NMC M.

COM SEM-3

P.G.CENTER OF M.COM.
NANDKUNVARBA MAHILA COLLEGE

DEVRAJNAGAR -2, SHIVAJI CIRCLE, RING ROAD, BHAVNAGAR

M.COM SEM-3(English)

PAPER NO - (201)

Financial Management

ELECTIVE GROUP: Compulsory Account

1|P ag e
 NMC M.COM SEM-3

M.Com. Syllabus
SEMESTER-III
Financial Management (Compulsory Paper)
Paper number 201 Syllabus

Unit Details of Syllabus Teaching Marks/

Hours Weightage

I Introduction: 15 18
Introduction, Meaning, Nature, scope and objectives of
financial management Financial decision making and types of
financial decisions-Finance as a strategic function- Role of
finance manager -Agency problem- Stock price maximization
and agency costs - Alternatives to stock price maximization-
Stakeholders’ wealth maximization- Risk-return framework for
financial decision making [Only Theory Questions]
II Capital Budgeting: 15 18
Introduction, Meaning, Nature, significance and kinds of capital
budgeting decisions, Cash flow estimation, Capital budgeting
techniques - ARR, Payback period, Discounted payback period,
NPV, Equivalent annual NPV, IRR, Incremental IRR and
Modified IRR. Capital rationing.
[Theory & Practical Questions]
III Capital Structure: 15 17
Theories of capital structure- NI, NOI, MM Hypothesis without
and with corporate taxes, Merton Miller argument with
corporate and personal taxes, Trade off theory, Pecking order
theory, Signaling theory and effect of information asymmetry
on capital structure. Optimal capital structure, Determinants of
Capital structure in practice
[Theory & Practical Questions]
IV Dividend Policy: 15 17
Forms of dividends, Theories of relevance and irrelevance of
dividend in firm valuation, (Walter’s model, Gordon’s Model,
MM Hypothesis, Bird-in-hand theory and Dividend signaling
theory), Relevance of dividend policy under market
imperfections. Traditional and Radical position on dividend.
Issues in dividend policy, Types of dividend polices in practice
(constant rupee dividend policy, constant dividend pay out
policy, smooth stream dividend policy etc.) Determinants of
dividend policy, Lintner’s Model on corporate dividend
behavior [Only Theory Questions]

2|P ag e
 NMC M.COM SEM-3

UNIT – 1

Introduction
Business concern needs finance to meet their requirements in the economic world. Any kind
of business activity depends on the finance. Hence, it is called as lifeblood of business
organization. Whether the business concerns are big or small, they need finance to fulfil their
business activities.
In the modern world, all the activities are concerned with the economic activities and very
particular to earning profit through any venture or activities. The entire business activities are
directly related with making profit. According to the economics concept of factors of production,
rent given to landlord, wage given to labour, interest given to capital and profit given to
shareholders or proprietors, a business concern needs finance to meet all the requirements. Hence
finance may be called as capital, investment, fund etc., but each term is having different
meanings and unique characters. Increasing the profit is the main aim of any kind of economic
activity.
Meaning of finance
Finance may be defined as the art and science of managing money. It includes financial
service and financial instruments. Finance also is referred as the provision of money at the time
when it is needed. Finance function is the procurement of funds and their effective utilization in
business concerns.
The concept of finance includes capital, funds, money, and amount. But each word is having
unique meaning. Studying and understanding the concept of finance become an important part of
the business concern.
Definition of finance
According to Khan and Jain, “Finance is the art and science of managing money”.
According to Oxford dictionary, the word ‘finance’ connotes ‘management of money’.
Webster’s Ninth New Collegiate Dictionary defines finance as “the Science on study of the
management of funds’ and the management of fund as the system that includes the circulation of
money, the granting of credit, the making of investments, and the provision of banking facilities.
1.1.A Objective of Financial Management
The main objective of a business is to maximize the owner’s economic welfare. Financial
management provides a framework for selecting a proper course of action and deciding a
commercial strategy.
Objective of
Financial
Management

Maximization of Cost Market Share Value Welth

EPS Maximization
Profit Minimization Maximization Maximization Maximizatiom

1. Profit Maximization: Profit earning is the main aim of every economic activity. A business
being an economic institution must earn profit to cover its costs and provide funds for
growth. No business can survives without earning profit. Profit is a measure of efficiency of
a business enterprise. Profit also serves as a protection against risks which cannot be ensured.
Arguments in favors of Profit Maximization / Advantage / Merits / Proms

3|P ag e
 NMC M.COM SEM-3

1. Objective of Business: - When profit earning is the aim of the business then the profit
maximization should be the obvious objective.
2. Barometer of efficiency: - Profitability is the barometer for measuring the efficiency and
economic prosperity of a business enterprise, thus profit maximization is justified on the
ground of the rationality.
3. Growth & Development: - Profits are the main source of finance for the growth of the
business. So a business should aim at maximization of the profits for enabling its growth and
development.
4. Social Goal: - Profitability is essential for fulfilling the social goals also. A firm by pursuing
the objectives of profits maximization also maximizes the socio economic welfare.
5. Survivable: - A business may be able to survive under unfavourable condition only if it had
some past earnings to rely upon.
Arguments against of Profit Maximization / Demerits / Corns / Disadvantage
1. Precisely Define: - It is precisely defined. It means different things for different people. The
term ‘Profit’ is vague and it cannot be precisely defined. It means different things for
different people. Should we mean (i) Short term profit or long term profit? (ii) Total profit or
earning per share? (iii) Profit before tax or after tax? (iv)Operating profit or profit available
for the shareholders?
2. Ignore the Time value of Money: - It ignores the time value of money and does not
consider the magnitude and the timing of earnings. It treats all the earnings as equal though
they occur in different time periods. It ignores the fact that the cash received today is more
important than the same amount of cash received after, say, three years.
3. Risk of Prospective earning: - It does not take into consideration the risk of the prospective
earnings stream. Some projects are more risky than others. Two firms may have same
expected earnings per share, but if the earning stream in one is more risky the market share of
its share will be comparatively less.
4. Effect on Dividend Policy: - The effect of the dividend policy on the market price of the
shares is also not considered in the objective of the profit maximization. In case, earnings per
share is the only objective then the enterprise may not think of paying dividends at all
because it retains profits in the business or investing them in the market may satisfy this aim.
2. EPS Maximization: Maximization EPS implies that the total earnings are retained and re –
invested in the business of the firm and no partition of the earing’s is distributed as divided
among the shareholders so long as earning can be re – invested at a rate of return higher than
opportunity cost of retained earnings.
Arguments against of EPS Maximization
1. Investors who prefer current dividend as against the future uncertain capital gains would not
like such a policy.
2. EPS lacks time value of Money.
3. Cost Minimization: Cost Minimization implies making the product / services available at the
minimum cost such a policy may not always result in highest sales revenue or highest profit.
Since market value is not the function of cost, minimizing cost will not result in highest price for
company’s share. Hence, such a policy may not always works as primary goal of financial
management.
4. Market Share Maximization: Market share maximization implies maximizing sales revenue
by serving maximum number of customers such a policy may not always results in highest profit.

4|P ag e
 NMC M.COM SEM-3

Since, maximizing market share will not results in highest price for the company’s share. Hence,
such a policy may not always works as Primary Goal of financial Management.
5. Value Maximization: Value Maximization includes the following; 1. Maximizing value of
firm, 2. Maximizing Shareholder’s value and 3. Maximizing share Price. The above may be
consider as three equivalent goals of Financial Management.
6. Wealth Maximization: Financial theory asserts that the wealth maximization is the single
substitute for a stake holder’s utility. When the firm maximizes the shareholder’s wealth, the
individual stakeholders can use this wealth to maximize his individual utility. It means that by
maximizing stakeholder’s wealth the firm is operating consistently toward maximizing
stakeholder’s utility. A stake solder’s wealth in the firm is the product of the numbers of the
shares owned, multiplied within the current stock price per share.
Stockholder’s current wealth in the firm = (No. Of shares owned) * (Current stock price
Per share)
Higher the stock price per share, the greater will be the shareholder’s wealth. Thus a firm
should aim at maximizing its current stock price, which helps in increasing the value of shares in
the market.
Maximum Max. Shareholder Max. Current
stock price of
Utility Wealth
Share
Implication of the wealth maximization:
1. Universally: - The Concept of wealth maximization is universally accepted, because it takes
care of interest of financial institution, owners, employees and society at large.
2. Strong Dividend Policy: - Wealth maximization guides the management in framing the
consistent strong dividend policy to reach maximum returns to the equity holders.
3. Serves Interest of Stakeholder: - Wealth maximization objective not only serves the
interest of the shareholder’s by increasing the value of their holdings but also ensures the
security to the lenders.
Criticism of wealth maximization:
1. Prescriptive Idea: - It is a prescriptive idea. The objective is not descriptive of what the firm
actually does.
2. Socially Desirable: - The objective of wealth maximization is not necessarily socially
desirable.
3. Controversy: - There is some controversy as to whether the objective is to maximize the
stockholder’s wealth or the wealth of the firm, which includes other financial claimholder’s
such as debenture holders, preference shareholders.
4. Difficulties in Separate Ownership: - The objective of wealth maximization may also face
difficulties when ownership and management are separated, as is the case in most of the
corporate form of organizations. When managers act as the agents of the real owner, there is
the possibility for a conflict of interest between shareholders and the managerial interests.
Difference between profit Maximization and Wealth Maximization
Basis Profit Maximization Wealth Maximization
Definition Profit Maximization is based on the Wealth Maximization is based on the
increase of sales and profits of the cash flows into the organization.
organization.
Focused Profit Maximization emphasizes on Wealth Maximization emphasizes on
short term goals. long term goals.

5|P ag e
 NMC M.COM SEM-3

Time Value Profit Maximization ignores the time Wealth Maximization considers the
of Money value of money. Time value of money time value of money. In wealth
refers the money receivable today is maximization, the future cash flows are
more valuable than the money which is discounted at an suitable discounted
going to be received in future. rate to represent their present value.
Risk Profit Maximization ignore the risk and Wealth Maximization considers the
uncertainty. risk and uncertainty.
Reliability In the new business environment Profit Wealth maximisation objectives
maximization is regarded as unrealistic, ensures fair return to the shareholders,
difficult, inappropriate and immoral. reserve funds for growth and
expansion, promoting financial
discipline in the management.
Objective Profit Maximization objective leads to Wealth Maximization provides
exploiting employees and consumers. it efficient allocation of resource, It
also leads to inequalities and lowers ensures the economic interest of the
human values. society.
NATURE OF FINANCIAL MANAGEMENT
1 Estimates Capital Requirements
Financial management helps in expectation of funds required for running the business. It
estimates working and fixed capital requirements for carrying out all business activities. The
finance manager prepares a budget of all expenses and revenues for a particular time period on
the basis of which capital requirements are determined.

2 Decides Capital Structure

Deciding optimum capital structure for an organization is a must for attaining efficiency and
earning better profits. It involves deciding the proper portion of different securities like common
equity, preferred equity, and debt. The proper balance between debt and equity should be
attained which minimizes the cost of capital.
3 Select Sources of Fund
Choosing the source of funds is one of the crucial decisions for every organization. There are
various sources available for raising funds like shares, bonds, debentures, venture capital,
financial institutions, retained earnings, owner investment, etc. Every business should properly
analyze different sources of funds available and choose one which is cheapest and involves
minimal risk.
4 Selects Investment Pattern
Once funds are procured it is important to allocate them among profitable investment avenues.
The investment proposal should be properly analyzed regarding its safety, profitability, and
liquidity. Before investing any amount in it all risk and return associated with it should be
properly evaluated.
5 Raises Shareholders Value
Financial management works towards raising the overall value of shareholders. It aims at
increasing the amount of return to shareholders by reducing the cost of operations and increasing
the profits. The finance manager focuses on raising cheap funds from different sources and
invests them in the most profitable avenues.

6|P ag e
 NMC M.COM SEM-3

6 Management Of Cash
Financial management monitors all funds movement in an organization. Finance managers
supervise all cash movements through proper accounting of all cash inflows and outflows. They
ensure that there is no situation like deficiency or surplus of cash in an organization.
7 Apply Financial Controls
Implying financial controls in business is a beneficial role played by financial management. It
helps in keeping the company actual cost of operation within the limit and earning the expected
profits. There are various processes involved in this like developing certain standards for
business in advance, comparing the actual cost or performance with pre-established standards,
and taking all required remedial measures.
SCOPE OF FINANCIAL MANAGEMENT
Two important functions of financial management are to procure finance for business and to
make effective use of it. In addition, decision about dividend policy also comes within the scope
of financial management. For procuring finance, it is important to make an estimate of the actual
requirements of finance and to explore sources from where this finance can be raised. This may
be termed as Planning for Finance Procurement. It must also be decided for which activities will
finance be needed and whether these are profitable activities or not. For example, capital
investment schemes likely to require substantial investment as well as the scheme of obtaining
working capital for existing business are included in this finance function. Decision regarding
how to calculate profit (including retained earnings, depreciation allowance etc.) and how to
distribute it among the shareholders are inseparable from financial management. Thus, the three
important managerial finance functions are investment decision, financing decision and dividend
decision.
There are two recognised approaches to the scope of financial management the traditional
approach and modern approach. Under the traditional approach, The role of the financial
manager is confined to raising of funds only. It does not consider effective utilisation of funds as
a part of financial management function. On the other hand the modern approach lays emphasis
on both the functions of financial management, namely, raising of funds and making efficient use
of funds. Thus the traditional approach represents a narrow view of the scope of financial
management, while modern approach is a broader view of the same. This distinction between the
traditional approach and modern approach to the scope of financial management is discussed
below :
The interpretation of the term finance function, that is, the opinion about the functions of a
financial manager has been undergoing constant changes from time to time. There are three
approaches to finance function: (1) the traditional approach, (2) the extensive approach and (3)
the modem or practical approach
(A) Traditional Approach : Till 1950, the approach to finance function was too narrow, as
it confined the role of a financial manager to raising of funds only. For example, F. W. Paish
remarked while defining the term finance function that, 'In the modern money-using economy,
financial management means to make provision to procure money when required.
Due to a too narrow interpretation of finance function, only following issues connected with
procurement of finance were included in the scope of financial management: (a) a study of
capital market or financial institutions, such as stock exchanges, commercial banks, specialized
institutions, investment banks etc.; (ii) a study of financial documents such as various types of
shares, debentures and other legal papers which are the instruments of raising funds. (iii) a legal
and accounting relationship between the firm and its suppliers funds. According to this

7|P ag e
 NMC M.COM SEM-3

interpretation, there are some major events at which the funds are required. They are promotion
of the company, registration, reorganization, merger, consolidation and liquidation etc. Hence, a
study these events constituted the scope of study of financial management. The organisation of
company finance was the main theme of the traditional approach. For this reason, the subject that
was taught in academic institutions was known as ‘Corporation Finance' and even textbooks and
advanced treatises on this subject were given the same title.
The traditional approach has been criticised on several grounds :
(i) The emphasis in the traditional approach is on raising of funds only. Hence, the personnel
who take internal financial decisions were ignored. The subject of finance is treated from the
angle of investors, creditors, banks and insurance companies. They are outsiders to the firm, and
hence the traditional approach is the ‘outsider-looking-in approach.'
(ii) The traditional approach concentrates mainly on the financial administration of the joint
stock companies. Since joint stock companies are only one of the components of the business
world, this approach is considered as too narrow. It ignores the finance function of the sole
proprietors. partnership firms, co-operatives etc.
(iii) The traditional approach represents an episodic view of the finance function. It considers
the requirements and procurement of finance on such events or episodes during the life time of a
company as promotion, incorporation, merger etc. Such events do not occur everyday while
financial management, is a problem which business has to face from day to day.
(iv) The traditional approach places emphasis on the long term financial requirements only
and ignores the importance of working capital management The long term requirements of
finance arise only once or twice in a year while the short term requirements are to be felt almost
every day. Hence problems of short term financing are more important and pressing.
(B) Too Wide Approach : This approach is extensive in that it covers all transactions
connected with cash in business. If we adopt this approach the whole field of business
management is covered by financial management because financial problems are to be faced in
almost all aspects of business management. e.g. the credit sale also is finally paid in cash. Thus,
every aspect of business such as production, purchase and sales will be included into finance
function. For this reason, this approach is not practical and has to be discarded.
(C) Modern Approach : This is the practical approach to finance function. Its development
is noticed mostly in the writings after 1950. According to this approach, finance function is
concerned with raising of funds and their effective utilization both. It lays emphasis on both-
raising of funds and the efficient use of funds. In the words of Shri I. M. Pandey, the emphasis
shifted from episodic financing to the managerial financial problem, from raising of funds to
efficient and effective use of funds.
Some opinions may be cited at this point.
Hoagland writes 'The financial management is concerned mainly with the issues as to how a
business corporation procures its funds and how it utilizes it.
J. C. Van Horne writes 'The financial manager is concerned with (a) the efficient allocation
of funds within the enterprise and (b) raising funds on as favorable terms as possible.'
According to J. F. Weston, 'Broadly defined, the area of business finance comprises of
operations of business firms directed towards procurement of capital funds and their investment
in the various types of assets."
The modern approach implies that financial management is concerned with two matters (a)
Acquisition of funds for business at minimum costs when required and (b) investing the funds
obtained in an optimum manner so that rate of return is maximized. Thus it suggests that only

8|P ag e
 NMC M.COM SEM-3

raising of funds is not financial management. It should see to it that the funds raised are utilized
most efficiently and effectively.
An analysis of the new approach reveals following important points about finance function.
(i) Procurement of Funds : The present and future requirements of finance are estimated
and then a decision is taken about the sources of finance. Each source of finance entails a certain
amount of cost. The financial manager has to raise the required funds in such manner that total
cost is minimized. This function is, of course, common to the traditional and modem approach
both.
(ii) Investment of Funds : The financial manager has also to take decisions about the assets
in which the available funds are to be invested. In taking this decision, he has to compare the rate
of return on investment with the cost of raising funds for it. If there are more than one investment
schemes, the most profitable scheme will be selected for investment.
(iii) Income Management : The financial manager has also to consider the problem of
income distribution. It is the problem concerning the distribution of dividends among the
shareholders. He has to decide what part of total profit should be retained within the business and
what portion should be set aside for distribution among the shareholders.
Thus, the modern approach lays stress on three types of financial decisions : (i) Investment
decision, (ii) Financing decision and (iii) Dividend decision.
(a) Investment Decision : These decisions may relate to investment in both capital assets
like land, building, Plant and Machinery. Two important aspects of the investment decisions are
(i) Evaluation of prospective profitability of the new investment and the returns associated with
it. (ii) Measurement of a cut-off rate or minimum rate of return against that prospective return
could be compared. Since the benefits from the investment proposals extend into the future, their
measurement is difficult and predictions uncertain. Investment should therefore be analyzed in
terms of both expected return and risk. Major areas covered are :
Ascertainment of total value of funds, a firm can commit.
Appraisal and selection of Investment proposals using various techniques - NPV, IRR, P.I.
etc.
Analysis of risk and uncertainty in the investment proposal.
Fixing the priorities of investment decisions and allocation of funds.
Buy or lease decisions.
Asset replacement decisions.
(b) Financing Decisions: A finance manager must identify when, where and how the funds
can be acquired to meet the firm's investment needs.
In sourcing of finance, he should keep in view the cost of respective sources of funds, the
merits and demerits of various sources of finance impact of taxation etc. The finance manager
must strive to procure finance from different sources in such a way that capital structure is
optimum. Capital Structure is optimum when market value of shares is maximum.
Major areas covered are :
Consideration of cost of capital of various sources of finance keeping in view the impact of
taxation.
Optimization of financing mixes &maximizes shareholders' wealth.
(c) Dividend Decisions :The dividend decisions of a finance manager are mainly considered
with taking a decision
(i) Whether the firms should distribute dividend or retain the profits
(ii) Proportion of dividend out of total earnings to be distributed.

9|P ag e
 NMC M.COM SEM-3

The finance manager must decide about optimum dividend pay-out ratio. Optimum dividend
pay-out ratio is the one that maximizes the shareholders' wealth.
Major areas covered are:
- Determining Dividend Policies of the firm.
- Considering statutory provisions regarding dividends.
- Consideration of the profitability of firm's requirements of funds for modernization,
expansion or diversification.

(d) Liquidity Decisions or Working Capital Management : It is concerned with the

management of current assets. It is very important as short term survival is a must for long term
success. If the firm's investment in current assets is too little, firm will not be able to meet its
short term liabilities and thus invite the risk of insolvency. However, if the firm's investment in
current assets is too high, the firm will be losing interest on the extra blockade of funds in current
assets. The finance manager must ensure that funds would be made available when needed.
[6] TRADITIONAL APPROACH AND MODERN APPROACH: A COMPARISON :
Traditional Approach Modern Approach
1 Finance function means raising of 1 Finance function means the function
. finance for business That is, to procure . of raising finance as also of utilizing it
funds when needed from the most most effectively for business That is, the
advantageous sources. The function of financial manager has also to decide-
efficient utilization of funds is ignored how to invest the funds available to him.
under this approach.
2 The traditional approach concentrates 2 The modern approach deals with the
. on the problem of finance of joint stock . problem of finance of all types of
companies only. The non-corporate business units. It suggests the principles
business units are not taken into and procedures applicable to sole
consideration. proprietors, partnership firms,
cooperatives and companies.
3 It considers the sources of long term 3 It gives importance to both types of
. only. It assumes that there are no . financial problems. The problems of long
problems pertaining to working capital term finance as well as those of working
management. capital are included in the scope of
finance function.
4 It observes the finance function from 4 The finance function is examined
. the angles of outsiders to business, such . from the view-point of insiders and
as investors, that is the financial decision outsiders both. In fact the view point of
makers who deal with finance problems insiders is given same importance as that
daily in business are ignored. of the outsiders. This means, that it
examines not only the problem of its
efficient utilization also.
5 It represent an episodic approach 5 The modern approach is all
. which assumes that finance function is . inclusive. It takes into consideration the
basically the function of raising funds on requirements of finance arising during
such events as promotion, reorganization major events as also during the routine
and liquidation of the business enterprise. operation of the business from day to
day.

10 | P a g e
 NMC M.COM SEM-3

6 It represents a narrow view of 6 It represents a most practical and realistic

. finance function as it takes into account . approach as it covers all aspects of
only one aspects of it. finance.

FINANCE AS A STRATAGIC FUNCTION

This point is too wide but we can understand hear by following points. organizational
operations, which involves designing elements that will maximize the firm's financial resources
and using them efficiently. Here a firm needs to be creative, as there is no one-size-fits-all
approach to strategic management, and each company will devise elements that reflect its own
particular needs and goals. However, some of the more common elements of strategic financial
management could include the following.
Planning

 Define objectives precisely.

 Identify and quantify available and potential resources.
Budgeting

 Help Write a specific business financial plan.

the company function with financial efficiency, and reduced waste.

Identify areas that incur the most operating costs, or exceed the budgeted cost.
Ensure sufficient liquidity to cover operating expenses without tapping external
resources.
 Uncover areas where a firm may invest earnings to achieve goals more effectively.
Managing and Assessing Risk

 Identify, analyze, and mitigate uncertainty in investment decisions.

 Evaluate the potential for financial exposure; examine capital expenditures (CapEx) and
workplace policies.
 Employ risk metrics such as degree of operating leverage calculations, standard
deviation, and value-at-risk (VaR) strategies.
Establishing Ongoing Procedures

 Collect and analyze data.

 Make financial decisions that are consistent.
 Track and analyze variance—that is, differences between budgeted and actual results.
 Identify problems and take appropriate corrective actions.

ROLE OF FINANCIAL MANAGER

A financial manager is a person who is responsible for taking care of all the essential financial
functions of an organization. Nowadays, Finance Managers spend less time producing financial
reports and prefer to invest more time in conducting data analysis, planning and strategizing, or
advising senior managers or top executives.

11 | P a g e
 NMC M.COM SEM-3

Responsibilities of Finance Manager:

 Raising of funds: to meet the needs of the business, it is essential to have cash and liquidity so,
that a firm can raise funds by way of equity or debt. A financial manager is responsible for
maintaining the right balance between equity and debt.
 Allocation of funds: After the funds are raised, the next important thing is to allocate the funds.
The best possible manner of allocating the funds:
 Size of the organizations and their growth capability
 Status of assets about long term or short term
 The mode by which the funds are raised
These types of financial decisions can, directly and indirectly, influence other activities.

 Profit Planning: It is one of the primary functions of any business organizations. Profit earning
is essential for the survival and livelihood of any organization. Profits emerge due to various
factors such as pricing, industry competition, state of the economy, mechanism of demand and
supply, cost and output.
 Understanding capital markets: Shares of a company are traded on the stock exchange for a
continuous sale and purchase. It is understood that the capital market is an essential factor for a
financial manager. Hence, it is the responsibility of a concern person to understand and calculate
the risk involved in this trading of shares debts.
The role of a financial manager is rapidly increasing due to advance technology which has
significantly reduced the amount of time that was occupied to produce financial reports.

