Fundamentals of Financial Management Scanned with CamScannerSyllabus “Theory ‘Unit I. Score avo Onrecrives Unit IL, Twe Carma Bupcerinc Process = Unit IL. Cost oF Carat AND Fixancane Decision ‘Unit TV, Divioeno Decision ‘Unit V, Wonsona Caran Drcsions we Practicals Unit M, Tue Carma Buoceninc Paocess a 3 UnitiIL. Cosr oF Cartan AND Financrss Decision n UnitIV. Dpaso Decision ~ 7 Unit V. Womunc Carrrat Deatsions 07 © py Tables ow 32 University Question Papers 195 onwards Scanned with CamScannerLay Cee ae eosin io sch eee ee Terminal als alue QU, Capital budgeting under Rj inde oil Nags de jor Nae, Siem, i ag) aig Ol A er umn cing Decision: Sources of Longer fag on of como ‘ {Debt and Cos of Prk oa etaned Eamings, Cost 0 of Buty, Cost oN Cust of Capital (WAC) an Mariel Ca Capital Weigh peaies of Capital Structure (Net Income St et a le rh Oa Gree overage, Determinants of Capital Structure IV Sea el Ds: Tn or Reva, ard ears of rd at vation Walter's Mode, ; et rock dens, Diaend Poles i Posie ‘Determinants of Dividend. 4 a sonal (UaEV ® 7 Working Capital Decisions: Concepts of Working Capit, OPS sem ian, Cees Ce Rseretum wade of soures of shorter finales ca one nunogamet ceaes aPO5E™ STanagerent and payables management. “ a to ee EEE Sant 3s) and ene on ed for ing ude AS fet cu tao Relevance and irrelevance of divi forint secant 2 The sl bed Cit Ps fr Lasts one Cut Hr. wo POS er uch) for Patil Lab + ene Crit He for Tutorial Fe aaoo Scope and Objectives .1.Financial Accounting an Financial Management se complementary in nature. Do you agree? Expl. ‘he "Ans. Prin fale fnarcialacounting and financial management ae difeent from eat other, Financial accounting maily concerned with the rcording of facts and. the tansactions in monetary terms, However, the fnaeil management i concerned wit aking decons onthe basis of ciferent yps of Information (including that provided by financial accounting) for maximisation of shareholder’ wlth. The information generated by financial accounting is sed by the financial manager in the Uecsior-making procs. The finance manager cannot proceed unless he gets suficient infomation from the Accounting department in he form of Rana statement, cach Now and funds flow statement ec, Thus the two are complementary and it canbe sad hat financial management stats where financial counting ends; and. that ‘Accounting an input to Finance The relationship betveen financial be explnined as under 19 Franca Accounting provides the relevant information on the basis of ‘whch te camungs pr shar, te ash flows ef ean be ascertained for ache te nan deisors (nsneng aswell a investentdebiors) (@ Reguiseiformasn for Receivables management Ligidity management, Payables management ete is provid by Banal aounting, (provides the information regarding available posta profis and appropriations made, This information Is used in framing te dvdend policy of these. ‘Ths, financial management makes wie of the information generated by fieancilaccountng in aking decisions so hat the fm can achieves objectives. 2 Expl {0050R) ‘Ans. Responsbilies of Financial Manager in a modem enterprise, In 2 ‘enterprise the Financial Manager i a peacn whofe responsible in a sigificnt ‘way to eazy cut al he finance functions. Thus, hes the one who is concerned ot only with the saising of funds for the enlerprise but hei also connected innately even wilh the Production, Marketing and other functions im an ecterpise. Its he, who taker ll the daisons to crtinaouly review and ontol ‘the commitment or re-commitment ofthe finds tote new or the ongoing uses "ls faneuone are not only confined to rising fands (is taitonal funtion) bul these days Re pays quite an active vole of an overall advisor alo, He 4 counting an fvgncial management com Scanned with CamScannercova oe SEES spt fortune ofthe ener. Hels responsible rt efiene manne. His decisions th eis I ee ih uri the enlerpise Financial Manager are that of: * eh prope ae i ps tet ert eth profit and wealth weximsation . a iy