Professional Documents
Culture Documents
SFM - Sem 3
SFM - Sem 3
Syllabus
T 2 CHAP 1
T 2 CHAP 2
T 2 CHAP 4
T 2 CHAP 7 T 2 CHAP 14
Syllabus
Chapter 6 17-19 Analysis of Risk and Uncertainty
CHAP 12
T1
Chapter 7 20-23 Business Restructuring and Industrial sickness Chapter 8 24-27 Designing Capital Structure Chapter 9 28-30 Operating Financial and Combined Leverage
T 2 CHAP 16
T 1 CHAP 20
T 1 CHAP 18
Chapter 1
Financial strategy and planning
What is strategy?
Strategy :- where the organization want to go to fulfill its purpose and achieve its mission , it provides a frame work for guiding choices which determine the organizational nature and direction and these choices relates to the organizations products or services , markets , key capabilities , growth , return on capital and allocation of resources in short it is declaration of intent of the organization
A systematic analytical approach which reviews the business as a whole in relation to its environment with the object of the following . Developing an integrated , coordinated and consistent view of the route the company wishes to follow Facilitating the adaptation of the organization to environmental changes Process to establish priorities on what you will accomplish in the future Forces you to make choices on what you will do and what you will not do Pulls the entire organization together around a single game plan for execution Broad outline on where resources will get allocated
:Competitive forces for formulating 1.The threat of new entrant. and implementing business strategy
2.The threat of substitute product or services. 3.The rivalry amongst the existing players of industry. 4.The bargaining power of supplier. 5.The bargaining power of consumer.
International factors
Develop communities like European union Foreign exchange rates of countries Inflation, interest and wages rates Economic and trade agreement Entry barriers Economic environment Globalization and liberalization of trade business Double taxation relief agreements BOP and BOT Monetary and economic policy Personal and corporate tax rates Political situation
of the
Internal factors
Inflation rate GDP
Personal and corporate tax rates BOP and BOT Foreign exchange rates of countries Monetary and economic policy Government policy and subsidy Fiscal deficit Entry and exit barriers Un employment rates Availability of technology Man power
Organizational factors
Nature of business Size of business Expectation of market return Assets and liability structure of firm Efficiency of the firm Ownership pattern Age of the business Liquidity of the firm Technology adapted Efficiency of human resource ROI generated
It is a Part of Planning process. They are inferences as to what the future may be. Extends over a time horizon. Based on:
Economic assumptions (interest rate, inflation rate, growth rate and so on).
ii. Sales forecast. iii. Pro forma statements of Income account and Balance sheet. iv. Asset requirements. v. Financing plan. vi. Cash Budget A forecasts is a prediction of a given set of circumstances. The dictionary meaning of forecast is prediction, provision against future, calculation of probable events, foresight, prevision. It is called the calculation of probable events
(a) provides basic necessary information (b) acts as a control device (c) provides necessary information for decision making (d) optimum utilization of firms resources. (e) projects the funds requirement in advance. (f) alarms the management events concern going out control. (g) enables the preparation updating (h) information needed for expansion
Simple linear Regression method Multiple regression method Projected fund flow cash flow method External Funds requirement Internal Growth Rate Sustainable Growth Rate
Pro forma Income Statement. (Represents the operational plan for the whole organization.) Pro forma Balance sheet. (Reflects the cumulative impact of anticipated future decisions).
Assumes that future relationship between various elements of cost to sales will be similar to their historical relationships. These cost ratios are generally based on the average of previous two or three years. For example, Cost of Goods sold may be expressed as a percentage of Sales.
Day sales method It is traditional method used to forecast the sales by calculating the number of days sales and established its relation with the balance sheet items to arrive at the forecasted balance sheet. Specially emphasized on firms funds requirements
2.
3.
Employ Percent of Sales method to project items on the asset side, except Investments and Misc Exp & Losses. Expected values for Investment and Misc exp can be estimated using specific information. Use Percent of sales method to project values of current liabilities and Provisions.
Projected values of Revenue & Sales can be obtained by adding projected retained earnings from P&L Performa statement.
4.
Continue
5. Projected value for Equity and preferential capital can be set tentatively equal to their previous values. 6. Projected values for loan funds will be tentatively equal to their previous level less repayments or retirements. 5. Compare the total of asset side with that of liabilities side and determine the balancing figure. (If assets exceed liabilities, the balancing figure represents external funding requirement. If liabilities exceeds Assets, the balancing item represents surplus available funds )
Sales Dollars
EFR= A/S (S) L/S (S) m S1(1-d) Where, EFR= external funds requirement A/S = Current Assets and Fixed Assets as proportion of Sales
g* = ROE (1 - b)
where b = dividend payout ratio (dividends / net income) ROE = return on equity (net income / common equity) or
net income sales sales x assets x assets common equity
STEPS IN FINANCIAL PLANNING PROCESS Clearly define mission and goal Determination of financial objectives Formulation of policy [debt : equity : CR : WC] Designing financial procedure [day 2 day function] Search for opportunities. Identify possible course of action [need of finance can be met by various sources] Screening of alternatives [ risk and return ] Assembling of information [ helps in decision making] Evaluation of alternatives Implementation, monitoring and control
Nature of decision : A decision maker assumes that .. It should have a complete knowledge of all the possible alternatives . It should have the knowledge of all the possible outcome of taking every alternatives. It should attach definite payoff to each possible alternatives. Can order the payoff of each course of action in the sequences from highest to lowest.
