Dividend per share ( in Rs)
1994 10.50
1995 11
1996 12.50
1997 12.75
1998 13.40

Calculate the cost of equity?

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Cost of Equity Capital
• Dividend Price Approach
• – With growth in dividends (New issue of equity) –
• So formula to be used is Ke = D + g
Np
• Ke = Cost of Equity
• D= Rs 14 .10
• Np = 98% of Rs 150 = Rs 147
• g = expected growth in dividends can be calculated from the table
• Rs 10.50 is invested for 4 years and becomes Rs 13.40.
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Cost of Equity Capital
• 10.50(1+g)4 = 13.40
• (1+g)4 = 13.40/10.50 Calculate g
• Easier way :>>>>
• Divide the latest dividend by the first dividend
• Look in the compound value table for 4 year row for the above calculated
factor to find g.
• From both ways g= 6%.
• Put in the formula to calculate Ke = 14.10/147 + .06 = 15.6%

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Cost of Equity Capital
• Dividend Price Approach
• – With growth in dividends (Existing equity) – So formula to be used is
• Ke = D + g
Mp
• Ke = Cost of Equity
• D= Dividend given
• Mp = Market price of the share
• g = expected growth in dividends
• Example: A company's share has a market price of Rs 20.The company pays a dividend of Rs 1 per
share. The shareholders expect a growth rate of 5 % per year. Calculate the cost of equity.
• So formula to be used is Ke = D + g
Mp

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Cost of Equity Capital
• Ke = Cost of Equity
• D= Rs 1
• Mp = Market price of the share = Rs 20
• g = expected growth in dividends = 5%
• Put values in the equation: Ke = D + g
Mp
• Ke = Rs. 1/20 + .05 = .05 +.05
• Ke = 10%

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 Cost of Retained earnings

• The net Profit after tax that is not distributed by the company to the share
holders is called retained earnings.
• Such earnings are used by the companies for the future expansions
• Some people think that these earnings are free of cost and does not cost
anything to the company, WHICH IS ABSOLUTLEY WRONG!
• Because if theses earnings were given to the share holders then they would
have invested them somewhere and in turn have earned on that
investment.
• Thus the cost of the retained earnings is the “ Earnings Sacrificed “ or the
“Opportunity Lost” by the investors, if they were given the earnings
retained by the company.
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 Cost of Retained earnings
• Adjustment Required in Retained earnings
• The money retained by the company is not equal to that given to the investors.
• Investors pay tax on the money given as dividends
• They also incur brokerage cost on making adjustment
• This means if the company has 50,000 Rs as retained earnings and it decides to give it to
the investors then the investors will have less than 50,000 to invest while the company
will have Rs 50,000 to invest.
• ABC limited is earning a net profit of Rs 50,000 per annum. The shareholders
require a rate of return of 10%.It is expected that the retained earning if
distributed among the shareholders can be invested in a security of similar type
carrying a rate of return of 10% per annum. It is further expected that the
shareholders will incur a brokerage cost of 2% on the dividend received to make
the new investment. The shareholders are in the tax bracket of 30%.Calculate the
cost of retained earnings for the company.

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 Cost of Retained earnings
Dividend

Solution: In order to calculateDividend

the cost of retained earning we should
Dividend
Dividend
first calculate the net dividend available to the share holders net of tax
and other costs.
Dividend Given: Rs. 50000
Less Income Tax @30% 15000
After Tax Dividend 35000
Brokerage Cost @2% 700
Net Dividend available for investment 34300
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•
 Cost of Retained earnings
• Now the available money in the hands of the investor is Rs
34,300.Expected earnings = 10% of Rs 34,300 = Rs3430
• Thus the expectation of the investors is to earn Rs 3430 from the
retained earnings. Which in other words mean if the money is not
distributed to the share holders the company need to earn Rs 3430
on 50,000. Therefore Kr = 3430/50,000 = 6.86%

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Weighted Average Cost of Capital (WACC)
• Weighted Average Cost of Capital (WACC): Assume that Firm markets 3 Types of
Financial Products (or Securities or Instruments) to attract Investors’ Capital.
• Bonds (Debt): Cost = Coupon Interest
• Common Shares (Equity): Cost = Variable Dividend
• Preferred Shares (Hybrid Equity): Cost = Fixed Dividend
• The Firm Issues a Security or Financial Instrument to the Investor and Receives
Capital (or Money) in exchange. The Firm has to pay a “Rental Cost” for using the
Investors’ Capital.
• WACC % = Weighted % Cost of Debt + Weighted % Cost of Common Equity +
Weighted % Cost of Preferred Equity.
• Ka =(WTd x ATKd) +(WTp x Kp) + (WTs x Ks)
• WACC must take Taxes & Transaction Costs into account
Weighted Average Cost of Capital (WACC)
• WACC (Weighted Average Cost of Capital)
• We are going to talk about the very important component of capital structure
which is known as weighted average cost of capital (WACC).
• The objective of the company is to raise capital at the lowest possible cost .just
as when you go to the market you try to buy things at the lowest possible cost.
• Similarly, companies looking for money in financial markets they try to raise
funds at the lowest possible cost.
• This means that when the company raises money in the stock market issues that
it try to sell its shares at the price at which it can earn maximum profit.
• Similarly, when a company go to the money market to take loan it tries to get the
loan at the lowest possible rate of interest .
Weighted Average Cost of Capital (WACC)
• WACC = Ka =(WTd x ATKd) +(WTp x Kp) + (WTs x Ks)