a ‘hose providing funds 4 the enterprise ws, Ses Fhe Insitutions, Sharebee, _ fake Pesach over the sock market quostons and behaviour of companys share pres ; cg.s whale does a fiance manager pay fs. 2 modern fm? ‘Bas The Finacial Manager has o perfor thre factions: fae The con, Te, Fnancial Manager thes decision regarding saree dec ananzatien's funds in diferent asst which are either short term sorts ong term as, Fe ng Desiion The Final Manager hs to analyse vrious sources of Ft SAE fo come the one whichis salable fo the organization keeping in Fa ie enue rom the poet. He has to make a proper mix of debt SEES Tov tthe Hand ust to wich the fm eat be exposed ‘Didi Deesion, On mukirg Prot the far has to decide as to what roperton ath pot isto he dtd and wht proportion is tobe setae. Jae deck taken Keeping in view the objecive of maximisation of Sure wel ‘Q.“Finacial Management i nothing bat managerial decision making on set onl and pat aueaion” Buda the tenet O03 Pana Matageret (s9manageal actly which emphasizes on eg eat reg el eed tno lege ‘inion wth sn ajetive to munimine the value ofthe firm and hereby Iman he wel of omer or saretldes of «company “Toc em ay apna. Pita proach ane Daaioes caer eens cencemed wih pina uliten of asd fans and the sltions of Oe de apluhain od ceo opial smectite. are modem soc toe oth acquit fd 5 wa te ee an ou asaon in vaous aes of te entre The are rent ste ance and dered Financial Management ows -—— Ives L o Financing Dividend Asse mix u v Capita an Profit allocation ‘As oguns the trdonelapprooch whereby the Financial Management was coy celine to aranging ot acquiring of funds needed fran enterprise, the em approach fo Fiancal Managment Nights fur major decsns tobe taken by the Financial Managers. mde requirement decision which involves the proces of coptalsation forboth longterm a wel e short term needs of an enterpee- = Financing o” Fue raising decision Hera ths tage prope balance IPmed tobe achieved Bebreen the fied coat funds an varying cost {Gacusting co) funds. —Seatment decison. There ares the need 0 appraise diferent or [Mematve copia budgeting proposals. Thus, priorities are xed ard fans ar commited to diferent projects or acheres Such dedions ao Cover acpects whereby funds are commited (0 skor-tenm ge curent ‘Sah This involves rea of Working Copal Management __ Dividend deetson lt meas laying down or determing good dividend poly forthe crganisation of enterprise which is one of the major ancora ofa Fisce Manager I also t be undartocd tala good dividend policy depends on several eteznal actors as well Q.5, "Financial Management has expanded in iy scope during last few dscades" Examine. the, modern approach tothe scope of Financial Management. ©) 213, 2014, 2015, "Ans, Finaylal Management has gone throug phases of. Traditional phase” 2, Tranional phase 3. Moder phase ‘While Traditional phase only took cave of financing decisions and was only Discount sate © | IRR= Discount ete NPV >0 NFV=0 “Accept the proposal_| Indifferent NPV<0 IRR Discount ate | Reject the Proposal. (Q. 8. Why do NPV and IRR techniques of evaluation of capital budgeting ead config project ranking? (eons, 2016 ir THE CAPITAL BUDGETING PROCESS 8 on Why i possible forthe IRR de NPV methods to result indifeent of anocdtment proposals? Which wil you prefer in that situation and why? eet (Net present value) is present value of Cash inflows ius present se of cash outows. aoa ject depends upon the rte at which the Cash flows are bring discounted scout intemal rate of retum of 3 project. Is the rate at which 2 piesa magial elisecy of cap Ii the count ate at wich NPVs ze. Tv is aly both NPV and IRR are same, Under NPV, Cash flows ate Fea partcalar rate whereas IRR isthe discount ate at which NPY Fea ad sve Went sults we ae dealing with conventions Fig ows ane the projets are independent in mare “The prablen arises thew: project have unconveitional Cash flows; 1 Projects are mutually exclusive. LNPW and FRR rany ge cofictng ra i) Projects