Identify causes
State aims
Examines resource s
Two or more partners united to conduct a business jointly, and What Does "limited liability the partners (LLP). Mean? to in which one or more of partnership" is liable only the extent of the amount of money that partner has invested. Limited partners do not receive dividends, but enjoy direct access to the flow of income and expenses.
Limited Liability Partnership is managed as per the LLP Agreement, however in the absence of such agreement the LLP would be governed by the framework provided in Schedule 1 of Limited Liability Partnership Act, 2008 which describes the matters relating to mutual rights and duties of partners of the LLP and of the limited liability partnership and its partners.
Advantages of LLP
Renowned and accepted form of business worldwide in comparison to Company. Low cost of Formation. Easy to establish. Easy to manage & run. No requirement of any minimum capital contribution. No restrictions as to maximum number of partners. LLP & its partners are distinct from each other. Partners are not liable for Act of partners. Less Compliance level. No exposure to personal assets of the partners except in case of fraud. Fewer requirements as to maintenance of statutory records. Less Government Intervention. Easy to dissolve or wind-up. Professionals can form Multi-disciplinary Professional LLP, which was not allowed earlier.
Audit requirement only in case of contributions exceeding Rs. 25 lakh or turnover exceeding Rs. 40 lakh.
Disadvantages of LLP
Any act of the partner without the other partner, may bind the LLP. Under some cases, liability may extend to personal assets of partners. Cannot raise money from Public.
Agency Costs : A type of internal cost that arises from, or must be paid to, an agent acting on behalf of a principal. Agency costs arise because of core problems such as conflicts of interest between shareholders and management. Shareholders wish for management to run the company in a way that increases shareholder value. But management may wish to grow the company in ways that maximize their personal power and wealth that may not be in the best interests of shareholders.
A/S =0.80 S=60 LAKHS L/S = 0.5 M=0.04 S1 = 500 LAKHS D = 0.6 There Will Be No Change In The Level Of Investment And Repayment Of The Term Loan In The Next Year. [A] Estimates The External Fund Requirement For The Next Year. [B] Suppose The Growth Rate Of Net Profit Margin Is 10% For The Next Year, what Then Will Be The External Fund Requirements.
The balance sheet of smart ltd for year march 2010 is as follows.
Liabilities
Share capital Reserves Long term loan Short term loan Payables Provisions
Amt [ lakh]
200 140 360 200 120 80 1100
Assets
f.A Inventories Receivables Cash and bank
Amt [ lakh]
500 300 240 60
1100
Sales for the year were rs 600 lakh. f or the year ending the sales expected to increase by 20%.the profit margin and dividend ratio are expected to be 4 % and 50% . Calculate:-1.quantify the amt of external fund requirements. 2.Determind the mode of raising a fund for given parameters.
[a] current ration should be 1.33 [b] ratio of FA to long term loan should be 1.5
[c] long term debt to equity ratio should not exceed 1.05
3.The fund are to be raised in the order of ST bank borrowing ,LT loan and Equity
Assignments
Topic Roll number
Chapter 2
Project Planning and Control
Capital Budgeting
Capital investment involves a cash outflow in the immediate future in anticipation of returns at a future date. The planning and control of capital expenditure is termed as capital budgeting. Capital budgeting is the art of finding assets that are worth more than they cost, to achieve a predetermined goal i.e. optimizing the wealth of a business enterprise.
Types of Projects
Balancing projects Modernization Projects Replacement Projects Expansion Projects Diversification Projects
The above report is also called Preinvestment Study Report. It is prepared for establishing the projects viability with sufficient backup for the purpose of evaluation of investment proposal by the entrepreneur.
Market Survey
Most useful for industrial products, consumer durables and for other products where buyer plans purchases in advance Useful for new products where no past sales data is available A project investment decision is made only if economical feasibility report suggests that basing on market survey.
Market survey
The effectiveness of this technique depends upon a number of variables I. Number of potential buyers.: if no is small then very high proportion of them can be questioned. II. Clarity of buyers in intentions III. Other factors:
I. The cost of identifying and contacting buyers II. Buyers willingness to disclose their intentions III. Buyers propensity to carry out their intentions
baselines like;
(a) Watch and measure the achievements at short intervals (b) Ascertain current variances and predict future variances (c) Ascertain root causes of variances (d) Take actions to offset the ill-effects of past variances (e) Prevent future potential variances
(f) Track and measure the quantitative output and cost inputs.
