MBEIII - 11 – Corporate

Financial Management
Unit 3
Course Objectives and Outcomes
After successfully completing this course, the student would be able to

● Take long term investment decisions with the help of capital budgeting tools

●Choose the best options for short term and long term finance requirements of the
business

●Undertake valuation of business and make dividend decisions

●Effect mergers and acquisition decisions by considering valuation and taxation

aspects

●To keep abreast with the contemporary trends in the field and incorporating the
same in real situations

●
Syllabus
Unit I: Long-term Investment Decisions: Capital Budgeting – Identification of
Cash Flows and evaluation of proposals, Risk and Uncertainty Analysis, Certainty
Equivalent Approach, Sensitivity Analysis, Probability Distribution Approach and
Decision Tree Approach

Unit II: Leasing, Hire-purchase & Project Finance - Types of leases, rationale
for leasing, Mechanics of leasing, Operating lease, Leasing as financial decision,
Lease Vs borrow & buy evaluation, Hirepurchase arrangement, Choice between
leasing & hire purchase, Project finance – Private Equity, Venture Capital.
Syllabus
Unit III: Valuation of business and Dividend Decisions - Valuation of business- Adjusted book value
method, value o\f shares and debt method, comparison method, DCF method. Dividend policies -
Concept, determinants and factors affecting, relevance and irrelevance concept, dividend valuation
models – Gordon, Walter and Modigliani-Miller models, Stability of dividends – concept and significance.

Unit IV: Mergers & Acquisitions and Contemporary issues in Financial Management - M&A –
Exchange ratio Financial evaluation of mergers, M&A as capital budgeting decision, Economic value
added & market value added Taxation aspects. Contemporary issues in Financial Management – Public
offerings - IPO, FPO, ASBA, book building, Reverse book building, private placement, Green shoe option,
Red Herring Prospectus. ESOP, ESPP, Refinancing, Securitization, Carbon Credit, Balanced score card,
P notes, GDR, ADR, ECB, Indian Depository Receipts, Hundi, Parta system
Unit III: Contents
●Valuation of business- Adjusted book value method
● value of shares and debt method
● comparison method
●DCF method.
●Dividend policies - Concept, determinants and factors affecting
relevance and irrelevance concept
● dividend valuation models – Gordon, Walter and Modigliani-Miller
models,
●Stability of dividends – concept and significance.
Valuation of business- Adjusted book value method
●The adjusted- book value approach to valuation involves a determination of the
going-concern fair market value of all the assets and liabilities of a business.

●The difference between the assets and the liabilities is the adjusted net worth of
the business, incorporating current values as opposed to those set forth by the
historical-cost accounting model.

●adjusted book value is a measure of a company's valuation after liabilities,

including off-balance sheet liabilities, and assets are adjusted to reflect true fair
market value.
example
Liabilities Amount Assets Amount

Share Capital 120000 Fixed Assets:

P & L account 40000 Land & Building 150000
6% Debentures 50000 Plant & Machinery 70000
Bank Overdraft 20000 Stock 60000
Creditors 40000 Debtors 35000
Provision for tax 50000 Cash 5000
Total 320000 320000

On 31 March, the assets were valued as follows: Land and Building:

230000, goodwill 45000 and Plant & Machinery 110000. Bad debts
were 6500 . Provision for tax is at 40%
 Solution
Assets:
Land & Building 230000
Plant & Machinery 110000
Stock 45000
Debtors (35000-6500) 28500
Cash 5000
Total 418500
Less: liabilities
Bank Overdraft 20000
Creditors 40000
Provision for tax (50000-6500*40%)
(50000-2600) 47400

Value of business 316100

value of shares and debt method
●.under this method,current value of all shares and debt s of the company
comparison method
DCF method
●DCF method defines the value of the firm as the present value of the firm’s future
free cash flows (FCF), discounted at the weighted average cost of capital (WACC)
 Dividend Policy refers to the explicit or implicit decision of
the Board of Directors regarding the amount of residual
earnings (past or present) that should be distributed to
the shareholders of the corporation.