having ferent ies (G} Projects having diferent tangs. {Projets having unequal ves are onctng esulis in NPV and IRR, we generally prefer amy te conistet wth tat of the objective of sharekolden’ wealth a as on By considering an adequate discount rte, oly those pve stich il ada val to the fim are sccepe Tahoe masini he min costo cop anit canes tat fate ios a naa ce eich ae fo bean eens epson Sour enone ry Pai nde ow dort ier fom etre value tho? “ ue eho ye (7) or Benefit Cost Ratio IC Rati. 8 Ue seta A eet cok isl ae Oe tel son bres Cie yang ie rem abe om tings certain situations Tike: Seay ithe intial cash out, 158 computed as under: resent af nt xt ows Proftabity Index (P= tateshoutsy pecptnce Re To cept pce, hou ogni a neo ce Teed pm ming compan of ee eS of Sagal in Dyce Feria abst evar, whee PL ee Cee Sam ae ese 9 ah ett ie pense ee PS meee cepantct he NEV ecg : etki en nt nl wo an dean wh oo Scanned with CamScannerva DEL UNIVERSITY SERIES ‘yale of money and therefore perfectly matches ge of wealth maximisation approach ofthe management. It consi we he eah flows, generated during the fife time of the project. 1 facia] stag ef the projets which is wot possible in case of NPV method 35 if can meee af evaluation of capital budgets. This ls why PI method j onsiderd superior to NPV method. 18 account the concept of time ‘Which iss euperior ranking criteria—Profitability Index or the Net Presexd Value (SPY? ‘onary, the NPV approach prefered exept uncer capita rationing as th gives absolute figures 26 oppased to profitability index which is relat preteure of profitability “This can be illustrated i the following marier a SNE reser ve of Ca ows Ct! Otay NV sale to) moon's rst de ‘According according to Profitability ‘he above illustration, projet capital ratoning) because it indicates $iB.oo0 acording to Pl method which i only a relative measure of profitability Atthough PI mcind is nse ot NPY, Its a beter evolution technique than NPY} 5 rationing sna situation of capi Vo Stampa two projects may have the sime NPV of 20,00 but preject roqulces Eos outlny of €1,00000 whereas Y requires only €S0000, Project Treuld be preferted as per the yardstick of PZ meio, NPV is cfined as the exces of present va of outflows. The rate of discount employed Suahitwe is some desied rate of rtazn which Is equivalent tthe cost of capital a rev [Eee -ahae at) -€ : seston es 1 thet ecod am = Msing op set [eit 5. “sstapevaoe ~t comet capi ‘Decision Citerion- the prsent value ofthe benoit ix equal Yo or greater ha the investment outlay, the prject would be accepted. Profitability Index. It is «imilar to NPV approach. Ik measures the preset vale of rete per rupee inwested, It he ratio vehich is obtained by dividing the PV ofthe future cash inflows by the present value of eash outlays. The Pro ‘wil qualify for aceptance ifs Prexceeds one, When Pls equal to ane, the 2%) is indiferent tothe project. qo the NPV maliwd, Proposal X would te prefered, wheres Ties, Proposal Y would be preferred. As its seen from fection by NPV method is better (except unde] “ablute figure of $20,000 as opposed ts) 1c of projet cask inflows over tal for obtaining the present value of {Nir He THE CAPITAL BUDGETING PROCESS ‘egtng Fee nllares ard ferences between the ieadjsted dicount eens unty equivalent tthods for incorporating sk into capt trgeting deision? an ndgeting te egjusted Discount Rate (RAD) Approach sone ofthe simplest aay mate for incorporating ek i copia budesng ad mos dey utr inherent inthe propel incorporated fn the eon oye im prs’ ae clusters. Realy chy Of discount rate Src hgh cco ates end relly safer projets would would Ive ate Aneun ste or 8 weary bil the RAD woud be quit nave lt epee RAD mould be regured we nerd tes 9 Mee vo hota ow retin nnd uci Ts pracll ee ee ung leet RAD fren type of aa nt Apposch (CEA) es i acount heifer rece ae opal of capil even! props, Te aang Snow ae adie by og lee estate cath Faw 2 a ws ef the res ae core to eae cea owes, Teale corsinty evan il