(g) Evaluate targets, output and input in financial terms. (h) Special monitoring of essential tasks by using techniques like red-lists, hotline reports to draw top managements attention. (i) Introduction of incentives for good performance. (j) Doing away with red-tapism (avoiding unnecessary rules and regulations) and Bureaucratic procedures.
5.
6. Insurance against loss in export of goods and services. ECGC also provides guarantees to banks and financial instructions to enable exporters to obtain better facilities from them. 7. Financial facilities at special confessional rates of interest are given by commercial banks. 8. 100% foreign equity participation is allowed but the company should be an Indian company
9.
Imports of capital goods/components and raw material are exempted from import duty.
10. Single point clearance with simplified procedures. 11. Relaxations are allowed in respect of sales tax property tax, octroi etc. 12. Tax holiday is available for 100% export oriented units.
3. Government provides comprehensive assistance to small entrepreneurs through various organizations like Small Industries Development Organization. 4. Priority and assistance is provided in allotment of land.
5. State Financial Corporations provide long and medium term loans to small industries at concessional rates.
F. Clear understanding of customers requirement and ensuring customers loyalty on-going basis.
G. Down-sizing, delivering and business process re-engineering to ensure efficiency in operations to service to customers.
H. Deployment of techniques like total quality management, six sigma, activity based cost management etc. I. Strategic alliance with Indian and foreign companies, joint ventures with foreign companies, start new business or revamp existing business
At Sectorial level- Where policies, planning and strategies focus on growth and development of a single sector like industrial or agricultural or social amenities etc. besetting certain parameters.
At Project level- Where one single project is planned and studied from all the economic. technical and financial and environmental perspectives in a more microscopic manner.
needs.
E. F. Controlling fiscal monetary frameworks in accordance with the changing times. Maintaining wage policy, exchange rate policy and other inflationary pressures. G. Motivating the economic behavior by rational allocation of resources, capital accumulation, and maintaining balance of payments etc.
E.
F.
1. Pre-feasibility Stage
A. Bureaucratic
delays in obtaining clearances e.g. pollution/
environmental clearance
B. Securing necessary approvals from regulatory agencies and financial bodies. C. Inadequate infrastructure facilities like roads etc. D. Failure to plan important resources, tie-ups and inputs needed
2. Evaluation Stage
A. The better the evaluation, greater the chances of eventual project success in terms of meeting time schedule and budget,
3. Choice of Technology
A. Selection of wrong and outdated technology. B. Selecting technology on considerations of credit offered by the supplier rather than of technical necessities. C. Delay in completing detailed engineering non-availability of
5. Construction Stage
A. Starting construction activities without proper planning and even before ensuring the availability of working drawings storage space, supply of equipment and materials and adequate infrastructure
commissioning contractors.
C. Defects in erection and installation and teething troubles resulting from bad quality control during erection and inadequate of equipment.
breakdown the project into Work Breakdown Structure (WBS) and develop from then the Master Schedule, Milestone Network and Master Budget. These major tools will help to control the time and cost factors of project performance.
B.
Time and Resources Schedule- From the Master Schedule and master Budget, detailed schedules of tome and resources are prepared. These
Its a tool to measure financial viability of project Formally, its an analytical tool that enables systematic comparison between the estimated cost and projected benefits from the project. Basically CBA used to determine
1. Whether or not a specific operation should be undertaken 2. Which of the possible alternative projects should be selected 3. Which time cycle would be most beneficial to the project
Determine problem to be considered Ascertain alternative solutions to problem Estimate and analyze costs and benefits Appraise estimated costs and benefits Decide on Optimal solution
Techniques of CBA
A. Discounted Cash Flow (DCF)
1) Net Present Value 2) Internal Rate of Return
Benefits of CBA
CBA can be used simply to ensure that value for money is obtained from a project which requires the investment of funds.
they produce and the costs that will be incurred CBA studies attempt to allow for social costs and benefits.
Public sector projects, the discipline of trying to apply a consistent method of measurement in these areas should help to produce better decisions which take important subjective factors into account. Placing realistic values on such things as good healthy, quiet houses or protection from a potential enemy CBA have sometimes attempted the impossible and the task of listing relevant costs and benefits of in itself a valuable discipline.
Limitations of CBA
The accuracy of data input. Not only are estimated costs and benefits difficult to forecast, but often they are even more difficult to quantify. A special form of capital budgeting which is applicable to public sector. Subjective judgment will also bean important part of costbenefit analysis Procedures for public sector project appraisal, the technique makes a significant contribution towards improved decisionmaking.
The following social desirability factors will be considered in accept or reject decisions of a project
A. Employment Potential B. Foreign Exchange Earnings C. Social Cost-Benefit Analysis D. Capital-Output Ratio E. Value Added per unit of Capital
The ERP offered to a particular stage of manufacture of a product is an important consideration in determination of competitive strength of the product.
indicator of competitive strength of a product in the international market. In calculation of ERP, the basic parametial is value added which is the difference of selling price of a product and the cost of material inputs. Value addition is the basic parameter in calculation of ERP.
