Introduction

 1. No business activity can be undertaken without

finance.
 2. Finance is the lifeblood of business. A business
cannot even be started without finance.
 3. Every kind of business organization, whether it is
small, medium or big, it needs finance.
 4. Every business activity is an economic activity
and these activities require finance.
 5. There arises the need for arranging and managing
finance in the businesses.
Meaning
 Financial management is concerned with the acquisition of funds
and their optimum utilization. It is all about acquiring funds at
minimum cost and generate optimum return by its optimum
utilization. Funds are acquired to meet financial aspects of business
activity.
 1. According to J.L. Massie:
 “Financial management is the operational activity of a business that
is responsible for obtaining and effectively utilizing the funds
necessary for efficient operations.”
 2. According to the Guthmann and Dougall:
 “Business finance can be broadly defined as the activity concerned
with planning, raising, controlling, administering of the funds used
in the business”
Nature of Financial Management
It is an indispensable organ of management. It is an
integral part of business decision-making process.
It is a continuous process.
It is centralized nature of finance function i.e
investment, financing and dividend decision.
Helpful in the decision making of top management.
It helps in measurement of performance
It is pervasive. All form of business organization,
big or small needs to manage finance.
It has a wide scope.
Scope of Financial Management
Estimating financial requirements
Deciding capital structure
Selecting a source of finance
Selecting a pattern of investment
Proper cash management
Implementing financial controls
Proper use of surpluses
Importance
Financial planning and successful promotion of
an enterprise
Acquisition of funds at the minimum cost as
and when required
Proper use and allocation of fund
Taking sound financial decisions
Improving the profitability through financial
controls
Increasing the wealth of the investors and the
nation
Objectives of financial management

Profit
maximization
Wealth maximization
Profit Maximization

Main aim is earning profit.

Profitability is a barometer for measuring
efficiency of a business enterprise
Profit reduces risk of the business
concern.
Profit is the main source of finance.
Profitability meets the social needs also.
Drawbacks of Profit Maximization

Ambiguity
Ignores Time value of money
Ignores Risk Factor
Dividend policy
Wealth Maximization
Main aim is to improve the value or wealth of the
shareholders.
It takes into consideration long run survival and
growth of the firm.
It suggests the regular and consistent dividend
payments to the shareholders
It considers the risk and time value of money
The financial decisions are taken with the view to
improve the capital appreciation of share price.
It considers all future cash flows, dividends and
earning per share.
Criticism of wealth
maximization
Itis a prescriptive idea.
Controversy between wealth of firm or
wealth of shareholders.
Not socially desirable
Finance Function
Finance function is the most important
function. It remains of all activities. The
need for money is continuous.

Approaches to Finance Function

Traditional approach
Modern approach
Traditional approach
Known as “ corporation finance”(1920 and
1930)
Only concerned with procurement of funds
on most suitable terms
Limitaions :
 outsider looking approach
Focus only procurement of funds
Ignored allocation of funds
No importance to routine financial problems
Modern approach
Focus on procurement as well as effective
utilization of funds
Covers financial planning, raising fund,
allocation of fund , financial control etc.
Considers the three basic management
decisions.
Investment decisions
Financing decisions
Dividend decisions
Financial decision making
Risk Return Trade off
Functions of Finance Manager
Financial forecasting and planning
Acquisition of funds
Investment of funds
Helping in valuation decision
Maintain Proper Liquidity
 Unit 2
Investment
Decision
Meaning
 The Investment Decision relates to the decision made by
the investors or the top level management with respect to
the amount of funds to be deployed in the investment
opportunities.

 The type of assets in which the funds will be invested by

the firm is termed as the investment decision.