be ied ik ese 28 rele em and he lye ovat ss fr ape pete ah es ne Raed cont Rte whch aoe chavs by varying the co Sis tentealy 9 upeae tate or the RAD approach ‘el ln alr i er for aferent aves Tee Cermereative approach In ehing 2 dang the ak to incosh AWs Scanned with CamScannerSS Cost of Capital and Financing Decision 1. "Cost of retained earnings is same as cst of equity.” Comment @ ings ea ‘ssc Ans. Cost of retained enmings. Eamings generated by a compar are generally Aistibuted among the equity shareholders. Howevsr, i the entire eamings are ‘ot distsbutedanela partis retained by the company then such reisined earnings are availble for reinvestment within the company. Retained earnings increase the shareholders’ equity in the same manner ae the issue of new equity share capital does. But the company isnot required to pay dividend on this part of shareholder’ fund (retained earning). Hence, it may be argue that the retained ‘amis have no cost as such. The cost of retained earnings must be considered 88 the opportunity cost ofthe foregone dividends. Any eanings retained by the company could have been invested profitably by the equity sharchoklers themselves, Therefore, there is an opportunity cost involved in the firm's ‘etaining the earings and an estimation this cost ean be taken up as ease of cost ofeapital of retained earings. The ens of retained earnings is taken 98 ‘squal to the cost of equity share capital since the retained camings are taker at {ech subscription tthe equity share capital. The cost of retained earings afer making adjustments fr income-tax and brokerage cost payable by sharehekers ‘an be determined according tothe formula given below: arta cit of ne ens beka-na-m es io freien ena spray te sstum om their investment in another enterprise by the firm whose cost of ‘eained earings is being, considered. The opportunity cost given by the ‘pctemal yield criterion, which can be consistently appled,can be sid to measure {whichis Ukely tobe equal 0 Therefor k should be used as but the lates ‘would be slightly lower than the former dt o differences in Aasfation cost (2.2 Stte the diferent approaches tothe calclation of cost of equ i 12008, 2012 Are ot ay cpl ee ininun me fe tt gust eam onthe ty naned orton ofan investment por trae leave the market price of the shares unchs sd. ‘The ie i es unchanged. Three Ivo. Pol ‘pronces that canbe employed ts catute We ext ch agar 0 UIT COST OF CAPITAL AND FRANCING DECISION cry () Dividend approach, and (i) Capital asset pricing model approach Dividend approach ic, Dividend Valuation model, The cost of equity capital {) js the discount rate that equates the present value of all expected future lividends per sbare with the net pracede of the sale (or the current market price) ofa share. Itean be measured withthe following equations () Dividends are expected to grow at uniform rate perpetually De Py Dy ees mere[Da Fapeced Didnt peste BE Ne seed ede ert mit fF =Goninmerpeid acs Dividends me be ssumed to grow al constant rae sy," per en eran. Dy=D, (1+ a (iy Varin rte f growth in dividends: ZB) , BD, 5 Pollen oe EG BREE ae aa se, seoeareiee fue S Saeeunece he, SS chucteeseeaet, > SRA pram ‘ecm cnbe sted walend Spice 2 catgut ses wae boymeged Seem — ro ry Prec hr ena ct ence sent toy Rg mi sre vl coe eras epetuneaare Nc nay emcee tare Hrhe w gaan te nee has ober sae ame oe ‘Site tom tor fray uate Saglnprtee aad pales Serta eee te porn che locletgte nedehen via tee ees iret pects dace Rema peed Ganteaiees te et ae ee ene ne te Eels rte by Aaceicne maeecpenelgslor tanita cel Ss teinmimotanuten gional « thy aera Mts con Te wl ae Weer dant noe eat Do ee Sinn Pan veda rng wie nen rt Ep spl vo eal apn ison Sas eat cra tapers esta apa oa eras sdvaal cpt cna glen cotta Tecpel estel pd eS ee tenet tas We cpp fede She en as ewe aon mnuithy Elkcun crtnnicat tad Py brite pict Bret att ad racee ples stfeopilandebocee opeed teen oetaan ee evens ac cole extl oa Scanned with CamScannersu DEL UNMERSITY SERIES