Chapter 3
Risk Evaluation in Capital Budgeting
2. Consideration of risk and uncertainty - The taking of right decision at right time is essential for the business. There are many occasions when one decision can lead to more than one outcomes, such situation are beset with uncertainty. - Uncertainty arises because of the lack of experience and knowledge, and mainly arise because of - Date of completion, level of capital outlay required, level of selling price, level of sales volume, level of revenue, level of operating cost and taxation rules,
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3. Risk analysis in project selection - The acceptability of projects depends upon cash flows and risk. - risk must be considered when estimating the required rate of return on project. - There is trade-off between risk and return which must be reflected in the discount rates applied to investment opportunities. - Project will be accepted which has probable lower risk and higher rate of return.
Risk Management
Risk management is the process of measuring or assessing risk and developing strategies to manage it. Objectives of RM - Anticipating the uncertainty and the degree of uncertainty of the events not happening the way they are planned. - Channelizing events to be happen the way the are planned. - Setting right deviations from plans, whenever they occur. - Ensuring that objective of the planned events is achieved by alternative means, when the means chosen proves wrong. - In case the expected event is frustrated, making the damage minimal.
Conti.
Steps in RM Process - Identifying and classifying the areas and nature of risks - Evaluating degree of risks - Eliminating the risks, wherever possible - Overcoming the risk by timely action - Transferring the risks appropriately
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Enterprise risk management It is defined as a process, effected by an entitys board of directors, management and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity, and manage risk to be within its risk appetite, to provide reasonable assurance regarding the achievement of entity objective. ERM is comprehensive and integrated approach to addressing corporate risk. ERM enables management to effectively deal with uncertainty and associated risk and opportunity, enhancing capacity to build value.
It is measure of likelihood of an event happening or not happening, as planned. It is basically statistical technique to measure probability of occurrence an event and probability of its nonoccurrence. The whole theory of probability is based on the following three axioms: 1. The probability (p) of an event ranges from zero to one. 2. The p of entire sample space is 1. 3. If A and B events are mutually exclusive events then probability of occurrence of either A or B denoted by: P(A+B) = P(A) + (B). The application of this theory requires the knowledge of Action, events, expected value, pay-off. Disadvantages: - It ignores the other characteristics of the distribution that is ranges and skewness. - It assumes that risk is neutral.
Probability analysis
Advantages: - Simple to understand and calculate - Represent whole distribution by single figure - Arithmetically take account of the expected variability of all outcomes. Example: 4.1A company has a variable cost 8 p.u and a fixed cost of rs
60000
70000`
0.2
0.1
40000
0.3
On the basis of EV contribution and profit , which sales price should be selected
Conti
Optimistic, most likely and pessimistic Approach. - This analysis will help in understanding the full range of possible outcomes from a decision and will help the decision
Example: 4.2
Value of Information
Information can reduce the uncertainty Value of Perfect Information: it removes all doubt and uncertainty from a decision and it would enable managers to make decisions with complete confidence. Value of Imperfect Information: market research findings or information from pilot tests and so on are likely to be reasonable accurate, but they can still be wrong , they provide imperfect information. It is possible to arrive at an assessment of how much it would be worth paying for such imperfect information, given that we have a rough indication of how right or wrong it is likely to be. Example: 4.3
Sensitivity analysis
Sensitivity analysis is made along with uncertainty and probability analysis, to determine the extent of action to be taken. The higher the sensitivity of influence on event, higher the risk and the damage. It can help to mitigate the impact of influence, depending upon the severity of damage occurring out of risks. It is study of key assumption on which management decision is based in order to predict alternatives outcomes of that decision if different assumption are adopted. It aids in identifying the most sensitive factors, that may cause the error in estimation. It involves the three steps - Identification of all those factors having influence on the projects NPV or IRR. - Define quantitative relationship among them. - Analyze impact of each of them on project. Example: 4.4
Simulation
It is representation of a system by a model which will react to change in a similar way to that which is being simulated. There are several technique of simulation, among them Monte Carlo method is more popular. It uses random numbers and is used to solve the problem which involves conditions of uncertainty. In simulation, generally computer is used. Some problems are too complex to solve with pure mathematics or risk situation that defy a practical mathematical solution. In such situation simulation is used.
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Steps in simulation process Define the problem precisely. Introduce the variable associated with the problems. Construct a numerical model. Set up possible courses of action for testing. Run the experiments. Consider the results and possibilities to modify the model of change data inputs. - Decides what course of action to take.
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Advantages - It can be used to investigate the behavior of problems which are too complex to be modelled mathematically. - It can also be used when the variables in the problem. E.g. arrival time, service time do not follow the standard distribution required for the mathematical models, i.e. Poisson distribution, Normal exponential distribution - It does not interfere with the real world system but only with table model and therefore, it results in savings of cost. - It is micro analysis of big and complicated system by breaking into each subsystem and studying the interface of the various subsystems. - It saves time and it allows us to study interactive effect of each variable.