 They analyze market trends to find opportunities for expansion or for acquiring companies.
 They have to do some tasks that are specific to their organization or industry
 They manage company credit
 Make some dividend pay-out decisions
 Keep in touch with the stock market if the company is listed
 Appreciate the financial performance concerning return investments
 They maximize the wealth for company shareholders
 To handle financial negotiations with banks and financial institutions
Agency Problems
A characteristic feature of corporate enterprise is the separation between ownership and
management as a corollary of which the latter enjoys substantial autonomy in regard to the
affairs of the firm. With widely – diffused ownership, scattered and ill – organized shareholder
hardly exercise any control on management which may be inclined to act in its own interest
rather than those of the owners. However, shareholders as owners of the enterprise have the right
to change the management. Due to the threat of being dislodged for poor performance, the
management would have a natural inclination to achieve a minimum acceptable level of
performance to satisfy the shareholders’ requirements, while focusing primarily on their own
personal; goals. Thus, in furtherance of their objective of survival, management would aim at
satisfying instead of maximizing shareholder wealth.
In proprietorship, Partnerships and cooperative societies, owners are actively involved in the
management. But in companies, particularly large public limited companies, owners typically are
not active managers. Instead, they entrust this responsibility to professional managers. Instead

12 | P a g e
 NMC M.COM SEM-3

this responsibility to professional managers who may have little or no equity stake in the firm.
There are several reasons for the separation of ownership and management in such companies.
 Large Amount of Capital: - Most enterprises require large sum of capital to achieve
economies of scale. Hence it become necessary to pool capital from thousands or even
hundreds of thousands of owners. It is impractical for many owners to participate actively in
management.
 Professional Manager: - Professional managers may be more qualified to run the business
because of their technical expertise, experience and personality traits.
 Separation of Ownership: - Separation of ownership and management permits unrestricted
change in owners through share transfers without affecting the operation of the firm. It
ensures that the ‘knowhow’ of the firm is not impaired, despite changes in ownership.
 Economic Uncertainties: - Given economic uncertainties, investors would like to hold a
diversified portfolio of securities. Such diversification is achievable only when ownership
and management are separated.
While there are compelling reasons for separation of ownership and management, a separated
structure lead to a possible conflict of interest between managers (agents) and shareholders
(Principals). Through managers are the agents of shareholders they are likely to act in ways that
may not maximize the welfare of shareholders.
In practice, managers enjoy substantial autonomy and hence have a natural inclination to
pursue their own goals. To prevent from getting dislodged from their position, managers may try
to achieve a certain acceptable level of performance as far as shareholders welfare is concerned.
However, beyond that their personal goals like presiding over a big empire, pursuing their pet
projects, diminishing their personal risks, and enjoying generous compensation and lavish
perquisites tend to acquire priority over shareholder welfare.
The lack of perfect alignment between the interests of managers and shareholders results in
agency costs which may be defined as the difference between the value of an actual firm and
value of a hypothetical firm in which management and shareholder interests are perfectly
aligned.
To mitigate the agency problem, effective monitoring has to be done and appropriate
incentives have to be offered. Monitoring may be done by bonding managers, by auditing
financial statements, by limiting managerial discretion in certain areas, by reviewing the actions
and performance of managers periodically and so on.
Incentives may be offered in the form of cash bonuses and perquisites that are linked to
certain performance targets, stock options that grant managers the right to purchase equity shares
at a certain price thereby giving them a stake in ownership, performance shares given when
certain goals are achieved and so on.
ALTERNATIVES

Divergent Objectives
The goal of shareholder wealth maximization specifies how financial decisions should be made.
In practice, however, not all management decisions are consistent with this objective. For
example, Joel Stern and Bennett Stewart have developed an index of managerial performance
that measures the success of managers in achieving a goal of shareholder wealth maximization.9
Their performance measure, called Economic Value Added, is the difference between a firm’s
annual after -tax operating profit and its total annual cost of capital.
Agency Problems

13 | P a g e
 NMC M.COM SEM-3

The existence of divergent objectives between owners and managers is one example of a class of
problems arising from agency relationships. Agency relationships occur when one or more
individuals (the principals) hire another individual (the agent) to perform a service on behalf of
the principals.12 In an agency relationship, principals often delegate decision-making authority
to the agent. In the context of finance, two of the most important agency relationships are the
relationship between stockholders and creditors and the relationship between stockholders
(owners) and managers.
Stockholders and Creditors
A potential agency conflict arises from the relationship between a company’s owners and its
creditors. Creditors have a fixed financial claim on the company’s resources in the form of long -
term debt, bank loans, commercial paper, leases, accounts payable, wages payable, taxes
payable, and so on. Because the returns offered to creditors are fixed whereas the returns to
stockholders are variable, conflicts may arise between creditors and owners.
For example, owners may attempt to increase the riskiness of the company’s investments in
hopes of receiving greater returns. When this occurs, bondholders suffer because they do not
have an opportunity to share in these higher returns. For example, when RJR Nabisco (RJR) was
acquired by KKR, the debt of RJR increased from 38 percent of total capital to nearly 90 percent
of total capital. This unexpected increase in financial risk caused the value of RJR’s bonds to
decline by nearly 20 percent.
Stockholders and Managers
Inefficiencies that arise because of agency relationships have been called agency
problems. These problems occur because each party to a transaction is assumed to act in a
manner consistent with maximizing his or her own utility (welfare). The example cited earlier
the concern by management for long-run survival (job security) rather than shareholder wealth
maximization is an agency problem. Another example is the consumption of on -the -job
perquisites (such as the use of company airplanes, limousines, and luxurious offices) by
managers who have no (or only a partial) ownership interest in the firm. Shirking by managers is
also an agency-related problem.
Examples of agency costs include
1. Expenditures to structure the organization in such a way as to minimize the incentives for
management to take actions contrary to shareholder interests.
2. Expenditures to monitor management’s actions, such as paying for audits of managerial
performance and internal audits of the firm’s expenditures.
3. Bonding expenditures to protect the owners from managerial dishonesty.
4. The opportunity cost of lost profits arising from complex organizational structures that
prevent management from making timely responses to opportunities.
Managerial Compensation

Properly designed compensation contracts can help to align shareholder management conflicts.
For example, providing part of the compensation in the form of stock or options to purchase
stock can reduce agency conflicts. Stock options granted to managers entitle them to buy shares
of the company at a particular price (exercise price). Typically, the options are set at an exercise
price greater than the price of the stock at the time options are granted and can be exercised only
after a certain period of time has elapsed.
These conditions are imposed so that managers won’t be tempted to cash in their options
immediately and leave the company. More important to stock value, this is an attempt to align

14 | P a g e
 NMC M.COM SEM-3

their interests more closely with those of the shareholders. Many firms, including Disney and
Oracle, provide key executives with significant stock options that increase in value with
improvements in the firm’s stock price. Two of the largest payoffs from the exercise of options
were the $706 million received in 2001 by Lawrence Ellison, chairman and CEO of Oracle, and
the $570 million paid in 1998 to Michael Eisner, chairman and CEO of Disney.
Threat of Takeovers
Takeovers also can serve as an important deterrent to shareholdermanagement conflicts. The
argument goes as follows: If managers act in their self -interest then share values will be
depressed, providing an incentive for someone to take over the company at a depressed level.
The acquirer can then benefit from instituting policies that are consistent with shareholder wealth
maximization, such as eliminating underperforming units and cutting overhead.

Risk return framework for financial decision making for Financial Management

Risk Management is one of those ideas, the sense that a logical, consistent and disciplined
approach to the future’s uncertainties will allow us to live with them prudently and productively,
avoiding unnecessary waste of resources. It goes beyond faith and luck, the twin pillars of
managing the future before we began learning how to measure probability. As Peter Bernstein
wrote, “If everything is a matter of luck, risk management is a meaningless exercise. Invoking
luck obscures truth, because it separates an event from its cause.”
Thus now Risk Management as a subject had assumed its destined role of preparing us to take
the future in our stride and excel in an environment where everything is in a state of flux. Indian
financial organizations should not underestimate the potential impact of inadequate risk
management practices.
Risk may be defined as the probability of incurring a loss or damage. In other words risk can be
defined as the chance that the actual outcome from an activity will differ from the expected
outcome. This means that, more variable the possible outcomes that can occur (i.e. broader the
range of possible outcomes), the greater the risk.
Risk management means a course of action planned to reduce the risk of an event occurring, and
minimizing or containing the consequential effects should that event occur. In order to achieve
this, a risk management policy should be put in place. Such a policy will need to be approved by
the senior management, and responsibilities acknowledged.
It is also important for the senior management to recognise that it is necessary to organise,
manage and encourage everyone within the institution to assist in managing risk. Training at all
levels is essential, and people need to be aware of the risks and of the steps which can be taken to
prevent threats becoming a reality. It should also be recognised that risk management is not just
an estate-related issue, but applies across the whole of the activities of an institution. In corporate
and banking sectors most of the efforts till date concentrated on the aspect of risk measurement
and control process, not risk management. The difference between the concept of risk
management and measurement and control is that the latter is more concerned with the
prevention of financial losses, while a true risk management uses the information of the risk and
uses the same to understand the business and proactively manages the exposures of the
organisation. Thus risk management is process of understanding the risk exposures of the
organisation and re-turning it to as per the risk appetite of the organisation to limit the future

15 | P a g e
 NMC M.COM SEM-3

losses. Thus risk management is one of the important areas, which requires the skills of a
financial engineer.

consists of the following steps :

1. Identifying the risk to which the organization is exposed to,

2. Quantifying the risk exposures,
3. Determination of the form of the outcome sought,
4. Design or engineer a strategy to transform the risk exposures into the desired form.
5. Monitoring risk levels and matching them to standards set.

 To manage risk—not to react to it. This may involve developing a risk strategy, or at the
minimum a set of formal risk management procedures.
 To make sure that risk management is embedded within the overall planning and
management process, particularly procedures.
 To ensure the Board of Directors and Senior Management are fully informed of risks
associated with various projects or issues.
 To provide appropriate training.
 Many organizations worldwide try to avoid risk by focusing on supposedly low-risk
areas. This is an unviable strategy. Risk is not limited to exotic products, instruments or
markets but is inherent in the most mundane of them.
In dealing with the key concepts of risk management and their application to estate management,
the estate manager has to be able to identify the main classes of relevant risk and to apply models

16 | P a g e
 NMC M.COM SEM-3

for determining the exposure of the institution to risk. In addition, the estate manager needs to
identify the level of control that can realistically be exercised over particular risks.
Risk can have different meanings but a common understanding is that the event associated with
the risk could actually happen, and the consequences of this risk might not be pleasant.
Definitions of risk must always relate to the risk of something happening in a specific time
period.
When preparing a plan for the future, the further that these predictions are projected, the greater
the increase in associated risk and uncertainty. It is also important to be clear about the
distinction between risk and uncertainty. An assessment of risk is an attempt to quantify events
about which some knowledge exists. Uncertainty, on the other hand, is concerned with events
that cannot be measured. Both risk and uncertainty may result in outcomes that are better or
worse than expected.
The logical process of risk management may be defined as:

 Identification of risk / uncertainties;

 Analysis of the implications (both individually and collectively);
 Response to minimize risk; and
 Allocation of appropriate contingencies.
Risk management should be an essential part of the continuous and structured planning cycle
within an institution. Furthermore, risk management needs to be seen as a process that:

 Requires an acceptance that uncertainty exists;

 Produces structured responses to risk in the form of alternative plans, solutions and
contingencies;
 Requires an imaginative and flexible thinking process; and
 Can change attitude in project staff by preparing them for risk events.
Risk exists when a decision is expressed in terms of a range of possible outcomes and when
known probabilities can be attached to the outcomes.
Uncertainly exists when there is more than one possible outcome of a course of action but the
probability of each outcome is not known.
In terms of using risk management to develop a safe system of work, five key elements can be
identified:

 Plan or identify hazards;

 Organize or assess the risks associated with the hazards;
 Institute control measures;
 Monitor the control measures; and

Review the system

UNIT 2

17 | P a g e
 NMC M.COM SEM-3

CAPITAL BUDGETING

INTRODUCTION:

First hear we should know about Business expenses. They are of two types : revenue
expenditure and capital expenditure. The routine operating expenses which are incurred to run
the business from day to day are called revenue expenses, e.g. wages, rent, taxes, postage,
insurance etc. On the other hand the expenditure incurred to purchase fixed assets such as land,
machinery, furniture, vehicles, tools and implements etc. are called capital expenditure. Once
investment in such assets is made, it yields a flow of benefits for a long period of time. The
project concerning the purchase of fixed assets is known as 'Capital Expenditure Project'. These
expenditures being huge in amount are to be planned in advance. This plan is known as 'Capital
Budget'. The process of taking decisions as to which assets should be purchased and how to
spend the funds for this purpose is called 'Capital Budgeting’.

The capital budgeting decisions are related to the allocation of funds to different long term
assets. Broadly speaking, the capital budgeting decision denotes a decision situation where the
lump sum funds are invested in the initial stages of a project and the returns are expected over a
long period. The capital decision involve the entire process of decision making relating to
acquisition of long term assets whose returns are expected to arise over a period beyond one
year.
The role of finance manager in the capital budgeting basically lies in the process of critical
and in – depth analysis and evaluation of various alternative proposals and then to select one out
of these. As already stated, the basic objective of financial management is to maximize the
wealth of the shareholders, therefore the objective of the capital budgeting is to select those long
term investment projects that are expected to make maximum contribution to the wealth of the
shareholders in the long run.
Under capital budgeting, we are not concerned with the financial capability of the investor.
Rather, we are only concerned with evaluation of various projects in our hand and choosing the
best among them in terms of profitability for the purpose of making investment. We are not
concerned about whether investor is in a position to invest or not. Capital budgeting only deals
with analyzing the costs and the benefits of the various investment proposals and choosing the
best among them.
Capital budgeting is nothing but a tool to analyze long term investment proposals. When a
firm is making a long term investment, it is sacrificing its present purchasing power to purchase
future purchasing power.

18 | P a g e
 NMC M.COM SEM-3

Capital Budgeting – Definition

“Capital budgeting” has been formally defined as follows.

1) “Capital budgeting is long-term planning for making and financing

proposed capital outlay”.
- Charles T. Horngreen
2) “The capital budgeting generally refers to acquiring inputs with longterm
returns”.
- Richards & Greenlaw
3) “Capital budgeting involves the planning of expenditure for assets, the
returns from which will be realized in future time periods”.
- Milton H. Spencer
The long-term activities are those activities that influence firms
operation beyond the one year period. The basic features of capital budgeting
decisions are:
There is an investment in long term activities
Current funds are exchanged for future benefits
The future benefits will be available to the firm over series of years.
Capital Budgeting – Nature
1. Capital budgeting involves capital rationing. This is the available funds that
have to be allocated to competing projects in order of project potential.
Normally the individuality of project poses the problem of capital rationing due
to the fact that required funds and available funds may not be the same.
2. Capital budget becomes a control device when it is employed to control
expenditure. Because manned outlays are limits to actual expenditure, the
concern has to investigate the variation in order to keep expenditure under
control.
3. A firm contemplating a major capital expenditure programme may need to
arrange funds many years in advance to be sure of having the funds when
required.

4. Capital budgeting provides useful tool with the help of which the
management can reach prudent investment decision.
5. Capital budgeting is significant because it deals with right mind of evaluation
of projects. A good project must not be rejected and a bad project must not be
selected. Capital projects need to be thoroughly evaluated as to costs and
benefits.
6. Capital projects involve investment in physical assets such as land, building
plant, machinery etc. for manufacturing a product as against financial
investments which involve investment in financial assets like shares, bonds or

19 | P a g e
 NMC M.COM SEM-3

mutual funds. The benefits from the projects last for few to many years.
7. Capital projects involve huge outlay and last for years.
8. Capital budgeting thus involves the making of decisions to earmark funds for
investment in long term assets yielding considerable benefits in future, based on
a careful evaluation of the prospective profitability / utility of such proposed
new investment.

Kinds of Capital Budgeting Decisions

The overall objective of capital budgeting is to maximise the profitability of a
firm or the return on investment. This objective can be achieved either by
increasing the revenues or by reducing costs. Thus, capital budgeting decisions
can be broadly classified into two categories:
(a) those which increase revenue, and
(b) those which reduce costs
The first category of capital budgeting decisions are expected to increase
revenue of the firm through expansion of the production capacity or size of
operations by adding a new product line. The second category increases the
earnings of the firm by reducing costs and includes decisions relating to
replacement of obsolete, outmoded or worn out assets. In such cases, a firm has
to decide whether to continue with the same asset or replace it. Such a decision
is taken by the firm by evaluating the benefit from replacement of the asset in
the form of reduction in operating costs and the cost/cash outlay needed for
replacement of the asset. Both categories of above decisions involve investment
in fixed assets but the basic diffemce between the two decisions lies in the fact
that increasing revenue investment decisions are subject to more uncertainty as
compared to cost reducing investment decisions.
Further, in view of the investment proposals under consideration, capital
budgeting decisions may also be classified as.
(i) Accept / Reject Decisions
(ii) Mutually Exclusive Project Decisions
(iii) Capital Rationing Decisions.
(i) Accept / Reject Decisions; Accept / reject decisions relate to independent
project which do not compete with one another. Such decisions are generally
taken on the basis of minimum return on investment. All those proposals which
yield a rate of return higher than the minimum required rate of return or the cost
of capital are accepted and the rest are rejected. If the proposal is accepted the
firm makes investment in it, and if it is rejected the firm does not invest in the
same.
(ii) Mutually Exclusive project Decisions; Such decisions relate to proposals
which compete with one another in such a way that acceptance of one

20 | P a g e
 NMC M.COM SEM-3

automatically excludes the acceptance of the other. Thus, one of the proposals is
selected at the cost of the other. For example, a company may have the option of
buying a new machine, or a second hand machine, or taking an old machine on
hire or selecting a machine out of more than one brands available in the market.
In such a case, the company may select one best alternative out of the various
options by adopting some suitable technique or method of capital budgeting.
Once one alternative is selected the others are automatically rejected.
iii) Capital Rationing Decisions: A firm may have several profitable
investment proposals but only limited funds to invest. In such a case,
these various investments compete for limited funds and, thus, the firm has to
ration them. The firm effects the combination of proposals that will yield the
greatest profitability by ranking them in descending order of their profitability.

Importance of capital budgeting decision.

Capital budgeting decisions are of paramount importance in financial decision. The
profitability of a business concern depends upon the level of investment made for long period.
Moreover, the investments are made properly through evaluating the proposals by capital
budgeting. So it needs special care. In this context, the capital budgeting is getting importance.
Such importance are briefly explained below.
1. Long-term Implications of Capital Budgeting: A capital budgeting decision has its effect
over a long time span and inevitably affects the company’s future cost structure and growth.
A wrong decision can prove disastrous for the long-term survival of firm. On the other hand,
lack of investment in asset would influence the competitive position of the firm. So the
capital budgeting decisions determine the future destiny of the company.
2. Involvement of large amount of funds in Capital Budgeting: Capital budgeting decisions
need substantial amount of capital outlay. This underlines the need for thoughtful, wise and
correct decisions as an incorrect decision would not only result in losses but also prevent the
firm from earning profit from other investments which could not be undertaken.
3. Irreversible decisions in Capital Budgeting: Capital budgeting decisions in most of the
cases are irreversible because it is difficult to find a market for such assets. The only way out
will be scrap the capital assets so acquired and incur heavy losses.
4. Risk and uncertainty in Capital budgeting: Capital budgeting decision is surrounded by
great number of uncertainties. Investment is present and investment is future. The future is

21 | P a g e
 NMC M.COM SEM-3

uncertain and full of risks. Longer the period of project, greater may be the risk and
uncertainty. The estimates about cost, revenues and profits may not come true.
5. Difficult to make decision in Capital budgeting: Capital budgeting decision making is a
difficult and complicated exercise for the management. These decisions require an overall
assessment of future events which are uncertain. It is really a marathon job to estimate the
future benefits and cost correctly in quantitative terms subject to the uncertainties caused by
economic-political social and technological factors.
6. Large and Heavy Investment: The proper planning of investments is necessary since all the
proposals are requiring large and heavy investment. Most of the companies are taking
decisions with great care because of finance as key factor.
7. Permanent Commitments of Funds: The investment made in the project results in the
permanent commitment of funds. The greater risk is also involved because of permanent
commitment of funds.
8. Long term Effect on Profitability: Capital expenditures have great impact on business
profitability in the long run. If the expenditures are incurred only after preparing capital
budget properly, there is a possibility of increasing profitability of the firm.
9. Complicacies of Investment Decisions: Generally, the long term investment proposals have
more complicated in nature. Moreover, purchase of fixed assets is a continuous process.
Hence, the management should understand the complexities connected with each projects.
10. Maximize the worth of Equity Shareholders: The value of equity shareholders is increased
by the acquisition of fixed assets through capital budgeting. A proper capital budget results in
the optimum investment instead of over investment and under investment in fixed assets. The
management chooses only most profitable capital project which can have much value. In this
way, the capital budgeting maximize the worth of equity shareholders.
11. Difficulties of Investment Decisions: The long term investments are difficult to be taken
because decision extends several years beyond the current account period, uncertainties of
future and higher degree of risk.
12. Irreversible Nature: Whenever a project is selected and made investments as in the form of
fixed assets, such investments is irreversible in nature. If the management wants to dispose of
these assets, there is a heavy monetary loss.

22 | P a g e
 NMC M.COM SEM-3

13. National Importance: The selection of any project results in the employment opportunity,
economic growth and increase per capita income. These are the ordinary positive impact of
any project selection made by any company.
Estimating cash flows
Cash flow indicates a cash outflow and cash inflows. It is necessary to estimate the cash flow in
the process of analyzing investment proposal. While analyzing the cash flow, it is also necessary
to estimate the cash outflow as well as cash inflow. Estimation of the net cash flow in an
investment project should cover the following procedures:
Step 1: Determination of Net Investment or Net Cash Outlay or Initial Cash Outlay.
Initial investment or start-up costs are net cash outflows at present cost. It refers to the
sum of all cash outflows and cash inflows occurring at zero time periods. Net investment refers
to the amount of which will be required for the acquisition of fixed assets. Thus initial
investment of a new fixed assets or project comprises cost, freight, installation charges, custom
duty etc.
Determination of net investment in replacement case is different than investment of new
proposal. The following factors also effect on the determination of net investment of a
replacement proposal. The various factors are as follows:
Salvage Value Salvage value means the value which is estimated to be realized on account of the
sales of assets at the end of its useful life. To calculate the amount of depreciation, it is deducted
from the cost of assets. Salvage value is also known as residual value.
Salvage value can be divided as follows:
1. Book Salvage value: Remaining value of the fixed assets after charging depreciation is
known as book salvage value. It is determined as follows:
Book salvage value = Cost of assets - Accumulated depreciation
2. Cash Salvage Value: Actual sales value of remaining assets is known as cash salvage value.
The book salvage value may be equal or more or less than cash salvage value. The existing
asset's cash salvage value effect the net investment when an asset is replaced.
Tax Adjustment When cash and book salvage value of asset is differentiate in this situation we
have to adjust the tax. Cash salvage value effects on an estimation of initial cash outlay.
a. If book salvage value is equal to cash salvage value: If existent assets are sold at their
book value there is no tax adjustment because tax is adjusted in profit or loss.