soe eure of ods which ot ona APY FAVE Homers te ing of he ir. Te pois ested byte rm Dat no sow ie, he eae aE parholders are ploughed back ad renvete ed amen ees ual ests ual uc of nds sent Te Eo br dari gly steel, they cul te fem ade Ends eum forthe) carer and wouldve ed enn em regan y te ines hen the pois 2 ye the fer as an impli cost ofthese retained earings Fort a Tenth oper cost of investors. Thus, he imp co ad i ag Un retem whch cold hae bs eared Dy he Investor, fad the pros bean toad to the Mee Fehon isn ele cot of tetaned earings, these Funds ae free cost” Cecally comment. eon, 2011 mes Ketan earings sa source of ance fr ivestnent propels dle steer oars ke Bet, Preference shaves ard Eq. Retained ervings do eee any formol anargement To Bc a sure of fds. There 1 | Signe Formal or implied em a firm to py rears onesie eerings. Ths heft fe tained enrmangs donot cary any cost see they repent funds | Mi Rove no bean raed fom outside. The corenon thst the reine Things are rec of cost srt cores. On the conary, they 6 inva a cost i Sly ther source of nonce Retention of earings mies wihhoing of uenda fom holier of equity shares I npn thatthe eq holds eel {feel to (oreo dvnends The cided foregone by the egy Rakes are {Eton opprtniy cost The reained earings nvelve opportu cost.The im ‘Bap quedo ear on th reine ering ee qual ote te ha Aro have ber ered by the equ olde had Ue eanngs been cistbutdl unidend Te opportunity cost sel known sini cost of epi, Shae oe may cold Ut though ined sings do not hae any exp et i say inpict es It means tat sch fr are aot enti eof cos they have act invlved and ths cost is the opportu cost “OG oMarket Value Weights are superior 10 Book Value Weight comment 7800) ‘Ae. The weighs ae ad to be Rook Value Weights the proparton iter i cen nthe at of era th Secoumting aes, The Bock Value Weighs con esl bv calulated by aking see erretton fon teria tart ogres ath alae che thefirm. The weighs are sid to be Market Value Weights ifthe proportions ol {ifeent sours of opt re cersined on the bss of the mkt vale Aiferen oaces The Book Value Weighs jor the markt values, The Book ‘Value Weighs system is not corlstnt with the definition ofthe overall at il eh Sl ate mir tof eum rst mata merit value. The Market Vale Weights provide current estimates ft investor's equi ate feta. The Marit Value Weighs ye god estima of the cost of capital that would be incurred should the fs incurred should the firm require additonal fends from tht The ce teen tock alu a he ah rant ony for bistoricl and target weighs. Incase of marginal weights, te) {question of ehoice does no arise at all and the weighing system willbe mark UT OST OF CAPITAL AND FIVAVONG DECISION Eo atu bsedenly. rom the above it scrytl ls ht "Maat Value Weights walfsperor to Bock Value Weights” EP Doc fem tact affect its cost f apt? What the effet ofthe nSicie oats nsecinted th a mew security isue on the firm’ cost of capital? 2010 tal tin’ tox rate affects ts cost of capital the cost of debt comes dae ttn cae appeabe ti Ue tx assy, 4 the cot of debt oir so the coupon rte. Tis eduction in cost of debt ultimately eas to ection in ACC, i hy station coat ssotated with new security issue wl increase the com of cable tne tun, Te net proceed ofthe new oe wb rede bow the cara ankt price because ofthe foataton cost associated with i, Therefore carmen aecsity wil aways be higher than the cost of existing security fe Sst he net proceeds fom Eh fresh capital ill aways be lower than the besa eke price. Esonpes ofthe floatation cost in case of isue of ity fetes are nderoiting expense, brokerage ee. ‘Ga, tala, in rie, the eights that you would take Sto consideration for computing weighted cot of opt, Why are marke value weights considered Stpeiar to the book-value weights? e010 te ver cost of Capital (should tke eae ofthe rave proportion of aft sources in he capital structure of he i Tus, Une overall cost of capital SAMGhe be calculated a the weighed average father than simple average of