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Disadvantages - It is not an optimizing technique, it simply allows us to select best alternatives. - Reliable results is only possible if simulation will continued for long period. - A computer is essential to cope up with amount of calculation in simulation modeling. - To develop simulation model means consumption of voluminous data and it may be very costly. Each model is unique and same solution cannot ne applied for another situation. - It does not produce answers by itself. - It is not as efficient as analytical methods. Example: 4.5
Project Beta
The measure of risk is expressed as Beta (). Beta is an expression of the market sensitivity of an investment, or how volatile it is compared with the normal volatility of the market. Example: 4.8, 4.9, 4.10, 4.11
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2. Statistical Exponential Analysis: - It is a study of pattern of occurrence of events and influence over periods of time based on past experience. - It is a graphical representation to extend the past into the future with necessary weightage.
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3. Computer Analysis - It is not a method by itself but the use if computers to capture, collate and analyze the mass data to derive at the pertinent information.
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4. ELGI Approach: - It means Estimate, learn, group, Implement - Scientific approaches of ELGI are: Uncertainty analysis Probability analysis Sensitivity analysis Statistical Exponential analysis Information analysis SWOT analysis
Chapter 4
Dividend and Retention Policies
Dividends
The dividends are periodic cash payments by the company to its shareholders. The dividends payable to the preference shareholders is usually fixed by the terms of the issue of preference shares. But the dividend on equity share is payable at the discretion of the board of directors of the company.
Kinds of Dividend
a) The dividend payments may be interim of final. This date on which the announcement is made of new dividend is called dividend declaration date b) The dividend payment will be made to the members whose names appear in the register of members on a particular date is called record date c) The date from which the stock begins to trade without the right to receive the dividend declared is called ex-dividend date d) The date on which the company actually mails the dividend warrants is called payment date
Dividend may be
Interim dividend Final dividend Preference dividend
DETERMINANTS OF DIVIDENDPOLICY
Transaction costs
Firms transaction costs Shareholders transaction costs
Personal taxation Dividend clientele Dividend Payout Ratio Dividend per share Earnings per share Dividend Cover Profit after tax Dividend
Dividend signalling Divisible profits Liquidity Rate of expansion Rate of return Stability of Earnings Stability of Dividends Legal provisions Contractual constraints Cost of financing Degree of control Capital Market Access State of Economy
Dividend Policies
Constant dividend payout Policy Constant Dividend Rate Policy Optimum dividend Policy
DPS
No. of Years The relation of EPS and DPS under this policy is shown in figure
Multiple dividend increase policy: Regular dividend plus extra dividend policy: Uniform cash dividend plus bonus share policy:
No. of Years The relation of EPS and DPS under this policy is shown in figure
B (combined effect)
Dividend valuation model assumes, a constant level of growth in dividends in perpetuity. Gordon growth model is a theoretical model used to value ordinary share equity share. The main proposition of the model is that the value of share reflects the value of future dividends accruing to that share. The model holds that shares market price is equal to the sum of shares discounted future dividend payments.
Assumptions
The firm is an all-equity firm and has no debt External financing is not used in the firm. Retained earnings represent the only source of financing. The internal rate of return is the firms cost of capital k. It remains constant and is taken as the appropriate discount rate. Future annual growth rate dividend is expeted to be constant. Growth rate of the firm is the product of retention ratio and its rate of return.
Cost of capital is always greater than the growth rate. The company has perpetual life and the stream of earning are perpetual. Corporate taxes does not exist. The retention ratio b, once decided upon, remains constant. Therefore, the growth rate g=br, is also constant forever.
Example
A Company earns Rs. 10 per share at a internal rate of 15%, the firm has policy of paying 40% earning as dividend, if the cost of capital is 10% determine the price of share by Gordon Model.
Criticism
In real world ,the constant dividend growth and earnings growth is a fallacy. The model implies that if Do is zero, the value of share is nil. The capital gains are igonred by the model. The false assumption is that investors will buy and hold the shares for an infinite period of time.
The model ignores the allowance for corporate and personal taxation. The diminishing marginal efficiency of investment is ignored. The effect of charge in the firms risk-class and its effect on firms cost of capital in ignored.
P=
D + R (E-D) a Rc R
Valuation
Market price per share is the sum of the present value of the infinite stream of constant dividends and present value of the infinite stream of capital gains.
P (DIV / k )
(r / k ) (EPS DIV) k
Where , P= Current market price of equity share E= Earning per share D= Dividend per share (E-D)= Retained earning per share Ra = Rate of return on firms investment Rc= Cost of equity capital ASSUMPTION: Internal financing Return on investment remain constant Infinite time 100% payout or retention Constant EPS and DIV IRR and cost of capital constant.
IMPLICATION BEHIND THE WALTERS MODEL: The optimum dividend policy of firm is determined by the relationship of Ra and RC . If R>R , the firm can retain the earning and that firms are called as growth firms and their dividend policy would be the plough back earnings. optimum payout ratio for a growth firm is nil.