23 | P a g e
 NMC M.COM SEM-3

b. If cash salvage value is more than book salvage value but less than original cost:
When company sells fixed assets more than book salvage value less than original cost
this more value is known as normal gain. In normal gain company has to pay tax. For
example, the assets which is purchased at ₹ 500,000 five years before. The book
value today is ₹ 250,000 and cash salvage value today is ₹ 300,000. In this case, the
profit will be ₹ 50,000, which is known as normal gain. If there is the provision of
40% normal tax ₹ 20,000 (40% of ₹ 50,000) must be paid as tax.
If the company desired to purchase the new assets of ₹ 600,000, the net investment can be
determined as follows:
Purchase price of new assets. = - 600,000
Cash salvage value of old assets. = + 300,000
Tax paid. = - 20,000
Net investment = - 320,000
Note: cash outflow is indicated my minus (-) and cash inflow is indicated by plus (+).
c. If cash salvage value is more than book salvage value as well as original value: The
difference between cash salvage value and original value of assets is known as capital
gain and different between original value and book value is known as normal gain. It
should be cleared as follows:
Normal gain = Original value - Book salvage value
Capital gain = Cash salvage value - Original value
Both capital and normal gain have to pay tax but capital gain tax may be low than normal gain
tax. For example,
Original value of assets = ₹ 300,000
Book salvage value of assets = ₹ 200,000
Cash salvage value of assets = ₹ 330,000
Then, capital gain = cash salvage value - original value = 330,000 - 300,000 = ₹ 30,000.
Normal gain = Original value - Book salvage value = 300,000 - 200,000 = ₹ 100,000.
Let capital gain tax rate 25% and normal tax rate is 40% in that case tax paid will be:
Normal tax (40% of 100,000) = ₹ 40,000
Capital gain tax (25% of ₹ 30,000) = ₹ 7,500

24 | P a g e
 NMC M.COM SEM-3

If company desired to purchase the new assets of ₹ 600,000, the new investment can be
determined as follows:
Purchase price of new assets = -600,000
Cash salvage value of old assets = + 330,000
Tax paid on capital gain = -7,500
Tax paid on normal gain = -40,000
Net investment = -317,500
d. If cash salvage value is less than book salvage value: Sometimes Company sells
fixed assets less than book salvage value. Company suffer from loss. In this situation,
it can save tax. In other words, when company faces loss, the tax need not to be paid.
As a result, the taxable amount comes to be surplus at a certain percentage. For
example:
Book salvage value of assets = ₹ 300,000
Cash salvage value of assets = ₹ 250,000
Loss = 300,000- 250,000 = ₹ 50,000
Tax saving:
Let tax rate = 40%
Tax saving = 40% of ₹ 50,000 = ₹ 20,000.
If the company desired to purchase the new assets of ₹ 600,000, the new investment can be
determined as follows:
Purchase price of new assets = - 600,000
Cash salvage value of old assets = + 250,000
Tax save on loss on sale of assets. = + 20,000
New investment. = -330,000
Working Capital Working capital may be defined as the funds required within a business for
supporting day to day business activities. Working capital may increase in case of new proposal.
These increases working capital increase cash outflow. Sometimes working capital may decrease
and these decrease working capital increase cash inflow. In other words, reduction refers to the
returning investing, it should be cleared as follows:
Increase in working capital = cash outflow (-)
Decrease in working capital = cash inflow (+)

25 | P a g e
 NMC M.COM SEM-3

Investment Tax Credit In order to encourage the industry, sometime government may provide
facilities of tax credit. It reduces initial cash outlay. There are many methods of determining the
investment tax credit allowance, however, following method is considered more appropriate:
Investment tax credit = Original cost of assets X ITC rate/100
Where, ITC = Investment tax credit.
On the basis of the above noted points, the net cash outlay of the replacement proposal can be
estimated. To estimate the net cash outlay or net investment the following table can be used:

Particulars..................................................................Amount
Purchasing price of new assets................................ (-) XXX
Transportation and installation cost......................... (-) XXX
Increase or decrease in working capital................. (+/-) XXX
Cash salvage value of existing assets...................... (+) XXX
Tax adjustments (outstanding or saving)................ (+/-) XXX
Investment Tax credit................................................ (+) XXX
Net cash outlay.......................................................... (-) XXX

Step 2: Determination of annual net cash inflow or cash inflow after tax: It is second step of
capital budgeting which is determined after the determination of net cash outflow of investment
proposal. In this step, net cash inflow is determined during the life of the project. It is called net
cash inflow or cash flow after tax. It is determined on the basis of accounting for cash flow
concept. To determine the net cash inflow, interest amount is not included. To determine net cash
flow following table is taken:

Particulars................................................New machine.................Old machine

Annual sales (Revenue)..........................................XXX............................XXX
Less: Cash expenses...............................................XXX............................XXX
Earnings before depreciation and tax.........................XXX............................XXX
Less: Annual depreciation (D)..................................XXX............................XXX
Earning before tax (EBT)...........................................XXX............................XXX
Less: Tax.................................................................XXX............................XXX

26 | P a g e
 NMC M.COM SEM-3

Earning after tax (EAT).............................................XXX............................XXX

Add back depreciation..............................................XXX............................XXX
Net cash flow or cash flow after tax (CFAT)...............XXX............................XXX

Alternative way of calculating differential cash flow after tax:

Particulars........................................................Amount
Annual increase in sales ...................................XXX
Less: increase in cash expenses.......................XXX
Or,
Add: decrease in cash expenses.......................XXX
Differential cash flow before tax........................XXX
Less: differential depreciation...........................XXX
Differential net income before tax......................XXX
Less: Tax...........................................................XXX
Differential net income after tax........................XXX
Add back differential depreciation....................XXX
Annual differential CFAT.................................XXX
Step 3: Determination of net cash inflow for the final year: Final year net cash flow may be
different due to course of working capital and salvage value of assets. If working capital is
invested in initial stage, less in net cash outflow and plus in final year net cash inflow. It is called
release of working capital. If working capital is reduced in initial year, Plus in net cash outflow
and less is final year net cash inflow. Similarly, final year net cash inflow is affected by salvage
value of assets. If salvage value of assets is not given, CFAT is effected only by working capital.
The tax is adjusted on profit or loss on sales of assets. To determine the final year's CFAT
following table is taken:
For New Proposal:
Annual cash flow......................................................XXX
Add: cash salvage value of project.........................XXX
Less: tax paid on profit on sale of assets...............XXX
Add: tax save on loss on sale of assets..................XXX
Add: working capital increases...............................XXX

27 | P a g e
 NMC M.COM SEM-3

Less: working capital decreases.............................XXX

Net cash inflow for final year.................................XXX
Differential Cash Flow (Replacement Proposal)
Particulars.................................................New machine................Old machine
Annual cash flow after tax..............................XXX..............................XXX
Add: cash salvage of machine........................XXX..............................XXX
Less: Tax paid................................................ (XXX)........................... (XXX)
Add: Tax save..................................................XXX..............................XXX
Add: working capital increase...........................XXX..............................XXX
Less: working capital decrease....................... (XXX)............................ (XXX)
Net cash inflow for the final year....................XXX...............................XXX

Techniques Of Capital Budgeting

Techniques of
Capital
Budgeting

Discounted
Traditional
Cash Flow
Traditional Tecniques
Techniques Techniques –
Pay Back Period

PBP ARR NPV IRR PI

1. PBP
refers to the
period within which the entire cost of the project is expected to be completely recovered
by ways of cash inflows. Cash inflow means earnings after tax but before depreciation.
How to Compute PBP
1. In the case of Equal Annual Cash Inflows
𝑰𝒏𝒊𝒕𝒊𝒂𝒍 𝑪𝒂𝒔𝒉 𝑶𝒖𝒕𝒇𝒍𝒐𝒘𝒔
𝑷𝑩𝑷 =
𝑨𝒏𝒏𝒖𝒂𝒍 𝑪𝒂𝒔𝒉 𝑰𝒏𝒇𝒍𝒐𝒘

28 | P a g e
 NMC M.COM SEM-3

2. In case of Unequal Annual Cash Inflows: PBP is calculated by computing

cumulative cash inflows till the Cumulative Cash Inflows become equal to Initial
Cash Outflow. Thus,
𝑷𝒂𝒚 𝑩𝒂𝒄𝒌 𝑷𝒆𝒓𝒊𝒐𝒅
= (𝒀𝒆𝒂𝒓 𝒖𝒑𝒕𝒐 𝑪𝒖𝒎𝒖𝒍𝒂𝒕𝒊𝒗𝒆 𝑪𝑭𝑨𝑻 𝒊𝒔 𝒍𝒆𝒔𝒔 𝒕𝒉𝒂𝒏 𝑻𝒐𝒕𝒂𝒍 𝑪𝒂𝒔𝒉 𝑶𝒖𝒕𝒇𝒍𝒐𝒘)
𝑻𝒐𝒕𝒂𝒍 𝑪𝒂𝒔𝒉 𝑶𝒖𝒕𝒇𝒍𝒐𝒘 − 𝑪𝒖𝒎𝒖𝒍𝒂𝒕𝒊𝒗𝒆 𝑪𝑭𝑨𝑻 𝒐𝒇 𝒕𝒉𝒆 𝒚𝒆𝒂𝒓 𝒊𝒏 𝒘𝒉𝒊𝒄𝒉
𝑪𝑪𝑭𝑨𝑻 𝒊𝒔 𝒍𝒆𝒔𝒔 𝒕𝒉𝒂𝒏 𝒕𝒐𝒕𝒂𝒍 𝑪𝒂𝒔𝒉 𝑶𝒖𝒕𝒇𝒍𝒐𝒘
+
𝑪𝑭𝑨𝑻 𝒊𝒏 𝒏𝒆𝒙𝒕 𝒚𝒆𝒂𝒓

Accept / Reject Rule:

Independent Project: Accept the project if payback period ≤ Maximum Acceptable Payback
Period, otherwise reject.
Mutually Exclusive Project: Project should be ranked in the order of payback period and the
project with shortest PBP should be selected.
Complimentary Project: if combined PBP of the projects is less than or equal to MPBP then
Accept these projects, otherwise Reject these Project.
Merits of PBP:
1) It is easy to understand and calculate.
2) It emphasises liquidity by stressing earlier cash inflows.
3) It uses the cash flows rather than accounting data.
4) It enable the management to cope with the risk associated with the project by having a
shorter PBP.
5) The reciprocal of the PBP is a close approximation of the internal rate of return.
Demerits of Pay Back Period:
1) It ignores the time value of money.
2) It ignores the cash flows occurring after the payback period.
3) There is no objective way to determine the maximum acceptable payback period.\
4) It is not a measure of profitability since the cash flows occurring after the payback period
are ignored.
5) It does not necessarily maximize the wealth of the shareholders.
Average Rate Of Return,

29 | P a g e
 NMC M.COM SEM-3

ARR: Average Rate of return means the average annual yield on the project. It is found out by
dividing the annual profit after taxes by the average investment.
How to compute
Step. 1 Calculate Annual Earnings after taxes as follows;
𝐸𝐴𝑇
𝑎𝑛𝑛𝑢𝑎𝑙 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥𝑒𝑥 =
𝑇𝑜𝑡𝑎𝑙 𝑝𝑒𝑟𝑖𝑜𝑑 𝑜𝑓 𝑡ℎ𝑒 𝑃𝑟𝑜𝑗𝑒𝑐𝑡
Step. 2 Calculate Average Investment as follows;
Average Investment = ½(Original Cost – Salvage Value) + Salvage Value + Working
Capital
Step 3. Calculation of ARR
𝐴𝑛𝑛𝑢𝑎𝑙 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑓𝑡𝑒𝑟 𝑇𝑎𝑥𝑒𝑠
𝐴𝑅𝑅 = 𝑥 100
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
Accept / Reject Rule:
Accept the project if ARR ≥ minimum Acceptable Rate of return,
Otherwise reject the project
Merits of ARR:
1. It is easy to understand and calculate.
2. It consider the entire profit over the life of the projects.
3. It uses the Accounting Data which manager are familiar.
Demerits of ARR:
1) It ignores the time value of money.
2) It does not use the cash flows.
3) There is no objective way to determine the minimum acceptable rate of return.
Discounted Cash Flow Technique –
NPV,
Net present value method (also known as discounted cash flow method) is a popular capital
budgeting technique that takes into account the time value of money. It uses net present value of
the investment project as the base to accept or reject a proposed investment in projects like
purchase of new equipment, purchase of inventory, expansion or addition of existing plant assets
and the installation of new plants etc.
The following is the formula for calculating NPV:

30 | P a g e
 NMC M.COM SEM-3

Where,
Ct = net cash inflow during the period t
Co = total initial investment costs
r = discount rate, and
t = number of time periods
Net present value (NPV): Net present value is the difference between the present value of
cash inflows and the present value of cash outflows that occur as a result of undertaking an
investment project. It may be positive, zero or negative. These three possibilities of net
present value are briefly explained below:
Accept / Reject Rule
Positive NPV: If present value of cash inflows is greater than the present value of the cash
outflows, the net present value is said to be positive and the investment proposal is considered to
be acceptable.
Zero NPV: If present value of cash inflow is equal to present value of cash outflow, the net
present value is said to be zero and the investment proposal is considered to be acceptable.
Negative NPV: If present value of cash inflow is less than present value of cash outflow, the net
present value is said to be negative and the investment proposal is rejected.
Advantages of Net Present Value (NPV)
1. NPV gives important to the time value of money.
2. In the calculation of NPV, both after cash flow and before cash flow over the life span of
the project are considered.
3. Profitability and risk of the projects are given high priority.
4. NPV helps in maximizing the firm's value.
Disadvantages of Net Present Value (NPV)
1. NPV is difficult to use.
2. NPV cannot give accurate decision if the amount of investment of mutually exclusive
projects are not equal.
3. It is difficult to calculate the appropriate discount rate.
4. NPV may not give correct decision when the projects are of unequal life.

31 | P a g e
 NMC M.COM SEM-3

IRR,
IRR: Internal rate of return or IRR is that rate of return at which NPV from the above investment
& cash flows will become zero. IRR is the rate of interest that makes the sum of all cash flows
zero, and is useful to compare one investment to another.
How to Calculate IRR
𝑁𝑃𝑉 𝑎𝑡 𝐿𝑜𝑤𝑒𝑟 𝑅𝑎𝑡𝑒
IRR = 𝐿𝑜𝑤𝑒𝑟 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑅𝑎𝑡𝑒 + (𝐿𝑜𝑤𝑒𝑟 𝑅𝑎𝑡𝑒 −
𝑁𝑃𝑉 𝑎𝑡 𝐿𝑜𝑣𝑒𝑟 𝑅𝑎𝑒 −𝑁𝑃𝑉 𝑎𝑡 𝐻𝑖𝑔ℎ𝑒𝑟 𝑅𝑎𝑡𝑒

𝐻𝑖𝑔ℎ𝑒𝑟 𝑅𝑎𝑡𝑒)
Accept / Reject Rule:
Accept the project if IRR ≥ Cost of Capital, otherwise reject the project.
Advantages of Internal Rate of Return Method
1. It considers the time value of money even though the annual cash inflow is even and
uneven.
2. The profitability of the project is considered over the entire economic life of the project.
In this way, a true profitability of the project is evaluated.
3. There is no need of the pre-determination of cost of capital or cut off rate. Hence, Internal
Rate of Return method is better than Net Present Value method.
4. Sometimes, the pre-determination of cost of capital is very difficult. At that time, Internal
Rate of Return can be used to evaluate the project.
5. The ranking of project proposals is very easy under Internal Rate of Return since it
indicates percentage return.
6. It provides for maximizing profitability.
7. Internal Rate of Return takes into account the total cash inflow and outflows.
8. It gives much importance to the objective of maximizing shareholder’s wealth.
Disadvantages of Internal Rate of Return Method
1. This method assumed that the earnings are reinvested at the internal rate of return for the
remaining life of the project. If the average rate of return earned by the firm is not close to
the internal rate of return, the profitability of the project is not justifiable.
2. It involves tedious calculations.
3. This method gives importance only to the profitability but not consider the earliest recouping
of capital expenditure. The reason is that sometimes Internal Rate of Return method favours
a project which comparatively requires a longer period for recouping the capital expenditure.

32 | P a g e
 NMC M.COM SEM-3

Under the conditions of future is uncertainty, sometimes the full capital expenditure cannot
be recouped if Internal Rate of Return followed.
4. The results of Net Present Value method and Internal Rate of Return method may differ
when the projects under evaluation differ in their size, life and timings of cash inflows.
PI,
Profitability index is a financial tool which tells us whether an investment should be
accepted or rejected. It uses the time value concept of money and is calculated by the following
formula.
How to Calculate:
𝑷𝒓𝒆𝒔𝒆𝒏𝒕 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝑪𝒂𝒔𝒉 𝑰𝒏𝒇𝒍𝒐𝒘
Profitable Index = 𝑷𝒓𝒆𝒔𝒆𝒏𝒕 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝑪𝒂𝒔𝒉 𝑶𝒖𝒕𝑭𝒍𝒐𝒘

Accept / Reject Rule: If PI is greater than 1, accept the investment. If PI is less than 1, reject the
investment and if PI = 1, then indifferent (may accept or reject the decision)
Description: Profitability index helps in ranking investments and deciding the best investment
that should be made. PI greater than one indicates that present value of future cash inflows from
the investment is more than the initial investment, thereby indicating that it will earn profits. PI
of less than one indicates loss from the investment. PI equal to one means that there are no
profits. Thus, profitability index helps investors in making decisions about whether or not to
make a particular investment.
Advantages of Profitability Index (PI)
1. PI considers the time value of money.
2. PI considers analysis all cash flows of entire life.
3. PI makes the right in the case of different amount of cash outlay of different project.
4. PI ascertains the exact rate of return of the project.
Disadvantages of Profitability Index (PI)
1. It is difficult to understand interest rate or discount rate.
2. It is difficult to calculate profitability index if two projects having different useful life.
TV: -
Under this method, it is assumed that each cash inflow is re-invested in another asset at a
certain rate of return and calculating the terminal value of net cash flows at the end of project
life. In short, the NCF and the outlay are compounded forward rather than backward by
discounting which is used by NPV method.

33 | P a g e
 NMC M.COM SEM-3

Acceptance Rule:
From the foregoing discussion it becomes clear that if the value of the total compounded re-
invested cash flows is greater than the present value of outflow, i.e. if NCF have a higher
terminal value in comparison with the outlay, the project is accepted and vice-versa.
The accept-reject rule can, thus, be formulated as under:
(1) If there is a single project:
Accept the project if the terminal value (TV) is positive.
(2) If there are mutually exclusive projects:
The project will be more profitable which has a highest positive terminal value (TV).
It can also be stated that if TV is positive, accept the project and if TV is negative, reject the
project.
It should be remembered that TV method is similar to NPV method. The only difference is that
in case of former, values are compounded while in case of latter, values are discounted, of
course, both of them will present the same result provided the rate is same, (i.e., discounting and
compounding).
Taxation Effect:
Net cash flows are calculated after tax but before charging depreciation. As such, it requires
explanation about the relevant provisions for depreciation and other allowance/charges which are
contained in the income-tax Act, 1961.
They are:
(1) Normal Depreciation [Section 32 (1) (i) and (ii)]:
Such depreciation is allowed at prescribed rates on actual or written down value (WDV)
of building, machinery, plant or furniture u/s 32(1), (ii) and on actual cost of ship u/s 32 (1) (i).
Where the actual cost of any machine or plant does not exceed Rs. 5,000, the actual cost thereof
shall be allowed as a deduction.
No normal depreciation will be allowed on asset sold or discarded or has been destroyed after
using a part of the year.
Normal depreciation will be allowed on an asset in full on the basis of Diminishing Balance
Method at prescribed rates even if it worked only for the last day of the year But it should be
remembered that whatever method is followed, the amount of depreciation is to be added back to
the profit after tax in order to ascertain the net cash flow for a specific period.

34 | P a g e
 NMC M.COM SEM-3

(2) Initial Depreciation [Section 32(1 )(iv) and (v)]:

Initial depreciation is allowed on assets in the following two cases, viz., in respect of erection
of a building or installation of an asset:
(a) At the rate of 40% of the actual cost of a building, which has been newly erected after
31st March, 1961;
(b) At the rate of 25% of the actual cost of a building erection of which is completed after
31st March, 1967.
This initial depreciation shall not be deducted in determining the written down value of an
asset, but it should be taken into account in ascertaining terminal allowance u/s 32(l)(iii) or
Balancing Charge u/s 41(2) on disposal or destruction of such building or asset.
Terminal Depreciation [Section 32(l)(iii)]:
According to Section 32(l)(iii) in the case of any building, machinery, plant or furniture
which is sold, discarded, demolished or destroyed, the amount by which the money payable in
respect of such asset together with the amount of scrap value, if any fall short of the written
down value, thereof, as reduced by initial depreciation, if any, shall be deductible by way of
terminal depreciation or allowance provided such deficiency is actually written off in the books
of the assesses.
Terminal depreciation cannot be claimed if the asset is not used for the purpose of business
or profession.
Balancing Charge [Section 41(2)]:
According to Section 41(2), where any depreciated asset, such as, building, machinery, plant
or furniture, which are used for the purpose of business or profession is sold, discarded,
demolished or destroyed and the money paid or payable in respect of such asset together with the
scrap value, if any, exceeds the written down value, so much of the excess as does not exceed the
difference between actual cost and the written down value, i.e., the total depreciation (including
initial depreciation, if any) allowed up to date, shall be chargeable to income-tax by way of
Balancing Charge, and the remaining surplus, if any, is taxable as capital gains.
It may be mentioned here that where the insurance company replaces the asset lost or
discharge the liability in respect of claim for asset lost under conditions of the policy, question of
Balancing Charge will not arise in that case as there is no payment of money. The rules laid

35 | P a g e
 NMC M.COM SEM-3

down by explanation 2 to Section 32(l)(iii) in respect of terminal depreciation are applicable in

case of Balancing Charge.
Practically, the amount of balancing charge will bring down the amount of net cash flow or
the amount realized on sale by the amount tax is payable on such Balancing Charge. In order to
encourage the development of industries, development rebate was also introduced by the Finance
Act, 1955 (Section 33) in respect of certain machinery or plant apart from the provisions already
discussed above.
Working Capital:
Requirement of additional working capital in the various components of additional current
assets, viz. Inventory (raw materials, work-in-progress and finished goods), as well as to pay off
wages and other bills, is needed in addition to the investment in fixed asset on a project.
Therefore, while determining total amount of investment, requirement of additional working
capital should also be taken into consideration.
Similarly, when the project comes to an end, the amount of working capital (in full or in part)
so realized, should also be considered along with the scrap value of fixed assets, if any.
Sometimes, a run-down of working capital investment may so happen before the project actually
conies to an end. In that case, the release of funds must be considered in the respective years
during the life of the project carefully.
MIRR
The modified internal rate of return (MIRR) assumes that positive cash flows are reinvested at
the firm's cost of capital and that the initial outlays are financed at the firm's financing cost. By
contrast, the traditional internal rate of return (IRR) assumes the cash flows from a project are
reinvested at the IRR itself. The MIRR, therefore, more accurately reflects the cost and
profitability of a project.
MIRR's Formula and Calculation
Given the variables, the formula for MIRR is expressed as:
𝑛 𝐹𝑉 (𝑃𝑜𝑠𝑖𝑡𝑖𝑣𝑒 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 𝑥 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐶𝑎𝑝𝑖𝑡𝑎𝑙)
MIRR = √ −1
𝑃𝑉 (𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑂𝑢𝑡𝑙𝑎𝑦𝑠 𝑥 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑛𝑔 𝐶𝑜𝑠𝑡)

FVCF(c)=the future value of positive cash flows at the cost of capital for the company
PVCF(fc)= the present value of negative cash flows at the financing cost of the company
n=number of periods

36 | P a g e
 NMC M.COM SEM-3

Limitation
1. MIRR is that it requires you to compute an estimate of the cost of capital in order to make
a decision, a calculation that can be subjective and vary depending on the assumptions
made.
2. As with IRR, the MIRR can provide information that leads to sub-optimal decisions that
do not maximize value when several investment options are being considered at once.
MIRR does not actually quantify the various impacts of different investments in absolute
terms; NPV often provides a more effective theoretical basis for selecting investments
that are mutually exclusive.
3. It may also fail to produce optimal results in the case of capital rationing.
4. MIRR can also be difficult to understand for people who do not have a financial
background.
5. The theoretical basis for MIRR is also disputed among academics.
Capital rationing
Definition: Capital rationing is a strategy that firms implement to place limitations on the cost of
new investments. Normally, capital rationing is engaged when a firm has a low return on
investment (ROI) from its current investments due to high investment costs.
The main objective of capital rationing is the maximization of shareholder wealth. In this
context, a firm may decide to implement capital rationing by seeking new investment
opportunities with a higher net present value as well as setting a higher ceiling on the cost of
capital.
In doing so, the firm can assume control over its resources and undertake fewer projects
or projects with a higher expected return on investment.
Project Investment Rate of Return Total annual Return
A 2,00,000 17.5 35,000
B 2,00,000 17 34,000
C 8,00,000 16.5 1,32,000
D 3,00,000 16 48,000
E 3,00,000 18 54,000
Suppose the firm has decided to select that project which yield a rate of return of 15% or
more. In this case we selected all the project and that time we need to Invested Rs. 18,00,000.

37 | P a g e
 NMC M.COM SEM-3

But all project we can selected when we have unlimited amount of investment fund with
it. In real term, no firm can have unlimited fund for the investment at that time firm has to
selected more profitable project in available resources.
Capital budgeting under inflation
Inflation has ramifications for the realized value of a capital project. When evaluating capital
projects, companies can evaluate capital projects in nominal or real (i.e. inflation adjusted) terms.
Real cash flows are based on purchasing power at the time the decision to invest would is
made.
Under a real cash flow approach, the discount rate would remove the expected inflation rate,
as the cash flows will already reflect the effects of inflation.
Commonly, capital projects are analyzed in nominal terms, so the discount rate applied is
inclusive of expected inflation; however actual inflation may veer from expectations and
inflation may impact the different project variables in different ways.
There are several aspects of inflation that an analyst must consider when evaluating a capital
project:
1. Inflation and the Depreciation Tax Shied: if inflation is higher than expected at the time of
the investment decision, then the value of the depreciation tax shield is lowered and true net
present value of the project is lowered.
2. Inflation and Debt Payments: the discount rate may be based on a company’s cost of debt,
if debt is used to finance the capital project. When inflation is lower than expected, this
increases the firm’s debt costs and lowers the net present value of the project.
3. Inflation, Revenues, and Expenses: the revenues and expenses associated with a capital
project will not be equally affected by inflation. When a firm is not able to pass the costs of
inflation to product inputs on to customers in the form of higher prices, the net present value
of the project will be lower.
SOME CALCULATIVE EXAMPLES

1. An investment of Rs. 4, 00,000 in fixed asset is expected to generate annual

cash flow Rs. 1, 00,000. Find its payback period.
4,00,000
Payback Period = 1,00,000
= 4 years

38 | P a g e
 NMC M.COM SEM-3

2. . 𝛼 Ltd. has C proposed of investing in a machine casting Rs. 1, 00,000 which

generate cash inflow of Rs. 20,000, Rs. 30,000, Rs. 40,000, Rs. 50,000 in 1 st,
2nd, 3rd and 4th years respectively. Find payback period.
1,00,000−90,000
Payback Period = 3 + 1,40,000−90,000
10,000
=3+ = 3.2 years
50,000
Illustration 1 :

A company wants to implement an expansion project in the year 2002 requiring an outlay of
Rs. 20,00,000. It will yield annually a profit of Rs.3,00,000 after depreciation at 12.5%. Assume
tax in be 50%.