Giferent specific cost of capital, The firm must have a cost of capital that Is cieghted, To refet the dseences In various sures used Teal the cost of Compensating, the debt investors preference sharcholders andthe eguiy sratholders The weights to be used for computing the WACC can either bebased ‘eine book value or the mart vale ofthe funds raised from diferent sources "Ihe coice betwen the book wale and the market value f rlevant oly for ustoat and target weights in ense of marginal weights, he question of choice Tess nat are at allan the weightage system wil be market value based only. Tri argucd that Hv book vale is more reliable than the market valu a tis nol alae Although iis ta that book value does not change oafen as ‘rk valu, thi is more azefetion ofthe weakness than of strength snc the tru va ofthe fig change over tam 2 both thefrm-speii andthe mazket- ‘Eine information ae revealed The WACC based om maket value is usally renter than the WACC Insed or book value weights. The eason beg tha the ‘Brit capital having higher specic cost of eaptal wally has markt aloe Shove the bock val. However, hs isnot there “Thos market value weights silly eflecttre eighteens of capita 0.9: The ost of preference share capital s generally lower han he cost of ‘equity Slate the reason, pats ina. The preference shane capital i differentiated from equity capital on ‘acount of tive basi features: {) the preference shares are entitled to receive dividends ata feed rate in prinity ver the equity, (coe of quiation of he company the preference shareholders wil gt Iocan in prnaty over the dsubuton among the egy shareholders Scanned with CamScannermss sn 6 este ts or gupnit oe a Crete Seles ieanene g Stetina ete Ch iene, olde a id the dividends at the fixed rate, The eqs) Financial leverage reults from the presence of fixed financial charges in the taro ae enim sk i terms of payment of cvidend gag) firm's income SU “These fed charges do not vary with earings before teal on ligation, Duc to this very fac the cost of yun] interest and taxes (EBIT oF operating Prof Phan eveage contre tals moe than that ofthe preference shove capital ‘with the effects of changes in EBIT oF the earings available to eq phone | cop: at meant by “Trading on Equi’ Explain and discs et the abit fa firm to use ied fant charges to magniy the fects Ii) Up changes in EBIT on the earings per share ‘UM: COST OF CAPITAL AND FINANCING DECISION 2 is uy. he rum onsen efi smart ng ps bacon operating eee and final eee oe ra on A ofa he sation walled “Trading on Byape| carte two leverage Mere aie atm The followin are he itation of trading om equ Scar tee ee eve increases or decries the EBT also changes i : ‘eatin the sale revenue ereanls Edged Sword. Francal leverage 15 doubleedged Sworg q| Operating Leversss {OL} measures the relationship between (Dob ee a etimesinenl exe or eg] a ihe EU. meas a! he lt ee Sele can scl el i he RO verter dab omone cane ETT mesure ete by dig he pcre NTE Return on Investment it may result in decreasing EPS ‘by the percentage change in sles revert ie Go Mesetcin sk ad Tate of Interest Move the dsbt more thers of] gy, = --PtputemscerTrcnn ee a TT busines, as rate of interest goes on increasing with every addit (OL = sapaconate or Percentage change in Corban ~ = adlitiong Propo , ame! Leap FU) eases the eos bebween he EDT and (i) afl incase of fluctuation in earnings. High financll Te nna ert el of change a EDT on the level of EPS. Kit ‘cat only to tie imo fang able ming becaethe ineretag| cated by didn the percentage change in EPS the percentage changin SMinaheeltudcontetmeolfeeamngsacsableatmney| ai te ‘beable wo onrvieis es easily. On the contrary the earings acy : Foose nS fine going to pt hei under lot ef fnancial presse Fee ET (&) Restietions from financial institutions. The financial institutions als Tepe Pulte on compares hich emt to cersivetadingon teres, ol mesures he es of ean in slr everson he evel iirc onganeeunivet aces sadng pay | gn er mens int fone To Beet eE eee Se boa ign eats neo ith ven dees caning pe independent factor. 