If R<R, the optimum dividend policy would be to distribute the entire earnings as dividend and that firms are called declining firms. optimum payout ratio for this firm is 100%. If R=R, it does not matter whether the firm retains or distribute its earnings, and such firms are called normal firms and optimal payout ratio is irrelevant. The price per share does not vary with changes in dividend payout ratio.
Basic Tenets
MM-Dividend Irrelevancy Theory is based on the following tenets:
(1)Investment Policy (2)Earning Power (3)Signaling Effect (4)Information Content (5)Clientele Effect
MM dividend irrelevance model holds good in a world of certainty and confirms to condition of symmetric market rationality, which requires the following:
(1)All investors are expected to maximize their wealth. (2)All investors will have similar expectation. (3)All investors behave rationally and believe that other market participants also behave rationally.
According to MM model the market price of a share, after dividend declared, is calculated by applying the following formula:
P0
P1 + D1 1 + Ke
Where, P0 = Prevailling market price of a share P1 = Market price of a share at the end of period one D1 = Dividend to be received at the end of period one Ke = Cost of equity capital
The number of shares to be issued to implement the new projects is ascertained with the help of the following formula: I ( E nD1 )
N =
P1
Where, N = Change in the number of shares outstanding during the period I = Total investment amount required for capital budget E = earnings of the net income of the firm during the period n = Number of shares outstanding at the beginning of the period D1 = Dividend to be received at the end of the period one P1 = market price of the share at the end of the period one
Assumptions
(1) There are no personal or corporate taxes. (2) There are no stock flotation costs, transaction costs and brokerage fees. (3) Dividend policy has no effect on the firms cost of equity. (4) The firms capital investment policy is independent of its dividend policy. (5) Investors and managers have equal and cost less access to information regarding future opportunities. (6) All investors can lend or borrow at the same rate of interest.
(7) No buyer or seller of securities can influence prices. (8) Dividend decision are not used to convey information. (9) Perfect capital market exists with free flow of information. (10) Investors have rationally, they try to increase their income and wealth and are indifferent to the form in which a given increase to their income or wealth takes place viz, dividend or capital gain. (11) No tax differential between distributed and undistributed profits as also between dividends and capital gains. (12) Investment opportunities and future net income of all companies are known with certainty to all market participants.
BONUS SHARES
If a Company is profit making, its accumulated profits and reserves will go on increasing. Thus, actual capital employed i.e. share capital plus accumulated free reserves is much higher than the amount of share capital. The profit earned might appear to be much higher as compared to share capital. To avoid this abnormality in the capital structure, part of free reserves can be distributed among the existing shareholders by issue of bonus shares. Sometime, bonus shares also called as scrip dividends. As an alternative to paying out cash dividends every year, a company may choose to pay a scrip dividend. This is essentially a transfer to the shareholder of a no. of additional equity shares without the shareholder having to subscribe additional cash.
However, bonus share cannot be issued in lieu of dividend. The bonus issue increases the voting power of promoters marginally. The reason being, that the small shareholders position and representation gets diluted and spreads across the nation. Due to the increased volume of stock in hand, promoters are in a better position to trade and speculated well in the market without risk of being voted out.
ADVANTAGES
It preserves the companys liquidity as no case leaves the company. The shareholder receives a dividend which can be converted into cash whenever he wises through selling the additional shares. It broadens the capital base and improves image of the company. It is an inexpensive method of raising capital by which the cash resources of the company are conserved. It reduces the market price of the shares, rendering the shares more marketable. It is an indication to the prospective investors about the financial soundness of the company. The quantum of cash dividend will increase in future years. It improves liquidity for the stock in the market, as more shares available in the markets, as well as, the stock becomes attractive.
The bonus decision signals about the future growth and earning of the company.
DISADVANTAGE
The future rate of dividend will decline. The future market price of share falls sharply after bonus issue. Issue of bonus shares involves lengthy legal procedures and approvals. The chances of reaching a peak stock price performance may be lost. The company may not be in a position to maintain the same percentage dividend after a bonus issue. Retail shareholders have no choice except to accept the decision to bonus issue. Bonus shares cannot be declared in lieu of dividend. Bonus shares cannot be declared out of revaluation reserve.
Chapter 5
Valuation of Business
Introduction
The valuation of shares and business is resorted when the mergers and acquisitions proposals are under consideration. Based on the value of business the purchase consideration is determined. It may also be warranted at the times of business alliance, joint venture, employee stock option plan, wealth tax assessment, purchase of controlling interest or block of shares, conversion of shares, pledging of shares as security for obtaining loan etc.