 These assets fall into two categories:

1. Short term
2. Long term
Capital Budgeting
The word Capital refers to be the total
investment of a company of firm in
money, tangible and intangible assets.
Budgets are a blue print of a plan and
action expressed in quantities and
manners.
Capital budgeting decision involves
proper allocation of funds.
Definitions
“Capital budgeting (investment decision) as, “Capital
budgeting is long term planning for making and
financing proposed capital outlays.”
----- Charles T.Horngreen

 “Capital budgeting consists in planning development of

available capital for the purpose of maximizing the long
term profitability of the concern”
– Lynch
Features
Long term effects
Substantial Commitments
Irreversible Decisions
Affect the capacity and strength to
compete
Problems
Future Uncertainty

Time element

Measurement problem
Types of Capital Budgeting Decisions
From the point of view of firm’s existence
a) New Firm
b) Existing Firm:
I. Replacement and modernization
decision
II. Expansion
III. Diversification
Capital Budgeting process

Capital
Budgeting
process
Techniques of Evaluation
Pay back period method
The ‘pay back’ sometimes called as pay out or pay off period method
represents the period in which the total investment in permanent assets
pays back itself.

This method is based on the principle that every capital expenditure pays
itself back within a certain period out of the additional earnings generated
from the capital assets.

Under this method, various investments are ranked according to the length
of their payback period in such a manner that the investment within a
shorter payback period is preferred to the one which has longer pay back
period.

Payback period = Initial investment/Annual cash inflows

Annual cash inflow is annual net profit before depreciation and after taxes.
Illustrion1
A project cost Rs 100000 and yields an annual
cash inflow of Rs 20000 for 8 years. Calculate its
pay back period
Determine the payback period for a project which
requires a cash outlay of rs 10000 and generates
cash inflow of rs 2000, rs 4000, rs 3000and Rs
2000 in the 1st, 2nd , 3rd and 4th year respectively.
A project cost Rs 500000 and yields annually a
profit of Rs 80000 after depreciation @ 12% p.a
but before tax of 50%. Calculate the pay back
period.
Cont..
There are two projects X and Y. Each project requires
an investment of Rs 20000. you are required to rank
these projects according to the pay back method from
the following information
Years project X project Y
1st 1000 2000
2nd 2000 4000
3rd 4000 6000
4th 5000 8000
5th 8000 ------
(net profit before depreciation and after tax)
Merits
It is easy to calculate and simple to
understand.
Pay-back method reduces the possibility
of loss on account of obsolescence
Saves cost and requires lesser time
compared to other methods
Suited for a firm which has shortage of
cash
demerits
It ignores the time value of money.
It ignores all cash inflows after the pay-
back period.
It does not take into consideration the cost
of capital which is a important factor
Post pay back Profitability method
One of the serious limitations of Pay-back period
method is that it does not take into account the cash
inflows earned after pay-back period and hence the
true profitability of the project cannot be assessed.
Hence, an, improvement over this method can be
made by taking into account the return receivable
beyond the pay-back period.
Post pay-back profitability =Cash inflow
(Estimated life – Pay-back period)
Post pay-back profitability index= Post pay-back
profitability/original investment
Illustration
For each of the following project compute i) pay back period
ii)post pay back profitability

a) Intial outlay Rs 50000

Annual cash inflowRs 10000
Estimated life8 years
b) Initial outlay Rs 50000
Annual cash inflow
First three years Rs 15000
Next five years Rs 5000
Estimated life8 years
salvage Rs 8000
Accounting Rate of Return
This method takes into account the earnings
expected from the investment over their whole
life.
It is known as accounting rate of return method
for the reason that under this method, the
Accounting concept of profit (net profit after tax
and depreciation) is used rather than cash inflows.
According to this method, various projects are
ranked in order of the rate of earnings or rate of
return.
Cont.
Average Rate of Return Method
(ARR):
Under this method average profit after tax
and depreciation is calculated and then it
is divided by the total capital outlay or
total investment in the project.
ARR = (Average Annual profits) x 100
(Net investment in the project)
Cont..
Average Return on Average Investment
Method:
This is the most appropriate method of rate of
return on investment Under this method, average
profit after depreciation and taxes is divided by
the average amount of investment; thus:
Average Return on Average Investment =
(Average Annual Profit after depreciation and
taxes) x 100
(Average Investment)
Illustration :
 A project requires an investment of Rs 500000 and a scrap value of Rs 20000 after five years. It
is expected to yield profits after depreciation and taxes during the five years amounting to Rs
40000, Rs 60000, Rs 70000, rs 50000,Rs 20000. Calculate the average rate of return on the
investment