Calculate the Pay-back Period.

Solution :

The following formula is to be used to calculate the pay-back period.

(This formula is useful only when cash flow is the same every year).

Total Investment
Pay-back Period = Annual Cash Flow (After tax but before depreciation)
Cash flow can be calculated as followed :
Rs.
Profit before tax 3,00,000
Less : 50% tax 1,50,000
1,50,000
Add : Depreciation (at 12.5% on Rs. 2,50,000
20,00,000)
Annual Cash Flow 4,00,000

Total Investment
Pay-back period = Annual Cash Flow

20,00,000
=
4,00,000
= 5 years.

Illustration 2 :

A Company wants implement an expansion project in the year requiring an outlay of 15, 00,000.
It will annually profit of 3, 50,000, after depreciation at 15% Assume tax rate as 50%.
Calculate payback period
Ans:-
Particular Amt
EBT 13,50,000
-Tax 50% 1,75,000

39 | P a g e
 NMC M.COM SEM-3

EAT 1,75,000
+ Depreciation (15,00, 000*15%) 2,25,000
Cash flow every year 4,00,000

Payback period:-
Payback period = Total investment
Net cash flow
= 15, 00,000
4, 00,000
= 3.75 years,
Payback period = 3 years g months.

Illustration 3:
Bajaj Still Corporation purchase a machine costing 1, 10,000. The estimated returns as is
follows.
Year Returns
1 25,000
2 40,000
3 40,000
4 40,000
5 35,000
6 30,000
7 25,000
8 20,000
9 15,000
10 10,000

Economic life is 10 years. Depreciation as per Straight line method. Scrap value is 10,000
and tax rate is 50%.
Calculate the payback period.
Ans: - Calculation of depreciation:-
Depreciation = Machinery cost – Scrap value
Economic life
= 1, 10,000 – 10000
10 years
:. Depreciation = 10,000 Rs.
Calculation of net cash flow:-
Year Return Less tax FAT Add depreciation Cash inflow
1 25,000 12500 12500 10000 22500
2 40,000 20000 20000 10000 30000
3 40,000 20000 20000 10000 30000
4 40,000 20000 20000 10000 30000
5 35,000 17,500 17,500 10000 27500

40 | P a g e
 NMC M.COM SEM-3

6 30,000 15000 15000 10000 25000

7 25,000 12500 12500 10000 22500
8 20,000 10,000 10,000 10000 20000
9 15,000 7500 7500 10000 17500
10 10,000 5000 5000 10000 15000

Payback period = 3 years Months

Required for the next year = 30000 - 1, 10,000 – 82500
= 27500 Rs.

Cash flow Month

3000 12
27500 ?
= 11 Months.
:. Payback period = 3 years and 11 Months.

Illustration 4:
The Laxmi Trading Company is considering install a machinery. Two alternatives are open to it.
A machine or B machine. The relevant data about both machines are as follows.
Particular Machine A Machine B
Cost 3,00,000 75,000
Estimated life 6 years 7.5 years
Annual Sales 2,00,000 1,90,000
Cost of production
Raw Material 60,000 65,000
Labour 20,000 60,000
Other expense 45,000 40,000
Tax rate 50% 50%

Depreciation on straight line method. Calculate payback period.

Ans: - Calculation of net cash flow.
Particular Machine A Machine B
Sales 2,00,000 1,90,000
-Variable expense 1,25,000 1,65,000
Contribution 75,000 25,000
-Fixed Cost (deper.) 50,000 10,000
FBIT 25,000 15,000
Interest 0 0
EBT 250000 15,000

Calculation of depreciation:-
Machine A
Depreciation = machinery cost – Scrap value

41 | P a g e
 NMC M.COM SEM-3

Economic life
= 3, 00,000 – 0
6
= 50,000 Rs.
Machine B
= 75,000 – 0
7.5
= 10,000 Rs.
Particular Machine A Machine B
EBT 25000 15000
Tax 12500 7500
EAT 12500 7500
+depreciation 50000 10000
Net cash flow. 62500 17500

Calculation of payback period:-

Payback period = Total Investment
= Net Cash flow in every year
Machine A
= 3, 00,000
62500
= 4.8 years.
Machine B
= 75000
17500
= 4.29 years.

 Method :- 2
Average Rate of Return
Accounting Rate of Return
 Formulae :-
Average Rate of Return:-
Average Rate of = Average profit * 100
Average investment
Average profit = Total profit
No. Of Years.
Average Investment = Total investment + Scrap value

Illustration 5 :

42 | P a g e
 NMC M.COM SEM-3

In a project 5, 00,000 is invested. Total life of the project is 10 years. Scrap value at the
end of the project is realize 1, 00,000. Net profit for 10 years after depreciation 8 tax is 2, 50,000.
Calculate average rate of return.
Ans:-
Calculation of Average Rate of Return:-
Average profit:-
Average profit = Total profit
No. Of years
= 2, 50,000
10
:. Average profit = 2,500,000 Rs.

Average Investment:-
Average Investment = Total investment + Scrap value
2
= 5, 00,000 + 1, 00,000
2
= 6, 00,000
2
Average Invest = 3, 00,000 Rs.

Average Rate of Return:-

ARR = Average profit *100
Average investment
= 25000 * 100
300000
:. ARR = 8.33%

Illustration 6 :
In a project budget is 500000. Total life of the project is 10 years. Net profit after
depreciation and tax is 800000. Scrap value at the end of the project is realize 100000. Calculate
Average rate of return.
Ans: -
Calculation of Average Rate of Return: -
Average profit: -
Average profit = Total profit
No. Of years
= 800000
10
= 80000 Rs.

43 | P a g e
 NMC M.COM SEM-3

Average investment: -
Average investment = Total investment + Scrap value
2
= 500000 + 100000
2
= 600000
2
Average investment = 300000 Rs.

Average Rate of Return: -

ARR = Average profit *100
Average investment
= 80000 * 100
300000
:. ARR = 26.67%
Illustration 7 :
A Company has four proposal for investment. Find out payback period and Average Rate
of Return on investment for each proposal.
Proposal Investment 1st yr 2nd yr 3rd yr Total
A 15000 10000 5000 - 15000
B 25000 15000 20000 10000 45000
C 20000 10000 15000 5000 30000
D 30000 20000 8000 8000 36000

Which proposal is acceptable as per payback period and Which proposal is acceptable as
per ARR.
Ans: -
Calculation of payback period: -
Proposal Investment 1st yr 2nd yr 3rd yr Payback period
A 15000 10000 5000 - 2 years
B 25000 15000 20000 10000 1 years 6 months
C 20000 10000 15000 5000 1 years 8 months
D 30000 20000 8000 8000 2 years 3 months

Proposal = B
Required for the next year = Total investment - 1st year investment
= 25000 – 15000
= 10000 Rs.
Return Month
20000 12
10000 ?

44 | P a g e
 NMC M.COM SEM-3

6 Months
PBP = 1 Year and 6 Months

Proposal: - C
Required For the = Total investment - 1st year investment year
= 20000 – 10000
= 10000 Rs.
Return Month
15000 12
10000 ?
8 Months.
PBP = 1 Year 8 Month

Proposal: - D
Required for the = Total invest – year investment year
= 30000 – 28000
= 2000 Rs.
Cash flow Month
8000 12
2000 ?
3 Month
PBP = 2 Year 3 Months.

Calculation of Average Rate of Return: -

Proposal A
Average Profit
Average Profit = Total profit
= No. Of Years
= 15000
2
Average profit = 7500 Rs.

Average investment: -
Average investment = Total investment + Scrap value
2
= 15000 + 0
2
Average investment = 7500 Rs.
Average Rate of Return: -
ARR = Average profit * 100

45 | P a g e
 NMC M.COM SEM-3

Average investment
= 7500 * 100
7500
:. ARR = 100%

Proposal B: -
Average profit = Total profit
No. Of years
= 45000
3
Average profit = 15000 Rs.
Average investment = Total invest. + Scrap Value
2
= 25000 + 0
2
Average investment = 12500 Rs.

Average Rate of Return: -

ARR = Average profit * 100
Average investment
= 15000 *100
12500
:. ARR = 120%

Proposal c: -
Average Profit = Total profit
No. Of years
= 30000
3
Average profit = 10000 Rs.

Average investment = Total invest. + Scrap Value

2
= 20000 + 0
2
Average investment = 100000 Rs.

Average Rate of Return: -

ARR = Average profit * 100
Average investment

46 | P a g e
 NMC M.COM SEM-3

= 10000 * 100
10000
:. ARR = 100%

Proposal: - D
Average profit = Total profit
No. Of years
36000
3
:. Average profit = 12,000 Rs.

Average investment = Total investment + Scrap Value

2
= 30000 + 0
2
:. Average investment = 15000 Rs.

Average Rate of Return: -

ARR = Average profit * 100
Average investment
= 12000 * 100
15000
:. ARR = 80%
As per Payback period proposal: B is acceptable
As per Average Rate of Return Proposal B is acceptable.
Illustration 8:
A Company is Considering to Purchase a machine costing 50000 and estimated life is 4
years Scrap value after estimated life is 10000 Realised net profit for after depreciation but
before tax, is given below calculate payback period and Average Rate of Return.
Year Net profit
1 40000 Tax rate is 50%
2 40000
3 20000 Calculation of depreciation: -
4 20000
Depreciation = Machinery Cost –
Scrap Value
Estimated life
= 50000 – 10000
4
= 40000
4

47 | P a g e
 NMC M.COM SEM-3

= 10000 Rs.
Calculation of Net cash flow: -
Years Net profit Less Tax EAT Add Net cash flow
depreciation
1 40000 20000 20000 10000 30000
2 40000 20000 20000 10000 30000
3 20000 10000 10000 10000 20000
4 20000 10000 10000 10000 20000
60000

Calculation Payback period: -

Required for the = Total investment – 1 year invest
Next year
= 50000 – 30000
= 20000 Rs.
Returns Month
30000 12
20000 ?
8 Month
PBP = 1 Year 8 Month
Calculation of ARR: -
Average profit = Total profit
No. of Years
= 60000
4
= 15000 Rs.

Average investment = Total investment + Scrap Value

2
= 50000 +10000
2
= 30000 Rs.
ARR
ARR = Average profit *100
Average investment
= 15000 * 100
30000
:. ARR = 50%
Illustration 9 :
Calculate the ARR of a project X and project Y from the following information
Particular Project X Project Y

48 | P a g e
 NMC M.COM SEM-3

Investment 40000 50000

Expected life 4 years 5 Years
Scrap Value 2000 6000
Profit after tax
1st year 8000 10000
2nd year 10000 20000
3rd year 20000 20000
4th year 12000 6000
5th year - 2000

Calculation of ARR for Project X: -

Total profit = 8000 + 10000 + 20000 + 12000
= 50000 Rs.
Average profit = Total profit
No. of years
= 50000
4
= 12500 Rs.
Average investment = Total investment + Scrap value
2
= 40000 + 2000
2
= 42000
2
= 21000 Rs.
ARR
ARR = Average profit * 100
Average investment
= 12500 *100
21000
:. ARR = 59.52%
Calculation of ARR for project Y: -
Total profit = 10000 + 20000 + 20000 + 6000 + 2000
= 58000 Rs.
Average profit = Total profit
No. of Years
= 58000
5
= 11600 Rs.
Average investment = Total invest. + Scrap value
2

49 | P a g e
 NMC M.COM SEM-3

= 50000 + 6000
2
= 28000 Rs.
ARR
ARR = Average profit * 100
Average investment
= 11600 * 100
28000
:. ARR = 41.43%
Method: - 3
Net Present Value Method OR
Discounted Cash Flow Method
Net present Value: -
NPV = Total present Value of future cash flow
Original investment of project
NPV = Total present value – Total investment

Method: - 4 Profit ability Index Method

Profitability Index
Profitability Index = Total present value of future cash flaw
Original investment of project
OR
Profitability Index = Total Present value
Total investment

Illustration 10 :
A Company wants to purchase a machinery of 200000. Having a life of 5 years.
Estimated cash flow is as under.
Year Cash flow [after depre but before tax]
1 100000
2 100000
3 80000
4 80000
5 40000

A depreciation as per straight line method at 20% tax rate is 50% present value of 1 at
10% rate of interest is given. Discount factor is 0.909, 0.826, 0.751, 0.683, and 0.621.
Evaluate project for the following method pay
(i) Payback period method
(ii) Average Rate of Return method

50 | P a g e
 NMC M.COM SEM-3

(iii) Net present value method

(iv) Profitability Index method

Calculation of payback period method: -

Year Cash -Tax EAT +depre Net cash Discounted Net present
flow flow factor value(NPV)
1 100000 50000 50000 40000 90000 0.909 81810
2 100000 50000 50000 40000 90000 0.826 74340
3 80000 40000 40000 40000 80000 0.751 60080
4 80000 40000 40000 40000 80000 0.683 54640
5 40000 20000 20000 40000 60000 0.621 37260
200000 308130

Calculation of depreciation: -
= 200000 *20
100
= 40000 Rs.
Payback period: -
Required for the = Total investment – 2 year cash flow
Next year
= 200000 – 180000
= 20000
Return Month
80000 12
20000 ?
3 Month
PBP = 2 years 3 months.

Calculation of Average Rate of Return: -

Average profit = Total profit (EAT)
No. Of years
= 200000
5
= 40000 Rs.
Average investment = Total invest + Scrap value
2
= 200000 + 0
= 100000 Rs.
ARR: -
ARR = Average profit * 100
Average investment

51 | P a g e
 NMC M.COM SEM-3

= 40000 * 100
100000
:. ARR = 40%

Calculation of Net present value: -

NPV = Total Present value of – original invest.
Future cash flow of project
= 308130 – 200000
:. NPV = 108130 Rs.

Calculation of profitability Index method: -

PI = Total Present Value
Original investment of project
= 308130
200000
:. PI= 1.54:1

Illustration 11:
Sapana Company Itd. Is considering purchasing a machine. Three machines A, B, and C
are available each costing 400000. An estimated life of each machine is 5 years. There is no
Scrap value. The company’s required rate of Return is 12% Tax rate applicable to the Company
is a 50%. The expected earnings before depreciation and tax for the 3 machines are as under.

Year ‘A’ Machine ‘B’ Machine ‘C’ Machine

1 260000 140000 220000
2 200000 160000 260000
3 160000 260000 160000
4 140000 200000 120000
5 100000 120000 140000

The present value of 1 at a discount rate of 12% for the 1 st 5 years is 0.893, 0.797, 0.712,
0.636, and 0.567.
Select a cost of profitable Machines. On using the following methods.
(1) Payback period method
(2) Average rate of Return Method
(3) Net present value method
(4) Profitability Index
Ans: - For Machine – A
Calculation of the cash flow after tax but before depre
Year Cash -depre EBT -Tax EAT +depre Net Discount NPV
flow (50%) cash Factor

52 | P a g e
 NMC M.COM SEM-3

flow (12%)
1 260000 80000 180000 90000 90000 80000 170000 0.893 151810
2 200000 80000 120000 60000 60000 80000 140000 0.797 111580
3 160000 80000 80000 40000 40000 80000 120000 0.712 85440
4 140000 80000 60000 30000 30000 80000 110000 0.636 69960
5 100000 80000 20000 10000 10000 80000 90000 0.567 51030
230000 469820

Calculation of depreciation: -
Depreciation = Machinery cost – Scrap value
No. Of Years
= 400000 – 0
5
:. Depreciation = 80000 Rs.
(1) Calculation of the payback period: -
Required for the = Total invest. – 2 year cash flow
Next year
= 400000 – 310000
= 90000 Rs.

Cash flow Month

120000 12
90000 ?
= 9 Month
:. PBP = 2 year 9 month

(2) Calculation of the Average Rate of Return: -

Average profit = Total profit
No. of years

= 230000
5
Average profit = 46000 Rs.
Illustration 12:
Sapana Company Itd. Is considering purchasing a machine. Three machines A, B, and C
are available each costing 400000. An estimated life of each machine is 5 years. There is no
Scrap value. The company’s required rate of Return is 12% Tax rate applicable to the Company
is a 50%. The expected earnings before depreciation and tax for the 3 machines are as under.

Year ‘A’ Machine ‘B’ Machine ‘C’ Machine

53 | P a g e
 NMC M.COM SEM-3

1 260000 140000 220000

2 200000 160000 260000
3 160000 260000 160000
4 140000 200000 120000
5 100000 120000 140000

The present value of 1 at a discount rate of 12% for the 1st 5 years is 0.893, 0.797, 0.712,
0.636, and 0.567.

Select a cost of profitable Machines. On using the following methods.

1. Payback period method

2. Average rate of Return Method
3.Net present value method
4. Profitability Index

Ans: - For Machine – A

Calculation of the cash flow after tax but before depre

Year Cash -depre EBT -Tax EAT +depre Net Discount NPV
flow (50%) cash Factor
flow (12%)
1 260000 80000 180000 90000 90000 80000 170000 0.893 151810
2 200000 80000 120000 60000 60000 80000 140000 0.797 111580
3 160000 80000 80000 40000 40000 80000 120000 0.712 85440
4 140000 80000 60000 30000 30000 80000 110000 0.636 69960
5 100000 80000 20000 10000 10000 80000 90000 0.567 51030
230000 469820

Calculation of depreciation: -

Depreciation = Machinery cost – Scrap value

No. Of Years

= 400000 – 0

:. Depreciation = 80000 Rs.

(3) Calculation of the payback period: -

54 | P a g e
 NMC M.COM SEM-3

Required for the = Total invest. – 2 year cash flow

Next year
= 400000 – 310000
= 90000 Rs.

Cash flow Month

120000 12
90000 ?
= 9 Month
:. PBP = 2 year 9 month

(4) Calculation of the Average Rate of Return: -

Average profit = Total profit
No. of years

= 230000
5

Average profit = 46000 Rs.

Average investment = Total investment + Scrap value

= 400000 + 0

Average investment = 200000 Rs.

Average Rate of Return: -

ARR = Average profit * 100

Average investment

= 46000 * 100

= 200000

:. ARR = 23%

(5) Calculation of Net present value method: -

NPV = Net present value – Total investment

55 | P a g e
 NMC M.COM SEM-3

= 469820 – 400000

:. NPV = 69820 Rs.

(6) Profitability Index Method: -

PI = Net present value

Total investment

= 469820

400000

:. PI = 1.17:1

Calculation for the machine: - B: -

Cal. Of cash flow after tax but before depre: -

Year Cash -depre EBT -Tax EAT +depre Net Discount NPV
flow (50%) cash Factor
flow (12%)
1 140000 80000 60000 30000 30000 80000 110000 0.893 98230
2 160000 80000 80000 40000 40000 80000 120000 0.797 95640
3 260000 80000 180000 90000 90000 80000 170000 0.712 121040
4 200000 80000 120000 60000 60000 80000 140000 0.636 89040
5 120000 80000 40000 20000 20000 80000 100000 0.567 56700
240000 460650

Payback period method: -

1st year 110000 Rs.

2nd year 120000 Rs.

3rd year 170000 Rs.

400000 Rs.

PBP = 3 years.

Average Rate of Return Method: -

Average Profit = Total profit

56 | P a g e
 NMC M.COM SEM-3

No. of years

= 240000

:. Average profit = 48000 Rs.

Average investment = Total invest. + scrap value

= 400000 + 0

:. Average investment = 200000 Rs.

Average Rate of Return: -

ARR = Average profit * 100

Average investment

= 48000 * 100

200000

:. ARR = 24%

Net present value method: -

NPV = Total present value – Total investment

= 460650 – 400000

:. NPV = 60650 Rs.

Profitability Index: -

PI = Total present value

Total investment

= 460650

400000

57 | P a g e
 NMC M.COM SEM-3

:. PI = 1.15:1

Calculation for the machine C: -

Cal. Of cash flow after tax but before depre

Year Cash -depre EBT -Tax EAT +depre Net Discount NPV
flow (50%) cash Factor
flow (12%)
1 220000 80000 140000 70000 70000 80000 150000 0.893 133950
2 260000 80000 180000 90000 90000 80000 170000 0.797 135490
3 160000 80000 80000 40000 40000 80000 120000 0.712 85440
4 120000 80000 40000 20000 20000 80000 100000 0.636 63600
5 140000 80000 60000 30000 30000 80000 110000 0.567 62370
250000 480850

Payback period method: -

Required for the = Total investment – 2 year investment

Next year

= 400000 – 320000

= 80000 Rs.

Cash flow Month

120000 12

80000 ?

8 Months

:. PBP = 2 Year & 8 Months.

Average Rate of Return Method: -

Average profit = Total profit

No. of years

= 250000

58 | P a g e
 NMC M.COM SEM-3

:. Average profit = 50000 Rs.

Average investment = Total invest. + Scrap Value

= 400000 + 0

:. Average investment = 200000 Rs.

Average Rate of Return: -

ARR = Average profit * 100

Average investment

= 50000 * 100

200000

:. ARR = 25%

Net present value method: -

NPV = Total present value – Total investment

= 480850 – 400000

:. NPV = 80850 Rs.

Profitability Index Method: -

PI = Total present value

Total investment

= 480850

400000

:. PI = 1.20:1

59 | P a g e
 NMC M.COM SEM-3

UNIT 3

CAPITAL STRUCTURE

INTRODUCTION:-

Capital structure refers to the composition of sources of funds the company has used to raise
the finance needed by it for its business. There are five sources of funds : (1) debentures, (2)
other long term debts, (3) preference shares and (4) equity shares (5) reserves and surplus called
retained earnings. Generally, the management of the company plans ar. ideal capital structure in
advance and raise funds accordingly as and when need for funds arises. In some companies, on
the other hand capital structure is not planned in advance, but they raise funds from different
sources according to the circumstances. The sources of funds which are included in capital
structure can be divided into two groups : (i) those which impose the burden of interest and
dividend payments on the company and (ii) those which impose no such burden on the company.
In the first category are included debentures, long-term debts and preference shares; because the
company has to pay a fixed interest on debentures irrespective of whether it makes profit or not.
Similarly, though preference shares are held by the company's shareholders, dividend has to paid
to them if business earns profit. Thus, debentures and preference shares are the securities with
fixed liability. In the second category are included equity shares on which payment of dividend
is' not compulsory and hence they impose no definite burden on the company.
As stated earlier, an ideal capital structure can be formulated by combining debts and
equities judiciously. The optimum or ideal capital structure refers to that capital structure which
maximises market value of the company's shares or minimises the average cost of its capital. A
number of factors have to be taken into account while determining an optimum capital structure
for the company.

2. DEFINITION OF CAPITAL STRUCTURE :

In simple words, Capital structure refers to the composition of capital.

According to GERSTERNBERG, "Capital structure of a company refers to the make-up of
its capitalisation." that is, the type of securities to be issued and the relative proportion of each
type of security in the total capitalisation. It includes all long term debts, preference share capital
and shareholders' funds.

West and Bringhamwrite, "Capital structure is the permanent finance of the firm represented
by long-term debt, preferred stock and net worth."

Thus Capital Structure = Long-term Debts + Preference Share Capital + Equity Share
Capital + Reserves.