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The valuation of shares and business require expertise knowledge and hence a specialist valuer is appointed for the purpose. Value of business depends not just on assets it carries but is determined mostly by the projects in hand, the risk profile of the different classes of business it carries and intangible assets it possess. It is not at all possible to ascertain the value of business accurately, but the valuer uses his skill, experience and knowledge in determination of fair value of business. It is done by determining its market price. In publically quoted companies, whose shares re regularly traded on the stock exchange, the valuation of a company is simply valued by multiplying up the share price by the number of shares in issue.
161
162
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Another way of ascertaining the value of company is: Enterprise Value = Equity value + Market Value of Debt + Monitory interests + pension provisions + Other claims Value per share = Shareholders equity No. of equity shares outstanding
163
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Difficulties in Valuation: Business are not alike and interchangeable Subject to corporate strategy Auctions are often oligopolistic Imperfect information Management makes a difference Closed auctions.
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Capital Structure and Business Value - A levered firm carries debt along with equity. - The difference in the value of the levered company is not just the value of debt. - The debt will bring with it interest tax shields which have a value in themselves, and it will also impose a different risk profile on the equity. - the more debt, the more the equity.
165
166
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Intrinsic Value of Equity share = Net Assets available to equity shareholders Number of Equity shares Example: 14.1 Example: 14.3
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1. Dividend yield method Value per share = (companys dividend per share / Industry average dividend per share) * Nominal value of companys share. Value of business = value per equity share * total number of equity shares.
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Disadvantages: - It ignores the elements of capital gain which is the important financial justification for investing in shares. - The growth of a company could be seen as being a mean to securing the flow of dividends to shareholders in future, rather than a goal in itself. - The method is based on the assumption that dividend policy will remain constant. In practice, companies can and do change their dividend policies. - In case of unquoted company, it is not suitable. Example: 14.3 Example: 14.4 Example: 14.5
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2. Earning yield method calculation of earning yield value involves three steps: A. Predict the future maintainable profits of the company being valued. B. Identify the required earning yield by reference to the results of similar companies. C. Apply the earnings yield to future profits using the following formula. Value of business = Companys expected future maintainable profits Industrys normal earning yield Example: 14.6, 14.7, 14.8, 14.9
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3. Return on capital employed method Steps are: a. Select the past period of investigation. b. Estimate the future maintainable profits, after making any necessary adjustments. c. Establish the acceptable normal rate of return on capital invested in a similar typr of company, allowing for the industry effect, the size of the company, and the level of capital gearing. d. Capitalize maintainable profits at a rate established as the acceptable rate of return. Value of Business: Companys estimated future maintainable profits Industrys normal rate of return on capital employed Example: 14.10, 14.11
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4. Price/earning method Value of business = Companys expected future maintainable profits * Industrys average P / E ratio. Value of Shares = Company's expected earnings per share * Industrys average P / E ratio. Example: 14.12
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Fair Value of Share It is = (Value of share under net asset method + value of share under dividend yields method) / 2
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Conti
1. Discounted Dividend Model It estimates the equity value based on the view that the value of the equity equals all future dividends discounted back today. Steps are: a. It requires the estimation of future expected dividend payments, say first five to ten years which us called as explicit period and then discounted back today using the appropriated cost of capital for each year. b. After the explicit period, long term dividend growth and the appropriate long term cost of capital need to be forecasted in order to determine the terminal value of equity after the explicit period to infinity.
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c. The terminal value then need to be discounted back to present. d. The cost of capital used in calculation should reflect the inherent risk in that particular cash flow. The higher the risk, the higher the cost of capital. e. Only one cost of capital and one growth rate is used in terminal value calculation. Equation : page No. 754
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2. Discounted Cash flow Model It equals the enterprise value of all future cash flows discounted back to today using the appropriate cost of capital. Steps are: a. Forecast the free cash flows and WACC for each year of the explicit period. b. Cash streams are discounted today. c. Cash streams after explicit year to infinity are calculated, assuming the cost of capital and growth rate are constant after the explicit period. Equation : page No. 754
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3. Discounted Internal Rate of Return Model in this, the future cash flows are discounted using the weighted average internal rate of return of all projects with the company. Equation: page no. 755
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4. Discounted Economic Value Added Model In this, the enterprise value equals the current capital stock plus the present value of all future EVA discounted to the present. It is measure of companys profitability and it is a variant of economic profit as determined by the accounting principles and practices. Equation: page no. 755
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1. Dividend growth valuation model It assumes a constant level of growth in dividends in perpetuity. Equation: page no. 756 Example: 14.16
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2. Walters share valuation model He argued that in the long run the share prices reflect only the present value of expected dividends, retentions influence stock price only through their effect on future dividends.
Conti
3. Modigliani and Millers dividend irrelevancy model MM argue that dividend policy does not have a significant effect on a firms value or on its share price. It asserts that firms value is determined solely by its investment decisions and that the dividend payout ratio is mere detail. Equation: page no. 758 Example: 14.18
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4. Capital asset pricing model It can be used to determine required rates of return on financial and physical assets. The model provides a strong analytical basis for evaluating risk-return relationship.