59 we can state acer a eae ; tis wrong In practice, trading om equity is resorted to with var wr view to increase eamings per equity share. The advantage to (0, 14 What does the ‘degre of combined Leverage’ measure? What should ‘Sembee orm Ge ecahid om 304 i te variags to eauty| O12 Mnger inthe degiee of combined leverage, ssuming other things deduct of eet nthe rm of ese x payable te goverment The | bengal allowing situation: re mice fet the value oly by seducing the share a he i) The fined cent fcreases earnings fim, However, the earnings avallatle tang | _ Ans. Degree of Combined Leverage (DCL). The Combined brverat (C1) 5 8 shuld maybe nce by theca ms to the | are eFoperting Leverage (OU) aed Finandal Leverage F) (0,12. The purpose of measuring oper i GT pes of meaning pean vege iteent fom ha contrition ae MCN omaeca arisen ae teint calle finan eversga Te eoSat with rancing icc a, wel iginy neyas smn el genie ce . Bea {DOL = Depe f Opeating Leese Inu Dep of Fiasac Levee oct = Depee of Combined Leverase Scanned with CamScanner~— a soa te ew txt: Cost OF CAPITAL AND FINANCING DECISION 28 the over ager nee 10 con i iis earzying fixed rate combined Leverage SE rancial Manager needs to Wy aga: A company can raise funds ether by ising sect fi “ccna ete praesent Eb ta ee oth he OL and FL Si cease in EBIT a8 well ag Heer imsruents of finance (oud at dabentres end eS bath he OL in rt Cot eg reset - apy)_ate company can ring an advantage othe egy Sheeler in rege ef is WIL ESP 22 acm ES en Bln hon aa lieing expels PO fo ey he eel oe uty sareolder. Thi & POSTE rae val simp seh eaetsr etic srt eh 2 Naber of units rode and sold ing] TAS ean he et te ceo betes an ed 5 Variable Cost/ait tig] SUPDEL eal In ler words he as raced fore oe 4. Fixed Cost 220009 | NE Pies (debentures ot preference shares) give a otum higher than the cost of 5, Financial Charge (interest) 4.009 | Sich und (cost of debt and cost of Preference Capita) then the EPS wout 6. teres in sting Fes Cost Fer eens (oer ances meaty oda’ investment i he Kem. Uso sing DCL = Contbaton/ EBT srr et certily much moeim case of debs beaut uit Oe CConebion = 25 ~ 15) x 4000 = £48,000 th ee pn cle ch lower than he aparen ate of erent 8 EBT Contiuion Fhe Cot - rane st the oe at. pret nor Sgn 7 reas 4 00 = P20 = #4000 = 64 Se eae dividend erly an appropriation ofthe prof Pte cial Leverages mos the sol deciding fctor in Capit Structure Thus Det » £88 025 ot nese Fe Cost» DO» #98 = Baa Bg oats ane cen Poe 32,00, DCI. Post decrease in SP, unit) = 20% ag (0.18 West noes on te rome-made ever ‘ox Homesnade Iversge. Inthe work inane erage meas tain eer ed ent ss o fine cet fans, Wien fed cst tse: oe used ie seine lel he emia van rn eo as ve have francs eee Homevace means something peso Tey meme wap me pa ag ft ie en cpap row an cate cpt ergs, i. whey Soro oi ea eal ema ge Of cane esa an te eee ng sare oft ee The cna pret fo si and Magarin oh cil are wiee they nonstate that verso eee pr eee hen hey move fr fn sate ‘pena at thei fetam and risk exposure remains unchanged, Sitatinma tee ee the capital structure policy ‘ofa firm {plomttuphimenae agus thy cn cee a Om | Q. 16. Why must the finance mar cpt Se et a ce as we a ied eget me estes cine it hs is effect on EPS. Company witha greater degree of EBT 5r one in I ein over of seq share pil providers. For desing Sener ptm Copia Soctare we cam ibs an aly f (he aoe ten EPS fe OTT nde diferent methods of nancing, sa eed the EPSEBIT analysis which a good Financial Manager would cS fs ane wae desing the Capital Suture of ay enterpaie, Dat Sr hy fearing» WO shan the cot of Ge and cot of pefecenee Fendi mores the ths SPSEBT technique shold ot be wae etal oe ees tne EPS canbe improved by iatroducng more deb or mre tn the expfl structure This ukimatey improves the market tue ofthe ey shares Tirancal leverage x35 ss a Finance Managers 3 ‘havior vl of theft ‘roa tums tothe ity share whenever