Capital structure of a company shows how-or through which sources its, capital has been
raised-by issuing equity shares, preference shares, debentures or any two of them. It is concerned
with the determination of debt-equity composition. This influences both return and risk of the

60 | P a g e
 NMC M.COM SEM-3

shareholders. It has an effect on value of the firm and its cost of capital. Hence, determining
proper capital structure is an important question of financial management. The capital structure
may be presented as follows :

Net income approach

Different theories of capital structure suggest that a change in financial leverage would affect
the average cost of capital and market value of company’s shares also. The essence of net
income (NI) approach suggested by Durand, is that when there is a change in capital structure,
there takes place a change in
(i) Overall cost of capital and also in
(ii) Total value of firm.
To be more precise, if financial leverage is increased by raising the ratio of debts to equity,
there will be a decrease in weighted average cost of capital and an increase in the market value of
its shares. Conversely, if financial leverage is reduced by lowering the ratio of debts to equity,
there will be an increase in weighted average cost of capital and a decrease in the market value of
its shares. We try to understand this with a example.
Example: Earnings before interest and taxes (EBIT) of a X Limited Company is ₹ 80,000. The
equity capitalisation rate (K) is 10 per cent. The capital structure of this company consists of
equity shares of ₹ 10 each and ₹ 4,00,000 worth of 8% debentures. In this case, the value of the
company, market value of its equity shares and overall cost of its capital will be as follows
Particular ₹

Earnings before interest and taxes 80,000

Less: Interest on 8% debentures of ₹ 4,00,00 32,000
Net income available to equity shareholders 48,000
Equity Capitalisation Rate 10%

61 | P a g e
 NMC M.COM SEM-3

Market value of equity shares on the basis of earnings(48,000 x 10) 4,80,000

Plus market value of debentures 4,00,000
Market value of the firm (company) 8,80,000
(Value of Firm = S + D where S = Market Value of Shares and D = Market Value of Debt)
On the basis of above figures, the overall cost of capital will be as follows:
EBIT
K0 = V Where K0 = the overall cost of capital
EBIT = income before interest and taxes
V = total market value of the firm
80000 1
𝐾𝑜 = = = 0.099 = 9.9%,
880000 11

Now, to measure the effect of change in capital structure, let us assume that debentures
are increased by ₹ 1,00,000, while equities are reduced to the same extent.
Earning before interest and taxes ₹ 80,000
Less Interest on 8 per cent debentures of ₹ 5,00,000 ₹ 40,000
Profit available to equity shareholders ₹ 40,000
Value of equity shares on the basis of capitalisation of earning ₹ 4,00,000
40,000 ÷ 0.10
Plus market value of debentures ₹ 5,00,000
Overall value of the firm Rs 9,00,000
The rate of overall cost of capital will, therefore, be as follows
𝐸𝐵𝐼𝑇 80000
𝐾𝑜 = = = 0.088 or 8.8 per cent
𝑉 900000

The above calculations reveal that

1. When the ratio of debts to equity shares is raised, the overall value of the company increases
from ₹ 8, 80,000 to ₹ 9, 00,000.
2. Similarly, the rate of overall cost of capital falls from 9.9 per cent to 8.8 per cent.
Thus, the conclusion of the net income approach is that when debts are increased in capital
structure of a company, the market value of 4ie firm increases, while rate of overall cost of
capital goes down.
Basic Assumptions: The above calculations suggest that net income approach is based on
certain assumptions. They are as follows

62 | P a g e
 NMC M.COM SEM-3

1. There are no taxes on companies.

2. The cost of debt is less than the cost of equities.
3. A change in the ratio of debts to equity does not affect the degree of risk that the
investors bear.
Other words whatever may be the ratio of
debts to equity, the cost of debts as also the cost of
equity capital remain constant.
The implication of these assumptions is that, with
the increase in debts, a less expensive source of
capital increases in amount and consequently,
weighted average cost of capital this, while the
overall market value of the firm moves up.
Conversely, when debts are reduced, a less
expensive source of capital decreases in amount.
Consequently, weighted average cost of capital rises, while the overall market value of the firm
moves down.
In terms of graphs this may be represented as follows (In the above graph)
1. Degree of financial leverage is measured along horizontal axis while cost of capital is
measured along vertical axis-y.
2. The cost of debentures being constant, it is represented by a horizontal line (K).
3. Similarly, the cost of equity capital is also represented by a horizontal line (K) as it is also
assumed to be constant. Of course, cost of equity capital is greater than that of debentures.
Therefore, the line K lies above the line K.
4. The overall cost of capital diminishes with the increase in debentures in capital structure.
Therefore, the curve showing the overall cost of capital (K0) slopes downwards from left to
right.
The approach indicates that the high leverage brings down the cost of capital and raises
the value of the .firm and also the market value of its shares. It also suggests that the firm can use
100% debt to maximise its value.
But it suffers from certain limitations

63 | P a g e
 NMC M.COM SEM-3

1. Not Realistic Assumption: - Its basic assumptions are not realistic. With the increase of
leverage in its capital structure, its risk increases and equity shareholders expect higher return
that is, cost of its equity capital (K) increases.
2. Interest Rate Not Constant: - The assumption that rate of interest of debentures will remain
constant is also not realistic.
Net operating income approach,
The second approach, as propounded by David Durand, the Net Operating Income (NOI)
approach examines the effects of changes in capital structure in terms of net operating income.
In the net income approach discussed above, net income available to shareholders is
obtained by deducting interest on debentures from net operating income (EBIT). Then overall
value of the firm is calculated through capitalisation rate of equities obtained on the basis of net
operating income. Hence, it is called net income approach.
In the second approach, on the other hand, overall value of the firm is assessed on the
basis of net operating income, not on the basis of net income. Hence, this second approach is
known as net operating income (NOT) approach.
The NOT approach implies that
a) whatever may be the change in capital structure, the overall value of the firm is not
affected. Thus, the overall value of the firm is independent of the degree of leverage in
capital structure.
b) Similarly, the overall cost of capital is not affected by any change in the degree of
leverage in capital structure. The overall cost of capital is independent of leverage.
𝑁𝑂𝐼 𝐸𝐵𝐼𝑇
Here, the market value of a firm = =
𝐾𝑜 𝐾𝑜

where NOI = EBTT or net operating income ; 𝐾𝑜 = overall cost of capital which is constant.
Suppose, net operating income of a firm is ₹ 2, 00,000 and overall cost of capital is 10 per cent.
In this case, the value of the firm can be ascertained as follows
200000
Market Value = = ₹ 20,00,000
10%

Obviously, under this method, market value of a firm is ascertained on the basis of its net
operating income, assuming that overall cost of its capital remains constant. If capital structure
consists of debentures of ₹ 5, 00,000, the market value of equity capital will be calculated as
follows:

64 | P a g e
 NMC M.COM SEM-3

Market value of the firm — Value of debentures = Value of equity capital

Or V—D= S Where V=market value of the firm
D = value of debentures
S = value of equity capital
₹ 20, 00,000 — ₹ 5, 00,000 = ₹ 15,00,000
If the cost of debt is less than that of equity capital, the overall cost of capital must
decrease with the increase in debts, whereas it is assumed under this method that overall cost of
capital is unaffected and hence it remains constant irrespective of the change in the ratio of debts
to equity capital. How can this assumption be justified? The advocates of this method are of the
opinion that the degree of risk of business increases with the increase in the amount of debts.
Consequently, the rate of equity capitalisation also goes up, that is, investors expect a higher rate
of return over investment in equity shares. Thus, on the one hand, cost of capital decreases with
the increase in the volume of debts; on the other hand, cost of equity capital increases to the
same extent. Hence, the benefit of leverage is wiped out and overall cost of capital remains at the
same level as before.
Assumptions: Following assumptions are implicit in the net operating income approach
1) Market value of the firm is ascertained on aggregate capital basis. The distinction between
debentures and equity capital has no significance.
2) The cost of debt is constant.
3) The risk of the shareholders increases with the increase in debts, hence the rate of equity
capitalisation goes up. Consequently, the benefit of less expensive debenture capital is fully
cancelled out by the equivalent increase in the rate of equity eapitalisation.
4) There are no taxes.
5) Overall cost of capital of the firm (𝐾𝑜 ) is constant.

65 | P a g e
 NMC M.COM SEM-3

In the above, graph, Kd and 𝐾𝑜 are constant at all levels of leverage in capital structure
and hence both are represented by horizontal lines parallel to x-axis. Of course, as average cost
of capital is greater than the cost of debenture, 𝐾𝑜 line lies above 𝐾𝑑 line. But the cost of equity
capital is not constant. It increases with the total value of debts in capital structure. Hence K, line
moves upwards from left to right.
Traditional approach,
Traditional approach is an intermediate approach between, the net income approach and net
operating income approach. According to this approach,
1. An optimum capital structure does exist.
2. Market value of the firm can be increased and average cost of capital can be reduced
through a prudent manipulation of leverage.
3. The cost of debt capital increases if debts (or the degree of leverage) are increased
beyond a definite limit. This is because the greater the risk of business, the higher the rate of
interest the creditors would ask for. The rate of equity capitalisation will also” increase with it.
Thus, there remains no benefit of leverage when debts are increased beyond a certain limit. The
cost of capital also goes up.
Thus, at a definite level of mixture of debts to equity capital, average cost of capital also
increases. The capital structure is optimum at this level of the mix of debts to equity capital.
The effect of change in capital structure on the overall cost of capital can be divided into
three stages as follows
1. First Stage: In the first stage, the overall cost of capital falls and the value of the firm
increases with the increase in leverage. Thus, the leverage has beneficial effect as debts
are less expensive. The cost of equity remains constant or increases negligib1y. The
proportion of risk is less in such a firm.
2. Second Stage: A stage is reached when increase in leverage has no effect on the value, or
the cost of capital, of the firm. Neither the cost of 6apita falls nor the val4e 6f the firm
rises. This is because the increase in the cost of equity due to the added financial risk
offsets the advantage of low cost debt. This is the stage wherein the value of the firm is
maximum and cost of capital is minimum.

66 | P a g e
 NMC M.COM SEM-3

3. Third Stage: Beyond a definite limit of leverage, the cost of capital increases with
leverage and the value of the firm decreases with leverage. This is because, with the
increase in debts, investors begin to realise the degree of financial risk and hence they
desire to earn a higher rate of return on equity shares. The resultant increase in equity
capitalisation rate will more than offset the advantage of low-cost debt.
It follows that the cost of capital is a function of the degree of leverage. Hence, an
optimum capital structure can be achieved by establishing an appropriate degree of leverage in
capital structure. The effects of change in leverage can be graphically shown as follows
Cost of Capital (Percent)

Degree of Leverage
In the above diagram, 𝐾𝑑 line represents cost of debt capital which is constant in the first
stage as also in the second stage. It increase with the increase in leverage in the third stage. 𝐾𝑜
Line represents cost of equity capital which increases slightly with leverage in the first stage.
Thereafter it increases at an increasing rate. 𝐾𝑜 Line represents overall cost of capital which falls
with the increase in leverage in the first stage. Between A and B, therefore, it slopes down from
left to right. In the second stage,𝐾𝑜 is constant in spite of the increase in leverage. Hence between
B and C, 𝐾𝑜 line is parallel to the x-axis. In the third stage, 𝐾𝑜 rises with the increase in leverage.
Hence 𝐾𝑜 line is upward moving beyond point C.
Criticism: The traditional approach is criticised on the ground that the value of a firm depends
partly on its net operating income and partly on the degree of risk. The capital structure can
affect neither net operating income nor degree of risk. In other words, a change in leverage can
have no effect on the market value of the company. Only the distribution of net operating income
and risk will change with the change in leverage.
Modigliani- Miller approach,

67 | P a g e
 NMC M.COM SEM-3

In an article published in 1958, Modigliani and Miller propounded their view which is known as
‘Modigliani-Miller Approach’.* (MM Approach) Their approach is identical with the net
operating income approach. They have also concluded that, in the absence of taxes, a firm’s
market value and the cost of capital remain constant to the changes in capital structure. In other
words, an optimum capital structure does not exist. The net operating income approach leads to
the same conclusion, but Modigliani and Miller have provided a behavioural justification in
favour of this conclusion. That is, they refer to a particular behaviour of the investors in support
of this conclusion.
Assumptions: Their conclusion is based on the following assumptions:
1. Perfect Capital Market: - The capital market is perfect in the sense that investors have perfect
knowledge of market forces; they are free to buy and sell securities; the cost of transactions is
zero; and they behave rationally.
2. Equivalent Risk Class: - Firms can be classified into different groups, each group consisting
of firms having equal business risks. They can be divided into “equivalent risk class”.
3. Complete Information: - Since all investors have complete information, they all use the same
figure of not operating income of the firm to ascertain its market value.
4. 100 Percentage Dividend Pay-out Ratio: -All firms distribute the entire earning among their
shareholders in the form of dividend. It means dividend pay-out ratio is 100%.
5. Tax: - No corporate income taxes exist.
Under these assumptions, Modigliani and Miller have derived following propositions
1. Market value of the firm and the cost of capital are independent of capital structure. In other
words, a change in debt-equity ratio can have no effect on the market value of the firm as
also on the cost of capital.
2. The expected yield on equity has two components: the rate of equity capitalisation when
debts are non-existent plus a premium for the financial risk arising from debts. Therefore, the
advantage of low-cost debt is offset by the increase in expected yield on equity.
3. The financing decision has no impact on the expected yield (cut off rate) on equity. The
financing decision and investment decision are, therefore, independent of each other.
We shall consider in detail only first proposition which states that market value of a firm
and the cost of capital are independent of the degree of financial leverage in capital structure.
They explain this proposition in terms of the behaviour of investors.

68 | P a g e
 NMC M.COM SEM-3

Arbitrage Process: If the price of a product is unequal in two markets, traders buy it in
the market where price is low and sell it in the market where price is high. This phenomenon is
known as price differential or arbitrage. As a result of this process of arbitrage, price tends to
decline in the high-priced market and price tends to rise in the low-priced market, until the
differential is totally removed.
Modigliani and Miller explain their approach in terms of the same process of arbitrage.
They hold that two firms, identical in all respects except leverage cannot have different market
values. If two identical firms have different market values, arbitrage will take place until
difference in the market values is removed completely.
To illustrate, let us suppose that there are two firms - X and Y - belonging to the same
group of homogenous risk. The firm X is unlevered as its ‘capital structure consists of equity
capital only, while firm Y is levered as its capital structure includes 10 per cent debentures of ₹
1, 00,000. In this case, according to traditional approach, the market value of firm Y would be
higher than that of firm X. But, according to M-M approach, this situation cannot persist for
long. The market value of the equity share of firm Y is high but investment in it is more risky,
while the market value of the equity share of firm X is low but investment in it is safe. Hence
investors will sell out equity shares of firm Y and purchase equity shares of firm X.
Consequently, the market value of the equity shares of firm Y while fall, while the market value
of the equity shares of firm X will rise. Through this process of arbitrage, therefore, the market
values of the firms X and Y will be equalised. This is true for all firms belonging to the same
group. In equilibrium situation, the average cost of capital will be same for all firms in the group.
The opposite will happen if the market value of the firm X is higher than that of the firm
Y. In this case, investors will sell equity shares of X sand buy those of Y. Consequently, market
values of these two firms will be equalised.
This argument is based on the assumption that investors are well- Informed and behave
rationally, and hence they engage in ‘personal average’ or home-made leverage’ as against the
‘corporate leverage’ to restore equilibrium in the market. At this stage, it is necessary to
understand what does personal leverage. If the market value of a levered firm is high, investors
sell its equity shares. In addition to the money they receive in exchange of equity shares. They
borrow funds on their personal account and invest in the unlevered firm.to obtain the same return

69 | P a g e
 NMC M.COM SEM-3

for smaller investment outlay. This activity is known as ‘personal leverage’ or ‘home-made
leverage’.
M-M hypothesis with tax (It will be same but show a tax effect under MM)
If corporate taxes are introduced, it will be clear that the cost of capital is low for a levered
company and its market value is high. The debts are tax deductible. Hence cost of capital for a
levered company will be relatively low. In their 1963 article, Modigliani and Miller did
recognise that the value of the firm will increase and the cost of capital, will decrease with
leverage due to the deductibility of interest charges for tax computation. If we accept this fact,
we arrive again at the net income approach which asserts that with the increase in the degree of
financial leverage, the cost of capital declines and va1ue of the firm goes up. Hence, leverage
should be resorted to the maximum possible extent. The traditional approach, on the other hand,
concludes that, beyond a particular limit, risk increases and the cost of capital also increases with
the increase in debts. As against this the M-M approach advises to fix the amount of debts in
advance and suggest not to cross this limit. At this point, Modigliani and Miller frustrate their
own conclusions. When they concede that there should be a definite limit of debts.

Limitations of M – M Approach
The M-M approach has been criticised on the following grounds.
1. Capital Market is Perfect: - It is assumed that capital market is perfect. But this assumption
is unrealistic. The capital market being imperfect, a discrepancy between the market values
of levered and unlevered firms is bound to persist.
2. Risk of Insolvency: - The risk of insolvency increases with the amount of debts in levered
firm. Due to the risk of insolvency and also due to the possibility of lower value of the assets
in the event of insolvency, investment in this firm will be less attractive. Hence, its market
value will, persist at a low level.
3. Arbitrage not Operate: - It is assumed under this approach that investor’s barrow funds on
personal account and invest in unlevered firm. This is an undesirable activity. The person
indulging in personal leverage in place of corporate leverage, faces a greater risk. If the
unlevered company goes bankrupt, he loses not only his own money, but he will lose the
borrowed fund also. For this reason, personal leverage is rarely resorted to. Hence, switching

70 | P a g e
 NMC M.COM SEM-3

over of investment from levered firm A to unlevered firm B does not take place; arbitrage
does not operate.
4. Transaction Cost: - The existence of transaction costs, also interferes with the working of
arbitrage. Because of the costs involved in the buying and selling of securities, a smaller
amount of money will be available for new investment. Hence return on new investment will
be low.
5. Personal Leverage: - Institutional investors cannot engage in personal leverage. Fe instance,
the LIC invests on a large scale in the shares and debentures of number of companies. But it’
does not resort to personal leverage by borrowing on personal account to shift its investment
from the levered companies with high market value to unlevered companies with low market
value. Thus, the assumption of personal leverage does not hold good.
Choosing an optimal capital structure.
On the basis of the relative amounts of various types of security issued, it is possible to
differentiate between four patterns of capital structure. They are as follows
(1) Capital structure with equity shares only.
(2) Capital structure with equity and preference shares.
(3) Capital structure with equity shares and debentures.
(4) Capital structure with equity shares, preference shares and debentures.
Relative merits and demerits of these patterns of capital structure are described below:
1. CAPITAL STRUCTURE WITH EQUITY SHARES ONLY: This type of capital
structure comes into being when a company issues equity shares only and does not rely on
preference shares and debentures. This type of capital structure is preferred when a
company’s business is risky and its earnings are highly unstable. Of course, it can raise
additional capital through public deposits. All companies have to raise its basic capital by
issue of equity shares.
Merits: The main advantages of a capital structure consisting of equity shares only are as
follows
1. Simple: - It is simple and understandable to all investors. All the necessary information about
management of business can be easily obtained.
2. No Fixed Liabilities: - The directors of the company have greater discretion in declaration of
dividends and building up of reserve funds etc. This is because there are no fixed liabilities like

71 | P a g e
 NMC M.COM SEM-3

dividend on preference shares and interest on debentures. The directors are-free to deal with
earnings as they like.
3. No Harassed by Creditors: - Since there are no fixed charges, there is no danger to the
existence of the company even in bad times. There is no possibility of the company being
harassed by the creditors and debenture holders by resorting to law-courts to press payment for
interest and principal.
4. Credit Standing: - The credit-standing of the company is enhanced as it bears no burden of
payment of fixed Interest and dividends. The creditors are ready to lend money to companies
having this type of capital structure.
5. Mortgaging Fixed Assets: - In the absence of debentures, there is no burden of fixed charges
on the assets of the company. This helps company to raise debt capital in future by mortgaging
its fixed assets.
6. Freedom for Decision Making: - Some constraints are imposed on the management of the
company when preference shares and debentures are issued. But when only equity shares are
issued, management enjoys full freedom of decision making.
7. Reduce the Cost of Capital: - Long established companies can procure additional capital also
through the issue of right shares. They need not make arrangements for underwriting, nor is
much publicity needed for these equity shares. This reduces cost of raising Capital.
8. Return Capital: - It is not compulsory for the company to return the equity shares during its
existence.
Demerits
1. High cost of Financing: - Cost of financing is relatively more especially for the new or weak
companies because they will have to bar additional costs in the form of underwriting
commission and brokerage, advertisement etc.
2. Trading on Equity: - The company loses the benefit of trading on equity. By not trading on
equity, the company loses the Opportunity to pay high dividends to its shareholders.
3. Market price Decline: - In weak companies, the interests of the existing shareholders are
adversely affected if additional capital is continuously obtained through the issue of equity
shares only. The dividend rate and market prices of shares may decline if profit of the
company does not increase in proportion to its equity capital.

72 | P a g e
 NMC M.COM SEM-3

4. Control in Few Hand: -When the company issues additional equity shares, it has to grant to
the existing shareholders a right to purchase them on a priority basis. Hence managerial
control may jet concentrated into a few hands.
5. Control without extra Investment: - The existing shareholders will have to purchase
majority of the additional equity shares to strengthen their control over the company. But if
additional capital is raised through the issue of debentures, they can maintain their control
without extra investment.
It may be. concluded, therefore, that capital structure with equity shares is not an ideal one
Especially high cost of financing and the absence of benefits of trading on equity are strong point
this type of capital structure.
2. CAPITAL STRUCTURE WITH EQUITY AND PREFERENCE SHARES:
Preference shares may be issued along with the equity shares to make capital structure more
attractive to the investors. Both securities represent ownership capital. Equity shares attract the
more venturesome investors, while preference shares satisfy the investors who: are content with
fixed income. To make preference shares more attzactive4 different varieties such as cumulative
preference shares, participating preference shares and redeemable preference shares and non-
cumulative preference shares are issued.
Merits:
1. Enough Capital: - Company’s capital structure will appeal to investors of different attitudes.
Enough capital can be raised without entailing the burden of fixed payment of interest.
2. Trading of Equity: - Benefits of trading on equity are available. Because of issue of
preference shares, only a fixed dividend is to be paid to the preference shareholders and the
whole of the remaining profits is available for distribution among equity shareholders. The rate
of dividend on equity shares can thus be raised.
3. Cheaper: - The capital structure of the company is made more economical because it is
usually cheaper to raise capital with preference shares than with equity shares.
4. No Voting Right: - Preference shareholders have no voting right. Hence control over the
management of the company can be maintained and at the same time additional, capital can be
obtained.
5. No Fixed Interest: - During difficult times, there is no fixed burden on the company because
payment of dividends on both types of shares is not compulsory.

73 | P a g e
 NMC M.COM SEM-3

6. Dividend Payment: - If the company has issued redeemable preference shares, the company
can return this capital when it has enough ‘funds. Thus the company can get it of the burden of
dividend payments.
7. All the advantages of capital structure with equity shares only are available in this type also.
Demerits:
1. Burdensome: - This type of capital structure becomes burdensome during depression. Of
course, preference shareholders are paid dividends only when company makes profit. But in
case of cumulative preference there, company’s liability to pay dividends goes on increasing.
2. Expensive: - In computation of income tax, interest paid on debentures is regarded as
expenditure and therefore deductible. While dividends paid on preference shares are not so
deductible, therefore full benefits of trading on equity are not available.
3. Freedom: - Some of the restrictive provision of the preference shares curtail directors’
freedom.
4. High Rate of Dividend: - A higher rate of dividend has to be offered to preference
shareholders because they do not have the advantages of security and. certainty of income as
are available to debenture holders. Due to high rate, of dividend to equity shareholders, the
company cannot pay any dividend to equity shareholders when its earnings are low during
adverse times.
5. Voting Right: - Preference shareholders are given no voting right. But in deciding matters
that are likely to influence their interests, it is necessary to get their consent. To that extent,
management’s authority is restrained.
This type of capital structure includes owner’s capital only. Debentures are not convenient for
those companies which run a risky business but earn almost a steady income. Hence they prefer
to issue preference shares to systematise their capital structure.
3. CAPITAL STRUCTURE WITH EQUITY SHARES AND DEBENTURES: Most of the
companies now adopt the capital structure which include equity shares and debentures with the
aim to maintain dividend rate on equity shares by combining owners’ capital with creditors’
capital. This type of capital structure exists in some well-known companies.
Merits:

74 | P a g e
 NMC M.COM SEM-3

1. Trading on Equity: - It offers benefits of trading on equity. Generally, rate of interest on

debentures tends to be lower than the general rate of company’s earnings. Therefore
shareholders can be paid a higher rate of dividend.
2. Low Cost: - The cost of issuing debentures is relatively low. Much publicity is not required
as debentures represent safe investment. (There may be some exceptions)
3. Tax Benefit: - Interest paid to the debenture holders is deducted while assessing tax liability
of the company. To that extent, tax burden on the company is reduced making it possible to
pay a higher rate of dividend to the, shareholders.
4. No voting Right: - Since debenture holders have no voting rights, interference in the
management is avoided and yet additional capital can be obtained through the issue of
debentures.
5. Safety Income: - This type of capital structure can attract investors with different attitudes
and likings. It can attract venturesome investors as well as the conservative ones who prefer
safety to high income.
6. Flexible Capital Structure: - This is a flexible capital structure. In good times, when the
company has enough funds on hand, it can repay the debenture-holders and get rid of the
burden of interest payments.
7. Economical: - Generally, the rate of interest on debentures is lower than the rate• of
dividend on preference shares. Hence the cost of capital is reduced if debentures are issued
to obtain the required funds. In this sense, this capital structure is economical.
Demerits:
1. Fixed Interest Payment: - During periods of depression, interest payment becomes a
burden on the company. Because it has to pay fixed interest on debentures regularly
whether profits are positive or negative.
2. Liquidation: - In case of default, debenture holders can put a company into difficulty. The
company may be dragged to the law-court and may be forced into liquidation.
3. Credit Worthiness: - The company has to bear a burden of payments of fixed interest.
Also assets of the company are charged or mortgaged to debenture-holders for these
reasons, the credit-worthiness of the company is reduced.

75 | P a g e
 NMC M.COM SEM-3

4. Freedom: - The directors’ freedom to frame financial policy of the company is affected on
account of the strict rules and regulations of the government with regard to the issue of
debentures.
4. CAPITAL STRUCTURE WITH EQUITY SHARES, PREFERENCE SHARES AND
DEBENTURES: A company which requires capital on a large scale will have to adopt a capital
structure consisting of equity shares, preference shares and debentures. Thereby, the company
can attract all classes of investors. The capital structure in many of the companies in India is
exactly of this nature.
Merits:
1. Enjoy All Advantage: - A company with this pattern of capital structure can enjoy
advantages of all the patterns stated above.
2. High Return: - The market of the company’s securities is considerably widened, Debentures
can attract the most conservative investors. Preference shares can attract those investors who
are ready to face some risk if return are slightly high. Equity shares can lure those investors
who are venturesome and bold enough to bear all risks of business.
3. Trading on Equity: - Full benefits of trading on equity can be realised from this type of
capital structure. Dividend rate on preference shares and rate of interest on debentures being
comparatively low, high dividend rate can be offered to the equity shareholders.
4. Flexible: - This is a highly flexible pattern of capital structure. Additional capital can be
easily raised when required and burden of interest payment can be reduced by repayment to
debentures-holders when possible.
5. Economical: - It is the most economical pattern of capital structure.
Demerits:
1. Fixed burden: - During depression, interest payment on debentures and dividend payment
on preference shares is a burden on the company.
2. Complicated: - This is a most complicated pattern of capital structure and makes financial
administration difficult.
3. Not Free to deal: - The directors are not free to deal with the earnings of the company as
they wish.
4. Unexpected difficulties: - Unexpected difficulties cannot be met by raising additional
finance, if the company is burdened with debt.