 Calculate the average rate of return for projects A and B from the following:
Project A Project B
Investments Rs 20000 Rs 30000
Expected Life 4 years 5 years
(no salvage value)
Projected net income
(after tax and depreciation)
1 yr 2ooo 3000
2nd yr 1500 3000
3rd yr 1500 2000
4th yr 1000 1000 5th yr ----- 1000
If the required rate of return is 12% which project should be undertaken
Merits
It is easy to calculate and simple to
understand.
It uses the entire earnings of a project in
calculating rate of return and gives a
better view of profitability
It is based on the accounting information
rather than cash inflow.
Demerits
It ignores the time value of money.
It ignores the period in which profits are
earned
This method cannot be applied to a
situation where investment in a project is
to be made in parts.
NET PRESENT VALUE METHOD
Net present value is a tool of Capital budgeting to analyze the
profitability of a project or investment.
It is calculated by taking the difference between the present
value of cash inflows and present value of cash outflows over a
period of time.
If the present value of cash inflows is more than the present
value of cash outflows, it would be accepted. If not, it would be
rejected.

Formula for NPV

NPV = (Future Cash flows)/( 1+r)^n
r  = Discount rate
n= no of years
Illustration 1
 From the following information calculate the net present value of the two
projects and suggest which of the two projects should be accepted
assuming a discount rate of 10%
Project X Project Y
 Initial Investment 20000 30000
 Estimated life 5 yrs5 yrs
 Scrap Value 1000 2000
 The profits before depreciation and after taxes (cash flows) are as follows
yr 1 yr 2 yr 3 yr 4 yr 5
Project X 5000 10000 10000 3000 2000
Project Y 20000 10000 5000 3000 2000
Illustration:
No project is acceptable unless the yield is 10%. Cash
inflows of a certain project along with cash outflows are
given below:
Yearsoutflow inflow
0 150000 --------
1 30000 20000
2 30000
3 60000
4 80000
5 30000

The salvage value at the end of the 5th year is Rs 40000.

Calculate net present value.
Merits
It recognizes the time value of money.
It considers the total benefits arising out of the proposal.
It is the best method for the selection of mutually
exclusive projects.
It helps to achieve the maximization of shareholders’
wealth.
Demerits
It is difficult to understand and calculate.
It needs the discount factors for calculation of present
values.
It is not suitable for the projects having different effective
lives.
Internal rate of Return
This method is popularly known as time adjusted rate of return
method/discounted rate of return method also.
The internal rate of return is defined as the interest rate that equates
the present value of expected future receipts to the cost of the
investment outlay.
This internal rate of return is found by trial and error.
As the determination of internal rate of return involves a number of
attempts to make the present value of earnings equal to the
investment, this approach is also called the Trial and Error Method.
Internal rate of return is time adjusted technique and covers the
disadvantages of the Traditional techniques.
. It is expected by the following ratio

=initial investment/cash inflow

Illustration
Illustration:
Aasman Ltd has currently under examination a project which will
yield the following over the life of the project:
Year gross yield

1 80000
2 80000
3 90000
4 90000
5 83000
Cost of machinery to be installed amounts to rs 200000 and the
machine is to be depreciated at 20% p.a. at W.D.V. basis. Income
tax rate is 50%. The salvage value of machine is Zero. If the
average cost of raising capital is 11%, would you recommend
accepting the project under the internal rate of return method?
Merits
It considers the time value of money.
It takes into account the total cash inflow and outflow.
It does not use the concept of the required rate of
return.
It gives the approximate/nearest rate of return.