• This decision is considered a financing decision because

the profits of the corporation are an important source of
financing available to the firm.
 Firm has 2 choices
• Pay dividend
• Reinvest funds instead of paying out
• In the absence of dividends, corporate earnings accrue to the benefit of
shareholders as retained earnings and are automatically reinvested in
the firm.
• When a cash dividend is declared, those funds leave the firm
permanently and irreversibly.
• Distribution of earnings as dividends may starve the company of funds
required for growth and expansion, and this may cause the firm to seek
additional external capital.
Retained Earnings
Corporate Profits After Tax
Dividends
 There is no legal obligation for firms to pay dividends to
common shareholders
 Shareholders cannot force a Board of Directors to
declare a dividend, and courts will not interfere with the
BOD’s right to make the dividend decision.
 THEORY OF IRRELEVANCE
1. Residual approach
2. Miller and Modgilani approach
 THEORY OF RELEVANCE
 1. Walter’s approach
 2. Gorden approach
 Dividend irrelevance theory is one of the
major theories concerning dividend policy
in an enterprise. It was first developed by
Franco Modigliani and Merton Miller in a
famous seminal paper in1961.
 The authors claimed that neither the price
of firm's stock nor its cost of capital are
affected by its dividend policy.
 According to M-M, under a perfect market
situation, the dividend policy of a firm is
irrelevant, as it does not affect the value of
the firm.
 Dividend
received at
the end of the
year
P00 D1 P11 Market price
(1 K e ) of share at the
e end of year
Market price
of the share at Cost of equity
the beginning
of period
 Market price Dividend
of the share at received at
the beginning the end of the
of period year
P1 P0(1 ke) D1

Market price
of share at the Cost of equity
end of year
 Market total earning
Investment of the firm Number of
require shares which
Dividend
received at
the end of the
m I (E nD1) year
P1

Number of shares Market price

outstanding at the of share at the
beginning of the end of year
 Investment
Market price
require Market total
Value of the of share at the earning of the
firm end of year
firm

mP0 (n m)P1 (I E)
Cost of
(1 Ke ) equity

Number of Number of shares

share issue outstanding at the beginning
of the period
 There is perfect capital market
 investor are rational
 Information about company is freely
available
 there is no transaction cost
 No investor is large enough to effect
 there are no taxes
o According to relevant theory payment of dividend
affect the firm's stock and its cost of capital. this
theory is based on rate of interest and cost of capital.
 Walter'smodel supports the principle that
dividends are relevant. The investment policy of
a firm cannot be separated from its dividend
policy and both are inter-related. The choice of
an appropriate dividend policy affects the value
of an enterprise.
 Price of equity dividend

P D Expected
Ke g growth rate of
earning
dividend

Cost of equity
market price
per share
Earning per
share

P D r(E D) /ke
Ke

Internal rate of Cost of equity

return capital
 The investment of the firm are financed
through internal financing or retain earning
only.
 Rate of interest and cost of equity are
constant.
 Earning & dividend don’t change while
determining the value of the firm.
 Firm has very long life.
 If r>k than firm retain the whole income
If r<k than firm can pay 100% dividend

 r = rate of interest
 k = cost of equity
 When r > ke, the value of shares is inversely related to
the D/P ratio. As the D/P ratio increases, the market
value of shares decline. It’s value is the highest when
D/P ratio is 0. So, if the firm retains its earnings
entirely, it will maximize the market value of the shares.
The optimum payout ratio is zero.
 When r < ke, the D/P ratio and the value of shares are
positively correlated. As the D/P ratio increases, the
market price of the shares also increases. The
optimum payout ratio is 100%.
 When r = ke, the market value of shares is constant
irrespective of the D/P ratio. In this case, there is no
 A model for determining the intrinsic value of a stock,
based on a future series of dividends that grow at a
constant rate. Given a dividend per share that is payable
in one year, and the assumption that the dividend grows
at a constant rate in perpetuity, the model solves for the
present value of the infinite series of future dividends.
 Gordon's theory contends that dividends are relevant.
This model is of the view that dividend policy of a firm
affects its value.
 According to Gordon, the market value of a share is
equal to the present value of the future streams of
 P D
Ke g

Where:
D = Expected dividend per share one year
from now
k = Required rate of return for equity
investor
G = Growth rate in dividends (in perpetuity)
 Assumptions of this model

 The firm is an all equity firm. No external financing is

used and investment programmes are financed
exclusively by retained earnings.
 Return on investment( r ) and Cost of equity(Ke) are
constant.
 The firm has perpetual life.
 The retention ratio, once decided upon, is constant.
Thus, the growth rate, (g ) is also constant.
 Ke > g
THANKS