76 | P a g e
 NMC M.COM SEM-3

5. No dividend to Equity: - Equity shareholders earn no dividends when company’s earnings

are low. Whatever profit is earned, it gets distributed among preference shareholders and
debenture-holders.
It follows that, though this type of capital structure is the best, different kinds of securities must
be carefully and cautiously used for raising finance
Factors determining capital structure,
Determination of capital structure cannot be left to the arbitrary decisions and personal opinions
of the management. Some concrete factors must be kept in mind while determining capital
structure of the company. They are as follows
1. Nature of Business: The nature of business can have strong effect on the pattern of capital
structure. A business with fixed and regular income can safely rely on debentures and
preference shares which necessitate regular payment of fixed interest and dividends. But if
business is risky and its income is unstable, ordinary shares should be relied upon, because
it is not compulsory to pay dividends on them regularly.
2. Money Market Conditions: During boom period the investors will go in for equity shares
with the expectations of high dividends. But in times of depression, they will look more to
safety than income and will be willing to invest in debentures rather than in equity shares.
Thus, ordinary shares should be issued during boom period, while debentures and
preference shares should be issued in times of depression.
3. Stability of Earnings: The decision about the type of securities to be issued should be
taken in the context of earnings of the company. If earnings are regular and steady,
preference shares and debentures can be issued. Generally, public utilities raise finance
through fixed interest bearing securities such as bonds and debentures exactly for this
reason. On the other hand, earnings of the companies in consumers’ goods sector are
unstable and therefore they have to rely to a large extent on equity share capital.
4. Capital Requirement: Decision about the type of securities to be issued should be taken
in the context of overall capital requirement of the company. If a small amount of capital is
needed, only one type of security such as equity shares can be issued. But if a laçe amount
of capital is required, it will be necessary to issue different types of securities.
5. Retaining Control:When the existing management wants to retain control in their hands,
they will issue less of equity shares and raise more funds through preference shares and

77 | P a g e
 NMC M.COM SEM-3

debentures. Since preference shares and debentures have no voting rights, more funds can
be raised through their issue and at the same time control of the company can be retained
by the existing management.
6. Long Term Interest of the Company: Sometimes it happens that the type of security
which seems appropriate from the viewpoint of money market conditions, is not
appropriate from the viewpoint of long term interests of the company. During depression,
for instance, debentures can be easily issued, but looking to the nature of business, the
company may not be in a position to bear the burden of interest payments. Under such
circumstances, long term interests of the company should be given more importance.
7. Nature of Assets of the Company: If a company does not possess fixed assets of high
value, and therefore it cannot mortgage its assets, it cannot issue debentures. Similarly, if
the value of a company’s assets is subject to wide fluctuations, it will not be advisable to
issue debentures. The company will have to rely on equity shares.
8. General Level of Interest Rates: The rates of interest should be taken into account while
deciding the types of securities to be issued. If interest rates are high, it is better to issue
ordinary shares. If the interest rates are low, it is advisable to issue debentures.
9. Attitudes of Investors: There is a diversity of attitudes among the investors. Some
investors prefer safety to high income. To meet their needs, debentures and preference
shares should be issued. Some investors prefer high income to safety. To meet their needs,
equity shares should be issued. Thus, it is desirable to issue securities of different kinds to
obtain subscriptions from people with different attitudes and preferences. This will also
ensure wide distribution of securities.
10. Taxation Policy of the Government: When rates of tax on company’s profit are very
high, they prefer to issue debentures, because I debenture is regarded as a debt and hence
interest on it is considered as deductible expenditure in the income-tax law. Therefore by
issuing debentures, they can reduce their tax liability and pay a high rate of dividend to the
shareholders. If dividends are taxed, then also the companies prefer to raise funds through
debentures rather than shares. At present, large scale issue of debentures by the companies
in India can be attributed partly to tax relief granted on interest expenditure.
11. Cost of Financing: The cost of financing differs from security to security. It is relatively
high if financing is raised through the issue of equity shares. Because it necessitates

78 | P a g e
 NMC M.COM SEM-3

advertisement on a large scale, payment of underwriting commission and brokerage etc.

On the other hand, issue of debentures necessitates lower expenses as debentures are
regarded as safe investment. The law also requires to pay comparatively low underwriting
commission on debentures (The Companies Act does not allow to pay more than 5 per cent
underwriting commission on shares and more than 2.5 per cent underwriting commission
on debentures).
12. Legal Restrictions: The companies have to comply with legal provisions regarding the
issue of different securities. For example, in India, companies were required by law to seek
the permission of the controller of capital issues if they wanted to issue share capital of ₹
100 lacs or more. The Companies Act of 1956 does not allow any public company to issue
deferred shares.

Pecking Order Theory

The Pecking Order Theory, also known as the Pecking Order Model, relates to a
company’s capital structure. Made popular by Stewart Myers and Nicolas Majluf in 1984, the
theory states that managers follow a hierarchy when considering sources of financing.
In corporate finance, pecking order theory is used to help explain how companies decide where
to source their financing, and thus it helps explain what drives optimal capital structure, or the
ideal balance of debt and equity financing.
Pecking order theory definition
where they first use retained earnings (internal financing), then debt financing, then equity
Pecking order theory is the idea that company managers decide how to finance company
operations based on a hierarchy financing.
Internal financing is the first choice in pecking order theory because there is no extra cost
associated with using it. If a company uses only retained earnings for financing, there is no cost
of debt or cost of equity to be accounted for.
Debt financing comes in second because of the interest payments associated with using debt
capital. Whether the company decides to take out business loans or issue corporate bonds, they
will have to pay some interest, making the cost of debt more than the non-existent cost of using
retained earnings.
Equity financing is last in pecking order theory because it is the most expensive financing option.
The cost of equity capital—for example, stock shares—is higher than the cost of debt financing.
Issuing shares can indicate that a company’s management believes the shares are overvalued—a
signal to investors that they might be in trouble and their share price might be about to drop. This
is a case of asymmetric information, the core idea behind the pecking order theory. Let explain.

79 | P a g e
 NMC M.COM SEM-3

How does asymmetric information affect pecking order theory?

Asymmetric information is used to describe a situation between two parties in an economic
transaction where one party has more or better information than the other.
While you can explain pecking order theory in terms of how much each type of financing costs,
to truly understand it, you must understand how asymmetric information causes the differences
in cost.
Retained earnings are the least asymmetric (or most symmetric) form of financing—there is not
much room for differing information between a company and itself, so there is no risk involved
in using those internal finances.
External financing comes next—first debt financing, then equity financing. Debt investors don’t
know everything that’s going on behind the scenes, but they can be fairly sure they’ll be paid
back. Thus, they are at less of a risk than equity investors (remember, issuing additional equity
gives a bad impression as it makes company stock look overvalued).
Investors expect a higher rate of return based on more asymmetrical information. Less
information means a higher risk, and when the risk is higher, the expectation is that the payoff is
higher as well.

Trade-off Theory

The trade-off theory is a financial theory based on the work of economists Modigliani and Miller
in the 1950s, two professors who studied capital structure theory and collaborated to develop the
capital-structure irrelevance proposition. This proposition states that in perfect markets, the
capital structure a company uses doesn't matter because the market value of a firm is determined
by its earning power and the risk of its underlying assets. 4
According to Modigliani and Miller, value is independent of the method of financing used and a
company's investments. The M&M theorem made two propositions:

 Proposition I: This proposition says that the capital structure is irrelevant to the value of
a firm. The value of two identical firms would remain the same, and value would not be
affected by the choice of finance adopted to finance the assets. The value of a firm is
dependent on the expected future earnings. It is when there are no taxes. 5
 Proposition II: This proposition says that the financial leverage boosts the value of a
firm and reduces WACC. It is when tax information is available. 6

80 | P a g e
 NMC M.COM SEM-3

With a static trade-off theory, since a company's debt payments are tax-deductible and there is
less risk involved in taking out debt over equity, debt financing is initially cheaper than equity
financing. This means a company can lower its weighted average cost of capital through a capital
structure with debt over equity.
However, increasing the amount of debt also increases the risk to a company, somewhat
offsetting the decrease in the WACC. Therefore, static trade-off theory identifies a mix of debt
and equity where the decreasing WACC offsets the increasing financial risk to a company.
What Is Optimal Capital Structure?
The optimal capital structure of a firm is the best mix of debt and equity financing that
maximizes a company’s market value while minimizing its cost of capital. In theory, debt
financing offers the lowest cost of capital due to its tax deductibility. However, too much debt
increases the financial risk to shareholders and the return on equity that they require. Thus,
companies have to find the optimal point at which the marginal benefit of debt equals the
marginal cost.

 An optimal capital structure is the best mix of debt and equity financing that maximizes a
company’s market value while minimizing its cost of capital.
 Minimizing the weighted average cost of capital (WACC) is one way to optimize for the
lowest cost mix of financing.
 According to some economists, in the absence of taxes, bankruptcy costs, agency costs,
and asymmetric information, in an efficient market, the value of a firm is unaffected by
its capital structure.
 The optimal capital structure is estimated by calculating the mix of debt and equity that
minimizes the weighted average cost of capital (WACC) of a company while maximizing
its market value. The lower the cost of capital, the greater the present value of the firm’s
future cash flows, discounted by the WACC. Thus, the chief goal of any corporate
finance department should be to find the optimal capital structure that will result in the
lowest WACC and the maximum value of the company (shareholder wealth).
 According to economists Franco Modigliani and Merton Miller, in the absence of
taxes, bankruptcy costs, agency costs, and asymmetric information, in an efficient
market, the value of a firm is unaffected by its capital structure.
Determining the Optimal Capital Structure
As it can be difficult to pinpoint the optimal capital structure, managers usually attempt to
operate within a range of values. They also have to take into account the signals their financing
decisions send to the market.
A company with good prospects will try to raise capital using debt rather than equity, to
avoid dilution and sending any negative signals to the market. Announcements made about a
company taking debt are typically seen as positive news, which is known as debt signaling. If a
company raises too much capital during a given time period, the costs of debt, preferred stock,
and common equity will begin to rise, and as this occurs, the marginal cost of capital will also
rise.
To gauge how risky a company is, potential equity investors look at the debt/equity ratio. They
also compare the amount of leverage other businesses in the same industry are using—on the
assumption that these companies are operating with an optimal capital structure—to see if the
company is employing an unusual amount of debt within its capital structure.

81 | P a g e
 NMC M.COM SEM-3

Another way to determine optimal debt-to-equity levels is to think like a bank. What is the
optimal level of debt a bank is willing to lend? An analyst may also utilize other debt ratios to
put the company into a credit profile using a bond rating. The default spread attached to the bond
rating can then be used for the spread above the risk-free rate of a AAA-rated company.
Limitations of Optimal Capital Structure
Unfortunately, there is no magic ratio of debt to equity to use as guidance to achieve real-world
optimal capital structure. What defines a healthy blend of debt and equity varies according to the
industries involved, line of business, and a firm's stage of development, and can also vary over
time due to external changes in interest rates and regulatory environment.
However, because investors are better off putting their money into companies with strong
balance sheets, it makes sense that the optimal balance generally should reflect lower levels of
debt and higher levels of equity.

Indifference Point

It is the level of EBIT at which- he EPS is the same for two alternative financial plans. It is
‘a point of EBIT beyond which the benefits of financial leverage begin to operate with respect to
EPS. It means that if the debt is used beyond-this indifference point, it will lead to increase in
EPS. On the -other hand, if the level, of BElT is below the indifference point, the use of equity
capital would b advantageous.

There are -two methods of finding Indifference Point:

Algebraic Approach.
Graphic Approach.

(A) Algebraic Approach :

The formula used to determine the indifference point may be given as follows :
𝑋 ( 1−𝑡 ) (𝑋− 1 )( 1−𝑡 )
= 𝑁 =
1 𝑁 1
Where X = EBIT at indifference point
N1 = No, of equity shares if only equity shares are issued
N2 = No of equity shares issued when debentures are alsoissued
I = Interest
t = tax rate

Suppose a company wants to collect Rs. 10,00,000 for its capital project, it can do so

(i) either by issuing only equity shares or

(ii) by issuing equity shares of Rs. 5,00,000 and 10% debentures of Rs. 5,00,000

Assume tax rate to be 40% The face value of shares is Rs. 100
Solution :
=Indifference Point =
𝑋 ( 1−𝑡 ) ( 𝑋− 1) (1−𝑡 )
=
𝑁1 𝑁2

82 | P a g e
 NMC M.COM SEM-3

𝑋 ( 1 − 0.4 ) (𝑋 − 50,000)(1 − 0.4 )

∴ =
10,000 5,000
0.6 × 0.6 ×𝑅𝑠.30,000
∴ =
10,000 5,000
∴ 0.6 × = 1.2 × −𝑅𝑠. 60,000 (multiplying both sides by 10,000)
∴ 1.2 × −0.6 × = 𝑅𝑠. 60,000
∴ 0.6 × = Rs. 60,000
60,000
∴ X = 0.6 Rs. 1,00,000
∴Indifference Point = At EBIT of Rs. 1,00,000
Let us see whether this is correct
Only Equity +
Equity Deb
EBIT 1,00,000 1,00,000
Less : Interest 50,000
-
EBT 1,00,000 50,000
Less : Taxes 40,000 20,000
Earnings to equity shareholders 60,000 30,000
No. of equity shares 10,000 5,000
EPS Rs. 6 Rs. 6

At this point both financial alternatives have the same EPS.

if there are preference shares then the formula is slightly changed and pref. dividend is
shown as deduction

𝑋(1 − 𝑡) (𝑋 − 1)( 1 − 𝑡) − 𝑃𝑑
=
N1 𝑁2
(2) Graphic Approach :A chart can be prepared to show the Indifference point. For
drawing a graph, two sets of EPS values are requires. the figures given above my be. used, in
which EBIT my be taken at Rs. 80,000 and Rs. 1,10,000 and plan 1 and plan 2 are used.

The two lines interest at point P which is the Indifference point. At EBIT of Rs. 80,000
both plans show The same EPS 0.48 Result of algebraic method and graphic method are the
same, but the graphic method show the relationship of EBIT and EPS at a glance and so it is

83 | P a g e
 NMC M.COM SEM-3

more effective. it shows that upto EBIT of Rs. 80,000 EPS is more under all-equity plan,
whereas EBIT of Rs. 80,000 the debt- equity plan is more advantageous with regard to the EPS.

NI approach
Formulas: -
(1) Value of equity Share: -
Value of elsh = Net income * 100
(Ke) equity capitalization rate

(2) Value of firm: -

Value of firm (v) = Elsh (s) + Debenture (D)

(3) Overall cost of capital (ko) =

KO = EBIT * 100
Value of firm

Sum: - 1
Earning before interest & tax of x ltd. Company is 80000. The equity Capitalization rate
is 10%. The capital Structure of this Company Consist of Elsh of 10 each and 400000 worth of
8% debentures. Find out the value of firm, market value of Elsh and Overall cost of capital.

Ans: -
Overall cost of the firm: -

Particular Amt
Earning before interest & tax 80000
-Interest (8% of 400000) 32000
EBT (Earning before tax) 48000
-Tax 0
Net income 48000
: Elsh capitalization value 10%
(1) Value of Elsh 480000
+ Value of debenture 400000
(2) Value of firm 880000
Overall cost of = EBIT * 100 80000 * 100
Capital M.v.of firm 880000

(3) Overall cost of capital 9.09%

NOI approach

Formulae’s: -

84 | P a g e
 NMC M.COM SEM-3

(1) Total value of firm: -

Total value of firm (v) = Net income * 100
Overall cost of firm
(2) Value of Elsh capital (s): -
Value of Elsh Capital = Value of firm – value of debenture
Or
S = V – D.
(3) Cost of Capital = EBIT – Interest (Net income)
No. of Elsh
Net income = EBIT – Interest on debenture
Sum: - 2
The net operating income of the company is 200000. Its capital structure includes 8%
debentures of 500000. While the rate of Overall cost of capital is 10% compute the cost of
Equity capital. What would be the change in the rate of cost of equity capital if the debenture is
in the capital structure of the firm are increased to 800000?
Ans: -
Rate of cost of equity capital: -
Particulars 500000 debenture 800000 debenture
EBIT 200000 200000
-debenture interest 0 0
Net income 200000 200000
: Overall cost (ko) 10% 10%
Value of firm 2000000 2000000
-value of debenture 500000 800000
Value of elsh capital 1500000 1200000
Cost of equity = EBIT – interest on 200000 – 40000 * 100 200000 – 64000 * 100
debet 1500000 1200000
Capital value of Elsh cap * 160000 * 100 136000 * 100
100 1500000 1200000
10.67% 11.33%

Cost of equity capital

Traditional Approach: -
Sum: - 3
Net Operating income of X Company is 240000. While it’s total investment is 1500000
Rs. The rate of equity capitalization is 12%. When its capital structure does not includes
debenture. But the rate of equity capitalization is 12.5% when the company issue 8% debentures
of 500000. In exchange of its Elsh And it is 15% when it issues 10% debentures of 900000 in
exchange of its Elsh. Compute cost of capital and market value of the company under this three
situations according to traditional approach

Ans: -

85 | P a g e
 NMC M.COM SEM-3

Market value of the company as per traditional approach.

Particulars No debt 8% debenture of 10% debt of 900000

500000
EBIT 240000 240000 240000
-Interest on debenture - 40000 90000
EBT 240000 200000 150000
-Tax 0 0 0
Net income 240000 200000 150000
: capitalization rate 12% 12.5% 15%
value of Elsh capital 2000000 1600000 1000000
+value of debenture - 500000 900000
Value of firm 2000000 2100000 1900000
Overall = EBIT * 100 240000 * 100 240000 * 100 240000 * 100
Cost of value of firm 2000000 2100000 1900000
Capital
Overall cost of capital 12% 11.43% 12.63%
Sum- 04
Net Operating income of A Ltd. Is 7, 00,000 white it’s total investment is 50,00,000. The
rate of equity capitalization is 10% when it’s capital structure does not include debt. But the rate
of equity capitalization is 11%. When the equity capitalization is 11%, when the company issues
6% debentures of Rs.18, 00,000in exchange of its elsh compute cost of capital and market value
of the company under this 3 situations according to traditional approach.

Ans. Market value of the company as per traditional approach

Particular No. Dept 6% of debt of 8% dept of 15,00,000
18,00,000
EBIT 700000 700000 700000
-Interest on debenture - 108000 200000
EBT 700000 592000 500000
-Tax 0 0 0
Net income 700000 592000 500000
: equity capitalization rate 10% 11% 16%
M.velue of Elsh capital 7000000 5381818 3125000
+m.velue of debenture - 1800000 2500000
Value of firm 7000000 7181818 5625000
Overall = EBIT * 100 700000 * 100 700000 * 100 700000 * 100
Cost of value of firm 7000000 7181818 5625000
Capital
Overall cost of capital 10% 9.74% 12.44%

Sum- 05
Two Company X and Y ltd. Belongs to the homogenous risk class. Both are identical in
all respect except that ‘x’ is the levered company while ‘y’ is an unlevered company. In the
86 | P a g e
 NMC M.COM SEM-3

levered company’s capital structure there are 10% debenture of 3, 00,000. Total assets of both
company are worth of 10, 00,000. Both earn 15% return on there assuming that capital market is
perfect, investors behave rationally. Tax rate is 50% and rate of equity capitalization is 15%
calculate the following.
1. Value of X ltd. And Y Ltd Using net income approach

Ans: -
Calculation of EBIT
Total investment = 1000000
15% earn on Total investment = 1000000 * 15\100
= 150000 Rs.

Value of firm using net income approach

Particulars ‘X’ com. Itd. ‘Y’ com. Itd.

Levered Unlevered
Earning before interest &tae 150000 150000
-Interest on debenture (10% of 300000) 30000 -
EBT 120000 150000
-Tax (50%) 60000 75000
Net income 60000 75000
: Equity capitalization rate 15% 15%
Value of Elsh 400000 500000
+ value of debenture
300000 -
Value of firm
700000 500000
Sum: - 6
There are two firms A & B in the same risk class. The firm A has debenture in its capital
structure. While firm B is unlevered. The net operating income of A is Rs. 240000 and it has
issued 10% debentures of Rs. 1200000. The rate of equity capitalization is 15%. There are no
debentures in the capital structure of firm B and the rate of equity capitalization is 12.5%.
For above information calculate market value of firms and overall cost of capital.
Suppose and investor X holds 10% of the Elsh the firm A. How can be reduce his outlay
through the use of personal leverage?

Ans: -
Calculation of Overall cost of capital.
Particular Levered A Unlevered B
EBIT 240000 240000
-Interest on debenture 120000 -
EBT 120000 240000
-Tax 0 0
Net income 120000 240000

87 | P a g e
 NMC M.COM SEM-3

: equity capitalization rate 15% 12.5%

Value of Elsh 800000 1920000
+ value of debenture 1200000 -
Value of firm 2000000 1920000
Overall cost = EBIT * 100 240000 * 100 240000 * 100
Of capital value of firm 2000000 1920000
Overall cost of capital 12% 12.5%

MM Approach: -
Step: - 1 Sell Elsh of firm – ‘A’
It he sell all Elsh of firm A, He will obtain Rs. 80000. [10% of 800000] of Elsh]
Step: - 2 to raise personal leverage
To raise personal leverage he will borrow funds equal to 10% of debt. Of firm A.
There for value of personal leverage is…….
:. Personal leverage = 10% of 1200000
= 120000 Rs.
Step: - 3 Total investable fund: -
Now, this investor is having an investable fund is Rs. 200000
Sell of Elsh 80000 Rs.
+ Personal leverage 120000 Rs.
Total investable fund 200000 Rs.

Step: - 4 He will now bay 10% of the equity shares of the unleveraged company B. In other
words he will invest 192000 in the firm B.
Step: - 5 Total investable fund is 200000 with him. And he invest 192000 [10% of
1920000] in firm B. So his saving is 8000.
Saving Amt = investable fund – invest in firm B
= 200000 – 192000
= 8000 Rs.
Step: - 6 Return on investment:
The return on investment in the firm A was.
In dividend = 10% of 120000 = 12000
+ Interest on debt = 10% of 12000 = 12000
Return on invest from firm A = 24000
(10% of 240000)
Step: - 7 Conduction:
If he shifts his investment from firm A to B, he will earn the same income through his
less by Rs. 8000 that means his decision is true.
Effect of Arbitrage.
Firm A Firm B
(1) Total investment (1) Total investment Amt

88 | P a g e
 NMC M.COM SEM-3

= 10% of 800000 (i) Elsh 80000

= 80000 Rs. + personal leverage 120000
200000 Rs.
(2) Return (ii) Saved money: -
= 10% of 120000 =200000 – 192000
= 12000 Rs. = 8000 Rs.
(iii) Earning: -
= 10% of 240000 = 24000
-Debt. Int. = 12000
Net earning 12000
Sum: - 7
Companies A and B are identical in all respect except that there is no leverage in
company A, and there is leverage in company B. which has 10% debenture of Rs. 400000,
The market value of both of this company according to net income approach is as under.

Particulars Company A unleveraged Company B leverage

Net operating income (EBIT) 120000 120000
-Debenture interest - 40000
Net income 120000 80000
: Equity capitalization rate 15% 16%
Market value of Elsh 800000 500000
+ Market value of debenture - 400000
Market value company 800000 900000
Overall value of company 15% 13.33%
Debt equity ratio 0 0.8

(1) An investor holds 10% of equity shares of company B. How can he reduce his out lag
through the use of personal leverage
(2) When will his arbitrage come to an and according to MM approach

Ans: -
Step: - 1 Sell of Elsh of B Company:
If investor sales all Elsh of firm B. he will earn Rs. 50000 [10% of 500000 Rs]

Step: -2 to raise personal leverage

De will borrow fund equal to 10% of debenture of firm B.

Step: - 3 Total investiable fund: -

Now, Rs. 90000 as a investiable fund with him.
Sale of Elsh of firm B 50000 Rs
+ Personal leverage 40000 Rs
Investiable fund 90000 Rs.

89 | P a g e
 NMC M.COM SEM-3

Step: -4 Saving:
Total investiable fund with him amounted to Rs. 90000 of which he invest in firm
A Rs. 80000 (10% of 800000)
:. Saving Amount = Total investable fund – Investment
= 90000 – 80000
= 10000 Rs.
Step: 5 Return on investment:
From firm B:
The return on investment in the firm B was as under
(Net income) In Elsh dividend = 8000 Rs. (80000 * 10/100)
In debt. Interest = 4000 Rs. (40000 * 10/100)
Total Return 12000 Rs.
From firm A:
He invest in Elsh that means he earn only Elsh dividend from firm A.
:. Elsh dividend = 120000 * 10% = 12000 Rs.
Step: - 6 Conclusion:
It he shift his investment from firm B to A, he will earn same income through his
less by Rs. 10000 that means his decision is right.
Answer: - 2
According to mm approach the arbitrage process will end when the value of companies A
and B become equal.