Demerits:
It involves complicated computational method.
It produces multiple rates which may be confusing for
taking decisions.
It is assume that all intermediate cash flows are
reinvested at the internal rate of return.
Profitability Index Method
It is also a time adjusted method of evaluating the investment
proposals.
Profitability index also called as Benefit- cost Ratio or ‘desirability
factor ‘ is the relationship between present value of cash inflows and
the present value of cash outflow. Thus
Profitability Index= Present Value of Cash Inflow/Present Value of
Cash outflow
The proposal is accepted if the profitability index is more then one and
is rejected in case the profitability index is less than one.
The method is a slight modification of the net present value method.
The net present value method has one major drawback that it is not
easy to rank projects on the basis of this method particularly when the
costs of the projects differ significantly.
To evaluate such projects, the profitability index method is most
suitable
Illustration:
The initial cash outlay of a project is Rs
50000 and it generates cash inflows of Rs
20000, Rs 15000, Rs 25000, and Rs
10000 in four years. Using present value
index method , appraise profitability of
the proposed investment assuming 10%
rate of discount.
Illustration
A company has an investment opportunity costing Rs 40000 with the following expected net
cash flow after taxes and before depreciation
Year Net cash flow

1 7000
2 7000
3 7000
4 7000
5 7000
6 8000
7 10000
8 15000
9 10000
10 4000
Using 10% as the cost of capital, determine the following:
a) Pay back period
b) Net present value at 10% discount factor
c) Profitability index at 10% discount factor
d) Internal Rate of return with the help of 10% and 15% discount fcator
Unit 3
Meaning of Cost of Capital
Cost of capital is the rate of return that a firm
must earn on its project investments to
maintain its market value and attract funds.
Cost of capital is the required rate of return on
its investments which belongs to equity, debt
and retained earnings.
If a firm fails to earn return at the expected
rate, the market value of the shares will fall
and it will result in the reduction of overall
wealth of the shareholders.
Definition
According to the definition of John J.
Hampton “ Cost of capital is the rate of
return the firm required from investment
in order to increase the value of the firm
in the market place”.
According to the definition of Solomon
Ezra, “Cost of capital is the minimum
required rate of earnings or the cut-off
rate of capital expenditure”.
Cont….
From the definitions given we can conclude three basic aspects of the
concept of cost of
1. It is not a cost as such. It is merely a hurdle rate.
2. It is the minimum rate of return.
3. It consist of three important risks such as zero risk level, business
risk and financial risk.
Cost of capital can be measured with the help of the following
equation.
K = rj + b + f.
Where,
K = Cost of capital.
rj = The riskless cost of the particular type of finance.
b = The business risk premium.
f = The financial risk premium.
Classification of cost
Cost of capital may be classified into the
following types on the basis of nature and
usage:
Explicit and Implicit Cost.
Average and Marginal Cost.
Historical and Future Cost.
Specific and Combined Cost.
Significance of cost of capital
As an acceptance criterion in capital
budgeting
As a determinant of capital mix in capital
structure decisions
As a basis for evaluating the Financial
Performance
As a basis for taking other Financial
decisions
COMPUTATION OF COST OF
CAPITAL
Computation of cost of capital consists of two
important parts:
1. Measurement of specific costs
2. Measurement of overall cost of capital
Measurement of Cost of Capital
It refers to the cost of each specific sources of finance
like:
Cost of equity
Cost of debt
Cost of preference share
Cost of retained earnings
Cost of debt
Cost of Irredeemable debt: The cost of debt is the interest payable on debt.
For example a company issues Rs 100000 10% debentures at par : the before tax
cost of this debt will also be 10%
So Kdb = I/P
Where Kdb = Before tax cost of debt
I= Interest
P = Principal
In case the debt is raised at premium or discount , we should consider P as
amount of net proceeds received from the issue and not the face value of
securites . The formula may be changed to
Kdb = I/NP where NP= net proceeds
When debt is used as a source of finance , the firm saves a considerable amount
in payment of tax as interest is allowed as a deductible expense in computation
of tax. Hence the effective cost of debt is reduced . The after tax cost of debt
may be calculated as :
Kda = Kdb (1-t)
Illustration
X ltd issues Rs 50000 8% debentures at par. The tax rate
applicable to the company is 50%. Compute the cost of debt
capital.
Y ltd issues Rs 50000 8% debentures at a premium of 10%.
The tax rate applicable to the company is 60%. Compute
the cost of debt capital.
A ltd issues Rs 50000 8% debentures at discount of 5%.
The tax rate applicable to the company is 50%. Compute
the cost of debt capital.
B ltd issues Rs 100000 9% debentures at premium of 10%.
The cost of floatation are 2%. The tax rate applicable to the
company is 60%. Compute the cost of debt capital.
Cost of Redeemable Debt
The debt is issued to be redeemed after a
certain period during the life time of a
firm. Such a debt is known as redeemable
debt.