• Weighted % Cost of Bond (Debt): WTd x ATKd :

• Where : WTd =The weight, or proportion of debt used to finance the firm’s assets.
• ATKd =The after tax cost of debt.
• Weighted % Cost of preferred Equity: WTp x Kp
• Where : WTp = The weight, or proportion of preferred stock being used to finance
the firm’s assets.
• Kp = The cost of preferred stock.
• Weighted % Cost of common Equity ; WTs x Ks
• Where: WTs =The weight, or proportion of common equity being used to finance
the firm’s assets.
• Ks = The cost of common equity.
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NUMERICAL QUESTION ON WACC
Stars Corporation has an after tax cost of debt of 8 percent, a cost of
preferred stock Of 12 percent and a cost of equity of 16 percent.
What is the weighted average cost Of capital, Ka or WACC, for this
company? The capital structure of star company Contains 20
percent debt, 10 percent preferred stock and 70 percent equity.
 Solution
• WACC= Ka = (WTd x ATKd) + (WTp x Kp) +(WTs xKs)
• Where: WTd= 20%
• ATKD =8%
• WTp = 10%
• Kp 12%
• WTs = 70%
• Ks = 16%
• Put values in the equation
• Ka = (.2 x.08) + (.1 x .12) + ( .7 x .16)
• Ka = .016 + .012 + .112
• Ka = .14 or 14%
Weighted Average Cost of Capital
• The capital of the company consists of various components. Thus the company wants to
calculate the total cost of the capital. This total overall or the total cost of capital is calculated
based on the “weights” of each component on the total capital. Thus the total cost of capital is
also called the “weighted cost of capital “
• Steps involved in calculating the weighted average cost of capital.
• Calculate the cost of different capital components like cost of debt, cost of preference shares,
cost of equity, cost of retained earnings etc.
• Assign weights to each components.
• Ways to calculate the weights
• Weights based on the book value of the capital ( Book value Weights)
• Weights based on the basis of Market value of the capital ( Market Value weights)
• Both of the above together is called the “HISTORICAL WEIGHT METHOD” of calculating the
weight
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Weighted Average Cost of Capital
• Example: From the following capital structure calculate the overall
cost of capital by
• Book Value method
• Market Value method
• After tax cost of different components is as follows
• cost of equity capital =14%, Cost of Debt = 5%, cost of Preference
shares = 10%, Cost of retained earnings = 13%.

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Weighted Average Cost of Capital
Source Book Value Market Value

Equity Share Capital ( Rs Rs 45,000 90,000

10 pr share)

Retained earnings 15,000

Preference Share 10,000 10,000

Debenture 30,000 30,000

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Weighted Average Cost of Capital
• Steps: ( Book Value Method)
• 1. Calculate the weights of different components 2. Multiply diff
weights with after tax cost of capital.
• 3. Add all to get the weights average cost of capital

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Weighted Average Cost of Capital
Source Weights After cost of capital Weights cost

Equity Share Capital ( Rs 10 Rs 14% 6.30

pr share) 45,000/1,00,000
0.45
Retained earnings 15,000/100,000 = 13% 1.95
0.15
Preference Share 10,000/1,00,000 = 10% 1
0.10
Debenture 30,000/1,00,000 5% 1.5
=0.30
TOTAL 10.75%

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Weighted Average Cost of Capital

• Example: Excel industries ltd has the assets of Rs 1,60,000 which have
been financed by Rs 52,000 of debt, Rs 90,000 of equity and a general
reserves of Rs 18,000.The Profit after tax for the firm has been Rs
13,500.It pays 8% interest on the borrowed funds .It has 900 equity
shares of FV Rs 100 each, selling in the market at a price of Rs 120 per
share. Calculate the weighted average cost of capital both by market
value method and book value method. Tax Rate is 50%.

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Weighted Average Cost of Capital

• Steps( by Market Value Method)

• Calculate the weights
• Total capital =MV of Debt + MV of Equity
• Rs 52,000+108,000 = 1,60,000
• Wt of debt = 52,000/1,60,000 =0.325
• Wt of Equity = 0.675
• Calculate the cost of various components
• Kd =4%
• Ke= Not given so need to be calculated. EPS/MPPS = Ke
• Calculate the total cost of capital = .325X4% +0.675X12.5% = 9.74%
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