Unit – 4 - Dividend Policy

INTRODUCTION :

Dividend decision by any company is an important, issue to be determined by the financial

management. The important point is to determine how much earnings are to be distributed to
shareholders and how much amount is to be retained in the firm, what is the dividend pay out
ratio and what should be the retention ratio. Dividend pay out ratio is the percentage of earnings
paid by way of dividend, while retention ratio is the percentage of earnings retained by the firm,
not distributed as dividend.
Dividend policy decision has a significant effect on the credit standing of the firm, its share
prices and its future growth. If the firm follows a liberal dividend policy, it will not be able to
build sufficient internal resources and its future growth may be hampered leading to fall in the
value of the firm. Another consequence of the liberal dividend policy is that the shareholders will
receive higher dividends and would be satisfied as most of the investors have preference for
current income. But that would also reduce their chances of capital gains. Of course, in respect of
preference dividend, the management has little freedom, as, its rate of dividend is fixed and it has
to be paid in priority to dividend paid to equity shareholders. Similarly, there are certain
restrictions on the payment of dividend placed by the government and they have to be abided by.
The management has no freedom in that respect.

90 | P a g e
 NMC M.COM SEM-3

The dividends and retained earnings are the two, alternative aspects of financial decision. If
it is decided to pay a particular amount as dividend, the remaining earnings become the retained
earnings.
Conversely, if it is decided to retain a particular amount of earnings as retained earnings, the
balance of earnings automatically becomes dividend amount. Thus both decisions are
complementary to each other. No decision can be taken independent of the other.

Another important aspect of dividend policy is whether the dividend decision is taken first or
whether the retention decision should be made first. There is no rule and it all depends upon the
circumstances available in the firm. If the firm has on hand some investment programme of
growth expansion or replacement, which requires a particular amount to be j invested, then the
retention decision is first taken- However, it is generally the dividend decision which is made
first.

Forms of dividend
only if it anticipates proportionate increase in its future earnings. For new companies and
those with uncertain earnings, issue of bonus shares involve ‘considerable risk, as issue of
bonus shares carries an implied promise that the company would maintain the same rate of
dividend per share in future also. Hence, it is not advisable to go for issue of bonus shares if
the company is not sure about its future profits being steady and enough to maintain dividend
It must be remembered that
The company that issues bonus shares, capitalises its reserves and would result into
concentration of economic power in few hands, as more shares The dividends are classified
according to the medium in which they are paid. Generally, dividend is paid in cash, but it may
be in the form of shares (or stock), promissory notes, bonds or in the form of property. Thus
dividend is payable in following forms
1. CASH DIVIDEND: It is generally believed that dividend means cash dividend. Most of the
investors on wish that the company should pay dividend in cash only, which they may use for
consumption purposes. Mostly companies pay dividend in cash only. According to Indian
Companies Act also dividend is payable in cash only. It is also stated that the company can
issued fully paid bonus shares out of profit. But there are guidelines issued by SEBI for the
issue of bonus shares, in which it is provided that bonus shares cannot be issued in lieu of
dividend. Thus dividend is payable in cash only.
Before declaring cash dividend, the company should consider
i) Current Revenue: - Whether it has enough current profits or enough accumulated
past profits. It is advisable to pay dividend out of current revenue earnings only,
ii) Liquid Position: - Whether the liquid position of the company is satisfactory and
would have enough cash on hand to carry on business smoothly even after payment of
dividend,
iii) Expectation of Shareholder: - Types of shareholders. Most of the middle class
shareholders expect dividend in cash while in closely held companies, most of the
shareholders, are rich and would prefer capital gains or bonus shares than cash
dividends.
2. STOCK DIVIDEND OR BONUS SHARES: A stock dividend is a dividend payment in the
form of additional shares or stock instead of cash. It is a very popular system of dividend
payment in the U.S.A. However, in India issue of stock dividend is not permitted. Dividend

91 | P a g e
 NMC M.COM SEM-3

has to be paid in cash. According to SEBI’s guidelines on issue of bonus shares, bonus shares
cannot be issued in lieu of dividend. In addition to cash dividend, a company can issue fully
paid bonus shares.
Objectives or Benefits of Bonus Shares: The benefits or advantages of bonus shares can be
discussed from the viewpoint of three parties
BENEFITS TO THE COMPANY:
1. Keeping enough Cash: By issuing bonus shares, the company is able to retain cash
which would otherwise have been paid as dividend to shareholders and on the other
hand can satisfy the shareholders. Besides, an impression is created among investors
that the company is affluent and has considerable reserves. For growth companies,
stock dividend is extremely useful, as it allows them to use internal funds for
expansion without resorting to external sources.
2. To Reduce Rate of Dividend: Companies having low equity capital and high rate of
earnings may reduce rate of dividend by issuing bonus shares, as with increased
number of shares, the dividend per share will decline. This would help the company
in hiding its high earnings from the society, from the competitors, from the labourers
and also from the government. Otherwise, the high earnings per share would lead the
consumers to believe that the company is squeezing them, the labourers would
demand higher wages and bonus and the government may impose higher taxes.
3. To Retain Funds for Expansion: The external sources of funds are costly for
expansion and the prudent management would always retain major part of the profit
in business instead of frittering away profit in distribution of cash dividend. This
would reduce the burden of interest of debt finance.
4. Presenting Real Picture of Earnings: A company earns profit not on the basis of
paid up share capital but on the total capital employed in business. If number of
shares is increased by issuing bonus shares, the earning per share would be reduced,
indicating the real earnings on shares. Otherwise, the higher earnings per share would
give a wrong impression about the earning capacity of business.
5. Enhancing Prestige: A company issuing bonus shares creates an impression in the
capital market as a progressive company. This would help company in raising finance
from outside sources when need be, on favourable terms. The prices of shares would
also rise and investors would willingly buy shares of such companies.
6. Wide Market for Company Shares: If the management wants wide distribution of
shares in the hands of small investors, the issue of bonus shares is a good alternative.
Issue of bonus shares would increase the number of shares, reducing the value of
shares. If the value of shares is very high, it would not appeal to small investors.
BENEFITS TO SHAREHOLDERS: Of course, when a shareholder receives bonus shares,
he gets nothing except additional share certificate. But he is benefited by bonus shares in
following ways
1. Capital Gain: He has the advantage of making capital gains by selling the additional
shares without affecting his original holdings. The investors’ confidence in shares of
the company rises, so that original shareholders get ready market for their shares.
2. Tax Advantage: When a shareholder gets cash dividend, it is liable to income-tax,
but no tax is payable when he gets bonus shares. (It must be remembered that in
India, dividend has become tax-free in the hands of shareholders. Now no tax is

92 | P a g e
 NMC M.COM SEM-3

payable by him on dividend income). Due to tax benefit stock dividend has become
very popular in the USA.
3. High Dividends: If the company is able to increase its profit and maintain previous
rate of dividend, the shareholder gets higher earnings from dividend. It must be
remembered that prudent management would issue bonus shares only when ‘the
company’s earnings are likely to improve proportionately.
BENEFITS TO CREDITORS:Creditors are benefited in the sense that cash is retained in
the company which would strengthen the liquidity position of the company. This would
enable the company to pay interest regularly to creditors. Secondly, the assets of the
company increase as cash remains with the firm, which increases the security ‘available to
creditors. However, if the company continues to pay the same rate of dividend in future also,
more cash will go out, which would impair the safety margin for creditors.
1. LIMITATIONS OF BONUS SHARES Before issuing bonus shares, the management
must examine all pros and cons from various angles or it may entail a permanent burden
of dividend payment on the company. It should declare stock dividend go into their
hands.
2. As the company retains profits with it instead of distributing it to shareholders, money ‘is
not made available to those who could invest it elsewhere and earn extra income.
3. The companies conceal their real profit which’ could have been utilised in paying higher
wages and bonus to workers ‘or. thatreduce the prices of its products in the interest of its
consumers.’
3. OPTIONAL DIVIDEND: It is the dividend payable either in cash or stock (shares) at the
option of the shareholders. No company in India declares optional dividend. But some of the
companies in the USA have declared such opti6nal dividends. The company issues notice to
the shareholder to state his option within a specified time to ‘the company. It is the market
price of the shares and the amount of cash dividend, on which the decision of shareholders
depend, whether to opt for cash or shares. In most cases, the values of both are equal, e.g. a
company declares 20% dividend on its shares of ₹ 100 and in option, and the company offers
1 share for every .5 shares held. If the market price of shares is ₹ 100 only, then the
shareholder having 10 shares will get cash dividend of ₹ 200 (at 20% on ₹ 1,000) or he will
get 2 shares as dividend for 10 shares held. In this case, the shareholder would prefer cash
dividend, to save himself from the problems of selling shares received.
4. SCRIP DIVIDENDS: It is the dividend given in the form of promissory notes to pay the
amount at a specific future date. The promissory note is known as scripts or dividend
certificates. It generally bears the date on which the actual cash would be paid, but
sometimes no date is specified and it is left at the discretion of board of directors to decide
when to pay. It is a temporary stock dividend. When the company does not have immediate
cash but expects to get it in near future, it pays scrip dividend. Of course, it affects the
prestige of the company adversely, But when a company is a regular dividend paying
company but temporarily its cash position is affected due to locking up funds in receivables,
which is likely to be released shortly, this option is preferred. Scrip may be interest bearing
or it may not he interest bearing.
5. BOND.DIVIDEND OR SECURITY DIVIDEND: Generally, dividend is paid in the form
of cash or stock. But there is a practice in western countries of paying dividend in the form of
bonds or other securities. A company may issue bonds to the shareholders promising that
they will pay interest at a future date. If has a longer maturity date than Scrip dividend. It

93 | P a g e
 NMC M.COM SEM-3

always carries interest. It means the company pays interest every year on the bonds issued in
lieu of dividend. The company is thus incurring liability for future in return for nothing
except credit for declaring dividend. Some companies may issue shares of its subsidiary
company, which it had acquired in lieu of dividend or the subsidiary company may give
shares of holding company which it is holding to its shareholders for dividend. Some
companies may give shares of other companies in which it had made investment of its funds.
But this practice is not seen in - India nor legally allowed.
6. PROPERTY DIVIDEND: Some companies may pay dividend in the form of assets that it is
holding and which is superfluous for it. Many companies give coupons to buy its products to
shareholders in place of dividend. When there is over production and the company does not
have enough cash on hand, it issues coupons to shareholders with the help of which they can
buy company’s products. This is different from shareholders’ coupons issued by Indian
textile mills, which is in addition to cash dividend.

1.1 Dividend and valuation of firm,

As the dividend policy is the trade-off between retained earnings and paying out cash, there exist
three opposing views on its effect on firm value:
1. Dividend policy is irrelevant in a competitive market
2. High dividends increase value
3. Low dividends increase value
The first view is represented by the Miller and Modigliani dividend-irrelevance proposition.
Miller and Modigliani Dividend-Irrelevance Proposition
In a perfect capital market the dividend policy is irrelevant. Assumptions
- No market imperfections
• No taxes
• No transaction costs
The essence of the Miller and Modigliani (MM) argument is that investor do not need dividends
to covert their shares into cash. Thus, as the effect of the dividend payment can be replicated by
selling shares, investors will not pay higher prices for firms with higher dividend payouts.
To understand the intuition behind the MM-argument, suppose that the firm has settled its
investment programme. Thus, any surplus from the financing decision will be paid out as
dividend. As case in point, consider what happens to firm value if we decide to increase the
dividends without changing the debt level. In this case the extra dividends must be financed by
equity issue. New shareholders contribute with cash in exchange for the issued shares and the
generated cash is subsequently paid out as dividends. However, as this is equivalent to letting the
new shareholders buy existing shares (where cash is exchanged as payment for the shares), there

94 | P a g e
 NMC M.COM SEM-3

is not effect on firm value. Figure 11 illustrates the argument:

Figure 11: Illustration of Miller and Modigliani's dividend irrelevance proposition
The left part of Figure 11 illustrates the case where the firm finances the dividend with the new
equity issue and where new shareholders buy the new shares for cash, whereas the right part
illustrates the case where new shareholders buy shares from existing shareholders. As the net
effect for both new and existing shareholders are identical in the two cases, firm value must be
equal. Thus, in a world with a perfect capital market dividend policy is irrelevant.
Why dividend policy may increase firm value
The second view on the effect of the dividend policy on firm value argues that high dividends
will increase firm value. The main argument is that there exists natural clienteles for dividend
paying stocks, since many investors invest in stocks to maintain a steady source of cash. If
paying out dividends is cheaper than letting investors realize the cash by selling stocks, then the
natural clientele would be willing to pay a premium for the stock. Transaction costs might be one
reason why its comparatively cheaper to payout dividends. However, it does not follow that any
particular firm can benefit by increasing its dividends. The high dividend clientele already have
plenty of high dividend stock to choose from.
Why dividend policy may decrease firm value
The third view on dividend policy states that low dividends will increase value. The main
argument is that dividend income is often taxed, which is something MM-theory ignores.
Companies can convert dividends into capital gains by shifting their dividend policies.
Moreover, if dividends are taxed more heavily than capital gains, taxpaying investors should
welcome such a move. As a result firm value will increase, since total cash flow retained by the
firm and/or held by shareholders will be higher than if dividends are paid. Thus, if capital gains
are taxed at a lower rate than dividend income, companies should pay the lowest dividend
possible.
1.1.1 Argument for dividend irrelevance,
Modiglian and Miller put forward the hypothesis that dividend is a passive variable and it does
not influence the share valuation. Thus MM model is known as Dividend Irrelevance Model.
Modigliani and Miller provide the most comprehensive argument for the irrelevance of
dividends. They argue that, given the investment decision of the firm, the dividend pay-out ratio
is a mere detail and that it does not affect the wealth of owners. They argue that the value of the
firm is determined solely by the earning power of the firm and not its pattern of distribution of
earnings that will influence the value of shares.
Assumptions: The basic assumptions of M-M Hypothesis are as follows
I) Perfect capital markets exist and investors are rational. Information is available to all free
of cost. There is no investor large enough to influence the market price of securities.
II) There are no transactional costs. It means securities, can be bought and sold without
paying any brokerage or other expenses.
III) There are no floatation costs. Capital can be raised without incurring any costs like
advertisement, brokerage etc.
IV) No taxes exist or there is no difference in tax rates applicable to dividends and capital
gains.
V) The investment• policy of the firm is fixed and does not change. So the financing of
investment programme through retained earnings does not change the business risk and
there is no change in required rate of return.

95 | P a g e
 NMC M.COM SEM-3

VI) There is no uncertainty about the future investments and profits of the firm. So the
investors are able to predict future prices and’ dividends with certainty. (This assumption
was later dropped by -MM).
The crux .of the irrelevance h p thesis S the Arbitrage argument. Arbitrage process as is
explained in our chapter on capital structure is the process of entering simultaneously into two
transactions which exactly balance each other or completely offset each .other. The two
transactions. are payment of dividend and raising finance for capital investment projections from
eternal sources by issue “of-new shares or borrowing. If a firm decides to invest some money in
a capital project, it has two alternatives
1. either to retain earnings and use it for investment and not to pay dividend or
2. to pay out dividend and raise exactly the same amount by issue of shares or debentures.
This arbitrage process becomes necessary when the firm decides to pay dividend. When the firm
pays dividend, it will have to resort to external sources of finance for investment projects. When
the shares are issued, the total number of shares increases and the share prices decline. Thus, the
shareholders on the one hand get dividend and on the other hand lose by way of decrease in
value of shares. So the investors, according to Modigliani and Miller would be indifferent
between dividend and retention of earnings. The investors would not care whether the firms pays
dividend or retain the profit. Thus, the dividend decision is irrelevant.
Secondly, irrelevance of dividend will still hold good, whether the finance is raised through issue
of shares or by issue of debentures. The ‘investors would be indifferent between debt and equity
with respect to leverage. The cost of equity has no relation with leverage and the real cost of debt
is the same as the real cost of equity. Cost, of capital is also independent of dividend pay-out
ratio.
Thirdly, because of operation of arbitrage, the dividend decision would be irrelevant even under
conditions of uncertainty. The market prices of the shares of two firms, with similar business,
risk, prospective future earnings and investment policies would be the same, irrespective of their
pay-out ratios. This is because of rational behaviour of shareholders. The share value of two
firms are not affected by the current or future dividend policies.
Mathematical Formula: According to Modigliani-Miller, the market value of a share in the
beginning of the year is equal to the present value of dividends paid at the end of the year plus
the market price of share at the end of the period.
(1) It can be presented in the. form of a formula as follows
𝐷1 + 𝑃1
P = 1+𝐾
Where P = Prevailing market price of a share
D1= Dividend to be received at year end.
P1= Market price of a share at year end.
k.= Cost of capital.
(2) If it is assumed the there is no external financing, the value of the firm would be the no. of
shares multiplied by the price of each share (P0).
The formula will be
𝑛(𝐷1 + 𝑃1 )
V = n𝑃𝑛 = (1+𝑘) ,,
Equation V = nP
(3) If the internal financing is insufficient, the firm issues new share at a price of P1. In that case
the present value of the firm would be as follows
𝑛(𝐷1+ 𝑃1 )+𝑚𝑃1 −𝑚𝑃1
V = 𝑛𝑃𝑛 = (1+𝑘)

96 | P a g e
 NMC M.COM SEM-3
𝑛𝐷1 +𝑛𝑃1+𝑚𝑃1 −𝑚𝑃1
= (1+𝑘)
𝑛𝐷1 +(𝑛+ 𝑚)𝑃1−𝑚𝑃1
= (1+𝑘)
(4.) If the firm were to finance its investment programme through issue of additional shares, the
amount of new share would be.
𝑚𝑃1 = 𝐼1 − (𝑥1 − 𝑛𝐷1 ), 𝐼1 = Total amount of investment during first year. If we substitute the
value of m𝑃1 in equation about we get,
𝑛𝐷 +(𝑛+𝑚)𝑃1−(𝐼1− 𝑋1 +𝑛𝐷1)
𝑛𝑃𝑛 = 1 ,
(1+𝑘)
𝑛𝐷1 +(𝑛+𝑚)𝑃1− 𝐼1 + 𝑋1 − 𝑛𝐷1
= ,
(1+𝑘)
(𝑛+𝑚)𝑃1− 𝐼1+ 𝑋1
= (1+𝑘)
Thus in above equation there is no D i.e. no dividend. M – M argument that as per above
equation value of the firm does not depend on dividend whether declared or not.
Modigliani and Miller argue that dividend policy does not influence the valuation of the
firm, and the investors are indifferent between dividend and retention of earnings. This is
because, when the firm pays dividend, its advantage is offset by external financing, which
reduces value of the shares. It is the future earnings which affect the value of the firm.
Criticism of M. M. Hypothesis: The M-M approach is based on realistic assumptions.
They have over simplified these assumptions. The most .important criticism is that the
assumption of perfect capital market is totally unrealistic. Their assumptions that there are no
taxes, no transaction and floatation costs etc. are also untenable. Thus, their approach is far
removed from reality. Their approach is criticised on following grounds
(1) Tax Effect: M-M approach assumes that there are no taxes. This is quite unrealistic. In
actual life, taxes have to be paid by shareholders on either dividends or on capital gains
earned. (In India, the shareholders are not required to pay any taxes on dividends received
by them). Of course, the dividends are taxed at higher rates, while capital / gains are
always taxed at lower rates. Secondly, tax on capital gains is / payable only when shares
are sold.
(2) Floatation Costs: Another assumption of M-M hypothesis is that there are no floation
costs of raising finance through issue of shares or debentures. There ‘is: no difference
between internal financing and external financing. When a company pays dividend and
raises equivalent amount by issue of new shares or debentures, the finance its capital
investment projects, it has not to incur any costs. In real life’ this is not true.
(3) Transactional Costs : Another unrealistic assumption of M.M hypothesis is that there are
no transactional costs involved in buying or selling securities. When dividends are not
paid, those shareholders who want current income for consumption purposes would sell
their shares. But in practical life, when a shareholder sells his shares, he has pay brokerage
etc.
(4) Informational Content of Dividend: As opposed to M-M approach of irrelevance of
dividend, it can be said that dividends are relevant because •they have informational value.
Dividends contain information which the investors consider vital. The payment of
dividends. Conveys to the shareholders infatuation relating to the profitability of the
company. When a firm changes its dividend policy, it conveys that there are some changes
in the profitability of the firm:

97 | P a g e
 NMC M.COM SEM-3

(5) Near Dividend: The investors prefer near dividend to distant or future, dividend. If
dividend is not paid and is deferred, it will be paid in future, which is uncertain. The longer
the distance in future dividend payment, the higher is the uncertainty, which increases the
risks to the investors. They do not know when the future dividend would be paid and at
what rate. As the future dividend is uncertain and risky, the investors would prefer current
dividend. They would prefer a bird in hand that two in the bush’. So it V is not correct to
say that investors are indifferent to dividend payment.
(6) Uncertainty about Prices of Shares: M-M approach has assumed that even under
uncertainty, the dividend is irrelevant. But i is not so. When the firm distributes dividend,
and consequently ‘has to sell shares to raise equivalent amount, there is uncertainty ‘about
price at which it will be able to sell shares.
(7) Discount Rate not Constant:It has been assumed under M-M hypothesis that the discount
rate k remains constant, whether the firm uses external financing or internal financing.
Generally, investors desire to diversify their portfolio. So they would wish that the firm
pays dividend, which they can invest in some other firms.
(8) Low tax on Dividends: In countries like India where there is no tax on receipt of dividend
income, the investors would like the firm to pay dividend, so that they may not have to pay
any tax.
1.1.2 Arguments for dividend relevance,
The other school of thought considers dividend as an active variable affecting the value of
the firm. Myron Gordon, John Linter, James Walter and Richardson are associated with this
concept of dividend decision According to them the dividend policy almost always affects the
value of the enterprise. Investment policy of a firm cannot be separated from its dividend policy.
According to them
1. Price of Share: - Dividend removes uncertainty about the level of earnings. Hence, higher
dividend raises the prices of shares.
2. Capital Gain: - The investors are more interested in short run income which is more certain,
than the future long-term earning which results in capital gains.
3. Tax Liability: - Tax consideration is relevant. The investors in high tax bracket would prefer
that the firm retains profit with it, as it would reduce their tax liability.
WALTER’S MODEL OF DIVIDEND RELEVANCE:
Prof. James E. Walter contends that the dividend is relevant. Dividend is an active
variable that affects price of company’s shares and value of firm, because that leads to wealth
maximisation. The optimum dividend will be determined by the relationship of internal rate of
return (r) (which is the return’ on firm’s investment) and the cost of capital (k). If the rate of
return earned by firm in its business (r) is more than cost of capital (k) that is, the rate at which
funds and available to the firm from outside sources, the firm should retain the earnings, as it
could be invested more profitably in business. On the other hand, if the cost of capital (k) or the
expected return is more than the return available on firm’s investment (r), the firm should
distribute its earnings as dividend, as in that case, the shareholders receive dividend, and on with
they earn a higher return by investing it elsewhere.
Assumptions Walter’s model is based on the following assumptions
1. The firm finances its investment exclusively by retained earnings. It does not resort to debt
or new equity.
2. Its rate of return (r) and its cost of capital (k) are constant. Even with additional
investment, its risk does not change.

98 | P a g e
 NMC M.COM SEM-3

3. All earnings of the firm are either distributed as dividend or retained and invested
internally immediately.
4. There is no change in the earnings per share E and dividend per share EPS or D. They may
be changed in the model to determine the results.
5. The firm has a perpetual life i.e. very long life.
Share Valuation Model: Walter has given the following formula to determine the market price
per share to arrive at the appropriate dividend decision.
𝐷 𝑟(𝐸−𝐷)/𝑘
𝑃= 𝑘+ ,
𝑘
Where P = Market Price of Equity Share
D = Dividend per share (DIV)
E = Earnings per share (EPS)
r = Rate of return of the firm
k = Cost of Capital
The above formula suggests that the market value of share is the sum
a) the present value of all dividends (D/K) and
b) the present value of all capital gains which occur when earnings are retained in the firm.
[r (E — D) / k ÷ k]
Criticism of Walter’s Approach: Walter’s model attempts to simplify the relationship between
dividend policy and value of shares. However, the assumptions made under this model are not
realistic. They are criticised on following grounds:
3. Financing of Investments: Walter assumes that the firm uses its retained earnings for
financing its investment programmes. It does not resort to external financing — whether
equity or debt. In real life this is not the case. No firm finances its investment
programmes exclusively through retained earnings.
4. Constant Rate of Return: Walter assumes that the rate of return (r) remains constant.
This is not a realistic assumption. In fact, the rate of return changes with the size of
investments. As the investment increases the rate of return declines and would lead to
decline in the wealth of the owners. In fact, firm would stop further investment when r =
k, as thereafter the investment would not yield return equal to cost of capital.
5. Constant Cost of Capital: The assumption that the cost of capital (k) remains constant is
also theoretical and not realistic. In fact, this rate changes with the firm’s risk. Walter has
ignored the effects of risk on the value of the firm.
GORDON’S MODEL OF DIVIDEND RELEVANCE:
Another model relating to influence of dividend policy on valuation of the firm in terms
of market value of shares was put forward by Myron J. Gordon.* It is based on relevance
concept of dividend policy. According to him the market value of a share is equal to the present
value of dividends to be received by the shareholder.
The assumptions that he has made are almost the same as those by Walters. They are as follows
1. The firm is an all-equity firm. It means its capital Consists of only equity shares. There is no
debt capital.
2. The firm uses only retained earnings for financing its investment programmes. No external
financing is used.
3. The internal rate of return of the firm (r) is constant.
4. The cost of capital or the appropriate discount rate (k) of the firm is constant.
5. The firm has perpetual life and its earnings are also perpetual.
6. There are no corporate taxes.