The cost of redeemable debt capital may
be computed by using yield to maturity
also called internal rate of return or trial
and error method.
Shortcut Method
Illustration
A company issue 1000000 10% redeemable
debentures at a discount of 5%. The cost of
flotation amount to Rs30000. The debentures are
redeemable after 5 years. Calculate before tax and
after tax cost of debt assuming a tax rate 50%.
A 5 year rs 100 debenture of a firm can be sold
for a net price of rs 96.50. The coupon rate of
interest is 14% per annum and the debenture will
be redeemed at 5% premium on maturity. The
firm’s tax rate is 40%. Compute the after tax cost
of debenture.
Cost of preference share
A company issues 10000 10% Preference shares of Rs
100 each. Cost of issue is Rs 2 per share. Calculate
cost of preference capital if these shares are issued a)
at par b)at a premium of 10% c)at a discount of 5%.
A company issues 10000 10% Preference shares of Rs
100 each redeemable after 10 years at a premium of
5%.. Cost of issue is Rs 2 per share. Calculate the cost
of preference capital
A company issue 1000 7% Preference Shares of Rs
100 each at a premium of 10% redeemable after 5
years at par. Compute the cost of capital
Cost of Equity share capital
The cost of equity capital is a function of the
expected return by its investors.
Shareholders invest money in equity shares on
the expectation of getting dividend and the
company must earn this minimum rate so that the
market price of the shares remain unchanged .
The cost of equity share capital can be computed
in the following way:
a) Dividend Yield method
b) Dividend yield Plus growth in Dividend model
Dividend Yield Method
According to this method, the cost of equity capital is the discount
rate that equates the present value of expected future dividends per
share with the net proceeds(or current market price) of a share.
Ke= D/NP or D/MP
Assumptions: The basic assumptions underlying this method are
that the investors give prime importance to dividends and risk in
the firm remains unchanged. .
The dividend price ratio method does not seem to consider growth
in dividend
It does not consider future earnings or retained earnings
It does not take into account the capital gain.
This method is suitable when the company has stable earnings and
dividend policy over a period of time
Illustration
A company issues 1000 equity shares of
Rs 100 each at a premium of 10%. The
company has been paying 20% dividend
to equity shareholders for the past five
years and expects to maintain the same in
future also. Compute the cost of equity
capital. Will it make any difference if
market price of equity share is rs 160?
Dividend yield plus growth model
When dividends of the firm expected to
grow at a constant rate and dividend pay
out ratio is constant then this method may
be used to compute cost of equity capital.
Illustration
A company plan to issue 1000 new shares of
Rs 100 each at par. The floatation cost are
expected to be 5% of the share price. The
company pays a dividend of Rs. 10 per share
initially and the growth in dividend is
expected to be 5%. Compute the cost of new
issue of equity shares
If the current market price of an equity share
is rs 150, calculate the cost of existing equity
share capital
Cost of retained earning
Itis sometimes argued that retained
earning
Weighted Average cost of capital
Weighted Average Cost of Capital is the
average of the costs of specific sources of
capital employed by a company, properly
weighted by the proportion the various
sources of capital in the company’s capital
structure.
In simple, Weighted Average Cost is
nothing but average cost of the specific
cost of various sources of finance.
Steps involved in computing the WACC
Compute the specific cost of each source of capital ( i.e. cost of Equity Capital Ke,
Cost of Peference Capital Kp, Cost of Debenture Capital Kd and/ or cost of Retained
Earnings ) 2.
 Assign weight to each specific source of fund weights can be assigned to each
specific source of fund on the basis of historical weights method or marginal weights
method.
Historical weights method: under this method, weights are assigned on the basis of
the proportion of funds already employed by the company. Here book value weights
or market value weights can be used. book value weights are readily available from
the published financial statements of the company generally companies set their
capital structure on the basis of Book value and also their capital structure analysis is
also done on the basis of book value. It is more convenient to be used
Whereas, market values of securities are realistic as they give us the values of
securities that are close to the actual amount raised from sale of securities. Also while
calculating cost of capital we normally consider the prevailing market price. However
it is difficult to determine the market value because of frequent fluctuations. Use of
market values as weights helps the company's equity capital gain greater importance.
Cont…
 Marginal weights Method - under this method, specific cost or
sources are assigned weight in the proportion of funds to be raised from
each source to the total funds to be raised. In other words, the proportion
of each source of capital to the proposed total capital will be the basis of
weight .this method the new project to be financed wholly by raising
fresh capital.
The additional capital will be treated as marginal capital and proportion