a frm has debts or otber sonrees of funds It Lill to choose a rational capital mix so as to have "The presence of fixed interest sources of funds gives Holders Tis leo called trading on equity. But in SA ihe earnings ave not enough to.cover those fed financial charges then the ‘Kercholdere will love the returns and EPS will decline due to use of fixed Ehuncel charges, hence a Financial Manager must keep in. mind the financial Teyerage 20 a3 fo reap is benefits Q.17 Is it true that a firm Ihave high degree of financial leverage? “Ans, The Operating Leverage (OL) appears whereas the Financial Leverage (PL) appeats when the firm has a fixed financial Tharge The fined cost magnifies the effoct of variability ofthe sles inthe level of BEIT, and thus, the OL, incresges the varabilty of the EBIT. The fixed financial charge magnifies the effec of variability of the EBTT en the level of EFS land thus FL sereaces the varablity ofthe EPS. Thus there i a else similar ‘between OL and the FL in that both present an opportunity to gain from the fixed nature of certain costs in relation to incremental profits, Or the basis ofthe (Gla finance manager ean ascertain the zesonable level of fixed cost, The FL degree of operating leverage should pots ifthe frm has fsed operating cost Scanned with CamScannersaya ELH SERIES ihe eet of ed ar A736 FF tical | of et peared teach be, nl 1 avg ee 6 een anal anning? - . eso, con anys a i ig nan Beeen a= 1? =f «irancia] Breakeeven point FAE=0 snancial Manager must Keep in mind thy, 1 Mara erence AVidend ee) sximumn Tis Would serye "he fist sep ito know ET the EPS wil be eyual 0 ze) RO1SNon “Ans. There are different techniques of analyzing the Fisk-return etic eye capil soca. The Leverage Analysis and EBIT- Ts ee a rigs n vege ays, ereiaoship bebe) aca webs esd Totes of leverage are usual reerape and Pancal Leverage. A combine be calculated. The operating leverage establishes the rem Oe een Sales and ECT. The Sana leverage EOS. the opener given changein EBT “foaiy a he afc of diferent pte of financing o he Banc leverage onthe evel of returs othe shareholders, under diferent ccomtond ‘of EBIT is known as EBIT-EPS analysis. Thus it considers the effect on EPS ‘under, ent ofa ey ko hr te os ergs te ler of debt rani, gente vould e the ee aan ge Rs etn oat debt, then the effect of increase in leverage on EPS would be negative. 4 ‘Q., Camment pon the wll of nt income approach af aptl stra Pe jet Eee aes pe np Aig i ape th cpt ute in lett the eal th th hare inh opel cnc an veal ep ine cst pil ea hl woe tte higher dt SEE capil sie mes igh nan leverage nd this esl in ene te el or oie areag cot of pti ft i. ect mando ene inte va fey sare Seopa aun tet ale of equity shares 2 Sampo ot cremate mates Pal. There are usually thee (@) Corporate taxes do not exist. amipist Fr ett sips AND FINANCING DECISION a ofthe investors LUT: COST OF CAPTAL fon rte is Tess jp vet cn dns ot cing he PCE QB Sire hana gs 3 oqializat ty epi ae , ee eta ite oa es ena state NRE ET he i pis at eo ep i ino de a nd isn fae prac werd 0 a Bait ns sap sre oe =? eet ity and De. of a a ee cen Leverage and cost of capital 2 st iferent om net ope . eae" How i ie crest os portion of bt capital in total capa of he Seay ‘gin Discus sient income 2 Pf Levee eae Pa ff capt mens Cont of CPi or overal cst of exit 1 ee tego: cbt apa 0 ete etic erg nd com of capital et tate Peppa the over cst of ctl In se spproteh a ame Tapers the pec cot of ty ep ting Ince Approach cof Net Income ie, fim case of Net oe sttety tsi is expleined by way of 0 ittetions Ar income Approach: k= 036 (given) alee Fi 2300 ai a pao 175000 Nt Tmt | = creates | o18teor 13.16% i a 7 _ Rao ol Tat Net Income Approach. Proportk eral cost of capital fe, ky t@ mor from 16% to 13188, [Net Operating Income Approach; Giver sa ef Towest debt is 47%, This compels the wwe downwards, In this ilustration it moves E neooied Fin | Levered Finn 0000 @ 1% zawco | 0 224000 24000 NL 1.0.00 roo 7200 Scanned with CamScanner