Conti
a. Revenue or sales multiple It reflects the value of the enterprise in relation to its revenues. It used to calculate both enterprise value and equity value.\ Equation: page no. 760
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b. Operating profit multiple An EBIDT multiple express the enterprise value in relation to cash flow as ascertained from the income statement. Equation: page no. 761
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c. Operating free cash flow multiple In this method, operating free cash floe is considered in valuation of the enterprise. The operating free cash flow represents EBIDT as reduced by annual capital expenditure and extraordinary items. Equation: page no. 761.
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d. Operating multiple It express the value of the company in relation to a specific operational activity. For example: for cement industry, multiplier is EV / Metric tonnes production.
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e. Price/earning multiple It expresses the value of the equity in relation to its earnings after tax. The stock prices of quoted companies are regularly described in terms of their p ? E ratio. Equation: page no. 761
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f. Price/book value multiple It reflects the market value of equity in relation to the companys book value. Book value is the adjusted book value of total assets less adjusted value of liabilities.
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Chapter 6
Analysis of Risk and Uncertainty
1. 2. 3.
estimated returns. The decision can be broken in to 3 types: Uncertainty Risk Certainty Risk refers to a set of unique outcomes for a given event which can be assigned probabilities, while uncertainty refers to the outcomes of a given event which are too unsure to be assigned probabilities. In risks, decision make can assign probabilities to various outcomes when they have historical data in uncertainty decision maker has no historical data.
Starting a new product will have more uncertain returns than the one involving expansion of an existing one. Estimating of returns from cost reduction type of capital budgeting will be subject to a lower degree of risk, than revenue-expanding capital budgeting project. Risk with reference to capital budgeting, results from the variation between the estimated and the actual returns. The greater the variability between the two, the more risky is the project.
Sensitivity analysis
Is a behavioral approach that uses a number of possible values for a given variable to assess its impact on a firm s returns. One measure which expresses risk in more precise terms is sensitivity analysis. It provides information as to how sensitive the estimated project parameters, namely, the expected cash flow, the discount rate and the project life are to estimation errors. It provides different cash flow estimates under three assumption: the worst , the expected and the best outcomes associated with the project.Example no 12.1
I.
Simulation
Is a statistically based behavioral approach used in capital budgeting to get a feel for risk by applying predetermined probability distributions and random numbers to estimate risky outcomes. Example no: 12.3
Standard deviation
Is the square root of the mean of the squared deviation being the difference between an outcome and the expected mean value of all outcomes.
Certainty equivalents
Are risk adjusted factors that represent the percent of estimated cash inflow that investors would be satisfied to receive for certain rather than the cash inflows that are possible/uncertain for each year.
Chapter 7
Business Restructuring and Industrial sickness
Decision tree
Is a pictorial representation in tree form which indicates the magnitude probability and interrelationships of all possible outcomes.
Chapter 8
Designing Capital Structure
Financial distress
Includes a broad spectrum of problems ranging from minor liquidity shortages to bankruptcy.
EBIT-EPS analysis/approach
Is an approach for selecting capital structure that maximizes earnings per share (EPS) over the expected range of earnings before interest and taxes.
Coverage ratio
Measures the size of interest payments relative to the EBIT and the adequacy of EBIT to meet payment obligations.
Debt capacity
Relates to how much debt can be comfortably serviced. Example no 20.1
manoeuverability
Implies the ability to adjust source of funds in response to change in the need for funds.
flexibility
As to financing is important when future external financing will be necessary.
Summary
A host of factors both quantitative and qualitative,including subjective judgment of financial managers have. a bearing on the determination of an optional capital structure of a firm They are not only highly complex but also conflicting in nature and,therefore cannot fit entirely into a theoretical framework moreover the weights assigned to various factors also vary widely,according to conditions in the economy, the industry and the company itself. Therefore, a corporate should attempt to evolve an appropriate capital structure, given the facts of a particular case. The key factors relevant to designing an appropriate capital structure are; (i) profitability (ii) liquidity (iii) control, (iv) leverage ratios in industry, (v) nature of industry, (vi) consultation with investment banks/lenders, (vii) commercial strategy, (ix) company characteristics and (x) tax planning. Given the objective of financial management to maximise the shareholders wealth a corporate should carry out profitability analysis in terms of determining the amount of EBIT (indifference point) at which its MPS is identical under two proposed financial plans. In general, the higher the level of EBIT than the indifference point and the lower the probability of its downward fluctuation the greater is the amount of debt that can be employed by a corporate.Coverage ratio can also be used to judge the adequacy of EBIT to meet the firms obligations to pay financial charges,interest on loan preference dividend and repayment of principal. A higher ratio implies that firm can go for lager proportion of debt in its capital structure. Liquidity position of a firm is
Chapter 9
Operating Financial and Combined Leverage
Leverage
Is the employment of an asset/source of finance for finance for which firm pays fixed cost/ fixed return.
Operating leverage
Is caused due to fixed operating expenses in a firm.
Operating risk
Risk of not able to cover fixed operating costs by firm.