of each source in additional capital will be taken as marginal weights.
However, the marginal weights method does not considered the long
term implications of the company's current financing.
Formula for WACC:
𝐾𝑤 = Σ𝑋𝑊/ Σ𝑊
 Kw = Weighted Average Cost of Capital
X = Cost of specific source of finance’
W= Weight( proportion of a specific source of finance)
Illustration
Illustration
Illustration
Illustration
Illustration
Risk
Risk implies future uncertainty about deviation from
expected earnings or expected outcome. Risk measures the
uncertainty that an investor is willing to take to realize a
gain from an investment.
Types of Risk
Systematic risk
Unsystematic risk
The meaning of systematic and unsystematic risk in finance:
Systematic risk is uncontrollable by an organization and
macro in nature.
Unsystematic risk is controllable by an organization and
micro in nature.
Systematic Risk
Systematic risk is also referred to as non-diversifiable risk or
market risk.
Systematic risk is the fluctuations in the returns on securities
that occur due to macroeconomic factors. These factors could be
the political, social or economic factors that affect the business.
Systematic risk can be caused due to unfavorable reasons such
as an act of nature like a natural disaster, changes in government
policy, international economic components, changes in the
nation’s economy, etc.
Systematic risk is further divided into three categories:
Interest Risk
Inflation Risk
Market Risk
Unsystematic Risk
The fluctuations in returns of a company arising due to
micro-economic factors are termed as unsystematic risks.
These risk factors exist within the company and can be
avoided if necessary action is taken. The risk factors can
include the production of undesirable products, labor
strikes, etc.
Unsystematic risks are further divided into two categories:
Business Risks
Financial Risks
Capital asset pricing model
 The Capital Asset Pricing Model (CAPM) is a model that describes the
relationship between the expected return and risk of investing in a
security.
 It shows that the expected return on a security is equal to the risk-free
return plus a risk premium, which is based on the beta of that security.
 Beta is a measure of the market risk, or the systematic risk, of a security.
 A security with a large beta will have large swings in its price in relation
to the changes in the market index.
 This will lead to a higher standard deviation in the returns of the
security, which will indicate a greater uncertainty about the future
performance of the security.
 Beta of the market is equal to 1. The securities with more than average
risk will have beta greater than 1, and less risky securities have beta less
than 1. On this scale, the beta of a riskless security is zero. Such
securities will provide riskless rate of return, r, to the investors.
Cont...
Unit 4
Capital Structure - Introduction
Capital structure refers to the kinds of securities and the
proportionate amounts that make up capitalization.
It is the mix of different sources of long-term sources such as
equity shares, preference shares, debentures, long-term loans
and retained earnings.
The term capital structure refers to the relationship between
the various long-term source financing such as equity capital,
preference share capital and debt capital.
Deciding the suitable capital structure is the important
decision of the financial management because it is closely
related to the value of the firm.
Capital structure is the permanent financing of the company
represented primarily by long-term debt and equity.
Definition
According to the definition of Gerestenbeg,
“Capital Structure of a company refers to
the composition or make up of its
capitalization and it includes all long-term
capital resources”.
According to the definition of James C. Van
Horne, “The mix of a firm’s permanent
long-term financing represented by debt,
preferred stock, and common stock equity”.
Optimum capital structure
Optimum capital structure is the capital
structure at which the weighted average
cost of capital is minimum and thereby
the value of the firm is maximum.
Optimum capital structure may be defined
as the capital structure or combination of
debt and equity, that leads to the
maximum value of the firm
Objectives of capital structure
Decision of capital structure aims at the
following two important objectives:
1. Maximize the value of the firm.
2. Minimize the overall cost of capital.
Factors determining Capital Structure
Control
Risk
Tax consideration
Cost of capital
Government policy
Timing
Profitability
Company Size
Forms of capital structure
Capital structure pattern varies from company
to company and the availability of finance.
Normally the following forms of capital
structure are popular in practice.
Equity shares only.
Equity and preference shares only.
Equity and Debentures only.
Equity shares, preference shares and
debentures.
CAPITAL STRUCTURE THEORIES
Capital structure is the major part of the firm’s
financial decision which affects the value of the firm
and it leads to change EBIT and market value of the
shares.
There is a relationship among the capital structure,
cost of capital and value of the firm.
The aim of effective capital structure is to maximize
the value of the firm and to reduce the cost of capital.
There are two major theories explaining the
relationship between capital structure, cost of capital
and value of the firm.
Theories