99 | P a g e
 NMC M.COM SEM-3

7. The retention ratio (b), once decided upon is Constant (retention ratio is the proportion of
earnings retained in the business). Thus, the growth rate g = br is constant.
Like Walters, Gordon also contended that dividend policy of the firm is relevant and
affects the value of the firm. He says that investors always prefer dividend as current income and
not the dividend to be obtained in future, because the investors are rational and are risk averse,
that is, they do not like to take risk of uncertain future dividend. They put a. positive premium on
current dividend income and discounts uncertain future dividends as the current dividend
received removes any possibility of risk.
A Bird in hand Argument: As we have seen that investors are rational and are risk-
averse, meaning thereby that they do not like to take risk in respect of future dividend. Here risk
means the possibility of not getting dividend. Hence, the value of shares of those firm which pay
higher current dividend will be higher. The investors discount the distant dividend at a higher
rate than the near dividend. This argument is described as ‘a bird-in-the-hand’ argument.
Investors believe that a bird in hand is better than two in the bush. It means that what is available
today is more valuable than what may be available in futures.
This clearly emphasises that an investor prefers current dividend than the future dividend,
as future is uncertain. The more distant the future is more uncertain it becomes. Hence, when
dividend is withheld and earnings are retained, it becomes uncertain whether the dividend would
be received at all. Hence, the investors who are rational are prepared to pay a higher premium for
shares on which current dividends are paid and would discount the value of shares of a firm
which retains its earnings. The appropriate discount rate would increase with increase in
retention ratio.
Gordon’s Formula of Share Valuation: According to Gordon, the market value of a share is
equal to the present value of future streams of dividend. It is represented by the following
formula
𝐸 (1−𝑏)
𝑃 = 𝐾−𝑏𝑟 ,
Where, P = Price of a share.
E = Earnings per share.- (EPS)
b = Retention ratio
1-b = DIP Ratio.
k = Cost of Capital or Capitalisation rate.
r = Rate of return on investment of an all-equity firm
br = g (growth rate)
1.1.3 Determinants of dividend policy / Factor Affecting Dividend Policy
1. Type of Business: The type of business carried on by the company influences the dividend
policy. If the company is in a business which has a stable demand and stable earnings, it can
follow a stable dividend policy. While a company which deals in luxury items has irregular
flow of income and cannot adopt a steady dividend policy. Generally companies dealing in
necessities of life, public utilities etc. have stable income.
2. Current Year’s Earnings: A company has to determine the amount of dividend keeping in
view the actual earnings of the current year only. Of course, the whole of earnings is not
distributed by the company every year, but it is the base of dividend policy. Even the
companies following stable dividend policy makes some changes within a certain limit on the
basis, of current year’s profit.
3. Past Dividends: To a lesser extent the dividends declared during previous years must also be
considered. Shareholders do expect that the company would pay not less than dividend paid

100 | P a g e
 NMC M.COM SEM-3

in the past. Of course, if circumstances change, departure has to be made from the past trend
of dividends. But generally directors are reluctant to reduce the previous year’s rate of
dividend and if need be. They would try to maintain the rate of dividend, withdrawing from
the past accumulated profit.
4. Estimate of Future Earnings: A company cannot adopt a stable dividend policy without
taking into account the estimates of future earnings. The current year’s rate is rationally
determined only when estimate of future earnings is considered. If the profit is likely to rise
in future, then only the directors can think of raising current dividend. .If the future is not so
bright, the current dividend cannot be increased, as the rational dividend policy cannot ignore
the fluctuations in earnings from year to year.
5. Future Needs of Capital: The current profit is divided into retained earnings and dividend.
When the company is in need of additional capital for future expansion of business, has to
restrict its rate of dividend and keep a major part of its current earnings for meeting working
capital needs and fixed capital requirements of expansion of business. Particularly small
companies and newly established companies have no other source of raising finance and
would therefore depend mainly on this source.
6. Fluctuations in Business the alternative waves of depression and boom in business has a
considerable impact on dividend policy. A wise management would adjust itself to the
changes in business from time to time. During boom period, a company should build up a
good amount of reserves, so that it can withstand the period of depression and can maintain a
stable dividend policy. If need be, the company can easily raise finance by maintaining high
rate of dividend.
7. Present Amount of Reserves: A company having sufficient amount of reserves would be
able to face the times of low demand with confidence, the. Prudent management would
therefore, try to build up, sufficient reserves during boom period by restricting the rate of
dividend and thus try to strengthen its financial position. Of course, in India it has been made
compulsory by Companies Act that companies are required to transfer not more than 10% of
their net profits to Reserve if the rate of dividend exceeds 10% on graded rates. No company
is allowed to transfer less than this to the reserves before declaring dividend.
8. Distribution of Shareholdings: If the company is a closely- held, it is easy for the Board to
postpone the dividend and transfer the entire profit to reserves. However, in case the
shareholding is widely distributed, with a large number of shareholders, it would be difficult
for the Board to take decision of reducing or suspending .dividend. If shareholders are mostly
from middle class group of society, they expect a higher and consistent rate of dividend and
the directors cannot ignore the expectations of shareholders.
9. Age of the Company: The dividend policy is affected by the fact whether a company is an
old and established one or is a new one. A new company cannot afford to declare a high rate
of dividend from the beginning, as it has to fall back on retained earnings for its requirements
of funds for expansion. However, an established company would have built up enough
reserves and can afford to be liberal in dividend distribution.
10. Position of Liquidity: Dividend is payable in cash as per provisions of Companies Act.
Hence, the directors are required to take into account the liquid position before declaring
dividend. A company may have good deal of profit but may not have enough cash. In that
case dividend has to be postponed or the lower rate of dividend should be declared.

101 | P a g e
 NMC M.COM SEM-3

11. Government Policy: The changes in government fiscal policies, industrial and labour
policies considerably affect the working of some or all of the business firms. Their profits are
affected either favourably or adversely. Dividend policy has to be adjusted to such changes.
12. Taxation: Due to high rates of taxes, the company’s profits are reduced, leading to a lower
rate of dividend. In case of closely-held companies the shareholders who are mostly in the
highest tax brackets would like to receive less dividend and opt for capital gains.
13. Legal Restrictions: The Companies Acts of various countries may put restrictions of
payment of dividends. For example, according to Sec. 205 of Indian Companies Act, no
dividend can be paid without providing depreciation on fixed assets, dividend has to be paid
in cash, dividend warrants must be dispatched within 30 days of declaration of dividend etc.
14. Attitude of Management: The attitude of management has considerable impact on dividend
policy. The management with foresight and conservative attitude would declare lower
dividend and major part of the profit would be kept in business to strengthen its financial
position. The management with liberal attitude would be liberal in dividend policy. Prudent
management would always adopt a bit conservative dividend policy.
Dividend Signaling theory
Signaling Hypothesis

The M&M dividend irrelevance theory assumes that all investors have the same
Information regarding the firm’s future earnings. In reality, however, different
Investors have different beliefs and some individuals have more information
than others. More specifically, the firm managers have better information about
future earnings than outside investors.
It has been observed that dividend increases are often accompanied by an
increase in the stock price and dividend decreases are often accompanied by
stock price declines. These facts can be interpreted in two different ways:
Investors prefer dividends to capital gains; unexpected dividend increases can be
seen as signals of the quality of future earnings (signaling theory).
Types of dividend polices
1. Policy of No Immediate Dividend: Generally, management follows a policy of paying no
immediate dividend in the beginning of its life, as it requires funds for growth and expansion.
In case, when the outside funds are costlier or when the access to capital market is difficult
for the company and shareholders are ready to wait for dividend for sometime. This policy is
justified, provided the company is growing fast and it requires a good deal of amount for
expansion. But such a policy is not justified for a long time, as the shareholders are deprived
of the dividend and the retained earnings built up which will attract attention of labourers,
consumers etc. It would be better if the period of dividend is followed by issue of bonus
shares, so that later on rate of dividend is maintained at a reasonable level
2. Regular Or Stable Dividend Policy : When a company pays dividend regularly at a fixed
rate, and maintains it for a considerably long time even though the profits may fluctuate, it is
said to follow regular or stable dividend policy. Thus stable dividend policy means a policy
of paying a minimum amount of dividend every year regularly. It raises the prestige of the
company. in the eyes of the investors. A firm paying stable dividend can satisfy its
shareholders and can enhance its credit standing in the market. Not only that the dividend
must be regularly paid but the dividend’ must be stable. It may be fixed amount per share or

102 | P a g e
 NMC M.COM SEM-3

a fixed percentage of net profits or it may be total fixed amount of dividend on all the shares
etc. The benefits of stable dividend policy are
a. It helps in raising long-term finance. When the company tries to raise finance in future,
the investors would examine the dividend record of the company. The investors would
not hesitate to invest in company with stable dividend policy.
b. As it will enhance the prestige of the company, the price of its shares would remain at a
high level.
c. The shareholders develop confidence in management.
d. It makes long-term planning easier.
3. Regular Dividend plus Extra Dividend. Policy: A firm paying regular dividends would
continue with its pay out ratio. But when the earnings exceed the normal level, the directors
would pay extra dividend in addition to the regular dividend. But it would be named ‘Extra
dividend’, as it should not give an impression that the company has enhanced rate of regular
dividend, This would give an impression to shareholders that the company has given extra
dividend because it has earned extra profits and would not be repeated when the business
earnings become normal. Because of this policy, the company’s prestige and its• share values
will not be adversely affected. Only when the earnings of the company has permanently
increased, the extra dividend should be merged with regular normal dividend and thus rate of
normal dividend should be raised. Besides, the extra dividend should not be abruptly
declared, but the shareholders should have some idea in advance, so that they may sell their
shares, if they like. This system is not found in India.
4. Irregular Dividend Policy: When the firm does not pay out fixed dividend regularly, it is
irregular dividend policy. It changes from year to year according to changes in earnings level.
This policy is based on the management belief that dividend should be paid only when’ the
earnings and liquid position of the firm warrant it. This policy is followed by firms having
unsiable earnings, particularly engaged in luxury goods.
5. Regular. Stock Dividend Policy : When a firm pays dividend in the form of shares instead
of cash regularly for some years. continuously, it is said to follow this policy. We know stock
dividend as bonus shares. When a company is short of cash orb is facing liquidity crunch,
because a large part of its earnings are blocked in high level of receivables or when the
company is need of cash for its modernization and expansion, programme, it follows this
policy.. It is not advisable to follow this policy for a long time, as the number of shares will
go on increasing, which would result in fall in earnings per share. This would adversely
affect the credit standing of the firm and its share values will go down.
6. Regular Dividend plus Stock Dividend Policy A firm may pay certain amount of dividend
in cash and some dividend is paid in the form of shares (stock). Thus, the dividend is split in
to two parts. This policy is justified when (1) The company wants to maintain its policy of
regular dividend and yet (2) It wants to retain some part tf its divisible profit with if for
expansion. (3) It wants to give benefit of its earnings to shareholders but has not enough
liquidity to give full dividend in cash. All the limitations of paying regular stock dividends
apply to this policy.
7. Liberal Dividend Policy : It is a policy of distributing a major part of its earnings to its
shareholders as dividend and retain a minimum amount as retained earnings. Thus, the ratio
of dividend distribution is very large as compared to retained earnings. The rate of dividend
or the amount of dividend is not fixed. It varies according to earnings. The higher is the

103 | P a g e
 NMC M.COM SEM-3

profit, the higher will be the rate of dividend. In years of poor earnings, the rate of dividend
will be lower. In fact, it is the policy of Irregular Dividend.

FACTORS AFFECTING DIVIDEND POLICY :

There is no definite answer to the question as to what should be the quantum of dividend
every year. A number of factors affects it and be final figure of dividend is determined only after
considering the following.

Type of Business : - The type of business carried on by the company influences the dividend
policy. If the company is in a business which has a stable demand and stable earnings, it can
follow a stable dividend policy. While a company which deals in luxury items has irregular flow
of income and cannot adopt a steady dividend policy. Generally companies dealing in necessities
of life, public utilities etc. have stable income.
Current Year’s Earnings : A company has to determine the amount of dividend keeping in
view the actual earnings is not distributed by the company every year, but it is the base of
dividend policy. Even the companies following stable dividend policy makes some changes
within a certain limit on the basis of current years’s profit. There is no definite proportion
between dividend and profit but dividend is raised, if the current years’s profit has increased
considerably. As one author states, “The starting point of dividend policy is the earnings of the
firm. The upper limit on dividend, practically speaking, is fixed by the earnings of the current
period.”
Past Dividend : To a lesser extent the dividends declared during previous years must also be
considered. Shareholders do expect that the Company would pay not less than dividend paid in
the past. Of course, if circumstances change, departure has to be made from the past trend of
dividends. But generally directors are reluctant to reduce the previous year's rate of dividend and
if need be, they would try to maintain the rate of dividend, withdrawing from the past
accumulated profit.
Estimate of Future Earnings : A company cannot adopt a stabledividend policy without
taking into account the estimates of future earnings. The current year's rate is rationally
determined only when estimate of future earnings is considered. If the profit is likely to rise in
future, then only the directors can think of raising current dividend. If the future is not so bright,
the current dividend cannot be increased, as the rational dividend policy cannot ignore the
fluctuations in earnings from year to year.

Future Needs of Capital : The current profit is divided into retained earnings and dividend.
When the company is in need of additional capital for future expansion of business, has to
restrict its rate of dividend and keep a major part of its current earnings for meeting working
capital needs and fixed capital requirements of expansion of business. Particularly small
companies and newly established companies have no other source of raising finance and would
therefore depend mainly on this source.

Fluctuations in Business :The alternative waves of depression arid-boom in business has a

considerable impact on dividend policy. A wise management would adjust itself to the changes
in business from time to time. During boom period, a company should build up a good amount of
reserves, so that it can withstand the period of depression, arid can maintain a stable dividend

104 | P a g e
 NMC M.COM SEM-3

policy. If need be, the company can easily raise finance by maintaining high rate of dividend.

Present Amount of Reserves : A company having sufficient amount of reserves would be

able to face the times of low demand With confidence, The prudent management would
therefore, try to build up, sufficient reserves during boom period by restricting the rate of
dividend and thus try to strengthen its financial position. Of course, in India it has been made
compulsory by Companies Act that companies are required to transfer not more than 10% of
their net profits to Reserve if the rate of dividend exceeds 10% oh graded rates. No company is
allowed transfer less than this to the reserves before declaring dividend.

Distribution of Shareholdings : If the company is a closely- held, it is easy for the Board to
postpone the dividend and transfer the entire profit to reserves; However, in case the
shareholding is Widely distributed, with a large number of shareholders, it would be difficult for
the Board to take decision of reducing or suspending .dividend. If shareholders are mostly from
middle class group of society, they expect a higher and consistent rate of dividend and the
directors cannot ignore the expectations of shareholders.

Age of the Company : The dividend policy is affected by the fact whether a company is an
old and established one or is a new One. A new company cannot afford to declare a high rate of
dividend from the beginning, as it has to fall back on retained earnings for its requirements of
funds for expansion. However, an established company would have built up enough reserves and
can afford to be liberal in dividend distribution.

Position of Liquidity :Dividend is payable in cash as per provisions of Companies Act.

Hence, the directors are required to take into account the liquid position before declaring
dividend. A company may have good deal of profit but may not have enough cash. In that case
dividend has to be postponed or the lower rate of dividend should be declared. Even if the
present liquid position may be satisfactory, the company may require cash to buy assets for
expansion of business. In that case too, management should postpone payment of dividend.
There is thus a direct link between liquid position and payment of dividend. A company which
maintains a satisfactory level of liquidity at all times may be able to maintain stable dividend
policy in the long run. In order to have a proper idea of cash flows which may help formulate
dividend policy, it would be better to prepare a cash budget for say two to three years, which
would give an idea to the management whether it would have enough cash to declare dividend.

Government Policy :The changes in government fiscal policies, industrial and labour
policies considerably affect the working of some or all of the business firms. Their profits are
affected either favorably or adversely. Dividend policy has to be adjusted to such changes. In
some cases, the government may restrict the rate of dividend in certain industries or impose tax if
the rate of dividend exceeds a particular limit. Dividend policy is thus affected by changes in
government policies.

Taxation : Due to high rates of taxes, the company's profits are reduced, leading to a lower
rate of dividend. In case of closely-held companies the shareholders who are mostly in the
highest tax brackets would like to receive less dividend and opt for capital gains. (It must be
noted at this stage that dividends declared by Indian companies are completely tax-free in the

105 | P a g e
 NMC M.COM SEM-3

hands of the shareholders and so this argument does not hold good). Many companies would like
to issue bonus shares frequently instead of paying high rates of dividend.

Legal Restrictions : The Companies Acts of various countries may put restrictions' of
payment of dividends. For example, according to Sec. 205 of Indian Companies Act, no dividend
can be paid without providing depreciation on fixed assets, dividend has to be paid in cash,
dividend warrants must be dispatched within 30 days of declaration of dividend etc. No dividend
can be paid out of capital. It has to be paid out of earnings of the company. If the company
declares a dividend in excess of 10%, it is required to transfer a particular percentage of profit on
sliding scale to the reserve fund. It can make use of past accumulated profits for payment of
dividend subject to certain rules issued by the Central Government. The objective of legal
restrictions is to see that the paid up capital of the company is not reduced and the interest of
creditors and shareholders is not adversely affected.

Sometimes even the suppliers of loans also stipulate certain restrictions on dividend in the
agreements made with them.

Attitude of Management :The attitude of management has considerable impact on dividend

policy. 'The management with foresight and conservative attitude would declare lower dividend
and major part of the profit would be kept in business to strengthen its financial position. The
management with liberal attitude would be liberal in dividend policy. Prudent management
would always adopt a bit conservative dividend policy.

Traditional theory
According to the traditional theory put forward by Graham and Dodd, the capital
Market attaches considerable importance on dividends rather than on retained

earnings. According to them “the capital markets are overwhelmingly in favor

of liberal dividends as against conservative or too low dividends’
The following valuation model worked out by them clearly confirms the above
View
P = M (d + e / 3)
Where, P = market price per share, D = dividend per share, E = earnings per
Share, M = a multiplier
According to this, in the valuation of share the weight attached to
Dividends are equal to four times the weight attached to retained earnings. This is
Made clear in the following modified model – in this E is replaced by D+R
P = M [d + (d +r/ 3)]
R = retained earnings
The weights provided by Graham and Dodd are based on their estimation
and this is not derived objectively through empirical analysis. Not with standing
this observation, the major thrust of the traditional theory is that liberal pay out
policy has a favorable impact on stock price.
The Residual Theory of Dividends
One of the schools of thought, the residual theory, suggests that the
dividend paid by a firm is viewed as a residual, i.e. the amount remaining or

106 | P a g e
 NMC M.COM SEM-3

leftover after all acceptable investment opportunities have been considered and
undertaken.
In this approach, the dividend decision is done in stages as under:
1. First the optimal level of capital expenditures is determined;
2. Then the total amount of equity financing needed to support the expenditures
is estimated
3. Reinvested profits is utilized to meet the equity requirement.
4. after this, if there is a surplus available in reinvested profits after meeting this
Equity need, then the surplus, the residual, is distributed to shareholders as
Dividends.
Thus, under this theory,
Dividend = Net income – Additional equity needed.
Let us examine this with an example
Suppose our XYZ Limited plans to invest Rs.100 million in a new
Project and it has finalized the target equity ratio at 60% and decided to meet
this fresh equity through internal accruals. Suppose in that particular year, our
Firm earns Rs.90 million as profits. The amount that can be distributed as
Dividend by XYZ Limited would be
Requirement of new project Rs.100 million
At target equity ratio of 60, XYZ Limited will need to invest Rs.60 million
Profit earned by XYZ Limited in that year Rs. 90 million
Balance available after meeting this fresh equity need Rs. 30 million

Thus Rs.30 million can be distributed as dividend by XYZ Limited

Thus, under the residual dividend model, the better the firm’s investment
Opportunities, the lower the dividend paid. Following the residual dividend
Policy rigidly would lead to fluctuating dividends, something investors don’t
Like
To satisfy shareholders’ taste for stable dividends, firms should

1. Estimate earnings and investment opportunities, on average over the next five
to ten years;
2. Use this information to find out the average residual payout ratio;
3. Set a target payout ratio.
Issues in dividend policy

Normally, a firm would be using its dividend policy to pursue its objective of
Maximizing its shareholders’ return so that the value of their investment is
Maximized. Shareholders return consists of dividends and capital gains.
Dividend policy directly influences these two components of return.
Even if dividends are not declared but retained in the firm, the shareholders’
Wealth or return would go up.
We shall examine various ratios which impact our firm’s dividend policy.
1. Pay out ratio
It is defined as dividend as a percentage of earnings. It is an important concept
in the dividend policy. A firm may decide to distribute almost its entire earnings.

107 | P a g e
 NMC M.COM SEM-3

Another firm may decide to distribute only a portion of its earnings. Initially it
may appear, the former firm declares maximum dividends. However in the long
run, the latter firm which declares only a portion of its earnings may overtake
our former high pay out firm.
In the case of low dividend pay out company, in fact from the year 14 onwards,
the quantum of dividend paid has actually overtaken the high dividend pay out
company
If you look at the market value, a low pay out firm will result in a higher share
price in the market because it increases earnings growth.
Uncertainty surrounding future company profitability leads certain investors to
prefer the certainty of current dividends. Investors prefer “large” dividends.
Investors do not like to manufacture “homemade” dividends, but prefer the
company to distribute them directly.
Capital gains taxes are deferred until the actual sale of stock. This creates a
timing option. Capital gains are preferred to dividends, everything else equal.
Thus, high dividend yielding stocks should sell at a discount to generate a higher
before-tax rate of return. Certain institutional investors pay no tax.
Dividends are taxed more heavily than capital gains, so before-tax returns
should be higher for high dividend - paying firms. Empirical results are mixed --
recently the evidence is largely consistent with dividend neutrality
2. Retention ratio
If x is pay out ratio, then the retention ratio is 100 minus x. That is retention
ratio is just the reverse of the pay out ratio. As we have seen above, a low pay
out (and hence a high retention) policy will produce a possible higher dividend
announcement (and thereby higher share price in the secondary market leading
to huge capital gains) because it increases earnings growth.
3. Capital gains
Investors of growth companies will realize their return mostly in the form of
capital gains. Normally such growth companies will have increasing earnings
year after year but their pay out ratio may not be very high. Their retention ratio
will therefore be higher. Investors in such companies will reap capital gains in
the later years. However, the impact of dividend policy (high or low pay out
with low or high retention ratio) is not very simple. Such capital gains will result
in the distant future and hence many investors may consider them as uncertain.
4. Dividend yield
The dividend yield is the dividends per share divided by the market value per
share. The dividend yield furnishes the shareholders’ return in relation to the
market value of the share..

Linter’s model on corporate Behavior

Mr John Linter conducted a series of interaction with corporate leaders in the

1950s to find out their dividend policies. And he observed that the following
four facts do impact the dividend payments
- firms have long run target dividend pay out ratio. Mature companies with
stable earnings generally pay out a high proportion of earnings. Growth

108 | P a g e
 NMC M.COM SEM-3

companies have low payouts, if they pay any dividends at all

- corporate leaders focus on dividend changes rather than absolute levels.
For them paying 20% dividend is an important decision if they paid 10%
dividend last year. And it is not a big issue if the dividend pay out last
year was also 20%
- dividend changes follow shifts in long run, sustainable earnings. Leaders
smoothen out dividend payments. Temporary changes in earnings level
is unlikely to affect dividend pay outs
-leaders are reluctant to make dividend changes that may have to be
reversed in the future years. They would be concerned if they are to
lower dividend payout ratio.
Thus Linter’s findings suggest that the dividend depends in part on the
company’s current earnings and in part on the dividend for the previous year,
which in turn depended on that year’s earnings and the dividend in the year
before.
Check your progress
The following are several observations about typical corporate dividend
policies. Which are true and which are false?
i. companies decide each year’s dividend by looking at their capital
expenditure requirements and then distributing whatever cash is left
over
ii. most companies have some idea of a target dividend distribution
percentage
iii. they set each year’s dividend equal to the target pay out ratio times
that year’s earnings
iv. managers and investors seem more concerned when earnings are
unexpectedly high for a year or two
v. companies undertake substantial share repurchases usually finance
them with an offsetting reduction in cash dividends
Answer the following question twice, once assuming current tax law and once
assuming the same rate of tax on dividends and capital gains.
Suppose all investments offered the same expected return before tax. Consider
two equally risk shares ABC Ltd and XYZ Ltd. ABC Ltd pay a generous
dividend and offer low expected capital gains. XYZ Ltd pay low dividends and
offer high expected capital gains. Which of the following investors would prefer
the XYZ Ltd? What would prefer ABC Ltd? Which should not care? (Assume
that any stock purchased will be sold after one year)
i. pension fund
ii. an individual
iii. a corporation
iv. a charitable endowment
v. a security dealer

109 | P a g e