CAPITAL STRUCTURE THEORIES

M odern Approa ch

Traditional Approach
Net Income Approach Net operating Approach Modigliani miller approach
Net income approach
 Net income approach suggested by the Durand. According to this approach, the capital structure
decision is relevant to the valuation of the firm. In other words, a change in the capital structure
leads to a corresponding change in the overall cost of capital as well as the total value of the
firm.
 According to this approach, use more debt finance to reduce the overall cost of capital and
increase the value of firm.
 Net income approach is based on the following three important assumptions:
1. There are no corporate taxes.
2. The cost debt is less than the cost of equity.
3. The use of debt does not change the risk perception of the investor.
 V = S+B
 V = Value of firm
 S = Market value of equity
 B = Market value of debt
 Market value of the equity can be ascertained by the following formula:
 S = NI/Ke
 where
 NI = Earnings available to equity shareholder
 Ke = Cost of equity/equity capitalization rate
Illustration
Glamour Ltd earned a profit of Rs 20 lakhs
before providing for interest and tax . The
company’s capital structure is as follows:
1. 4,00,000 Equity shares of Rs 10 each and its
market capitalization rate is 16%
2. 25000 14% Secured redeemable debentures
of Rs 150 each
You are required to calculate the value of the
firm under ‘Net Income approach’. Also
calculate overall cost of capital of the firm
Net operating approach
 Another modern theory of capital structure,
suggested by Durand. This is just the opposite to
the Net Income approach.
 According to this approach, Capital Structure
decision is irrelevant to the valuation of the firm.
 The market value of the firm is not at all affected
by the capital structure changes.
 According to this approach, the change in capital
structure will not lead to any change in the total
value of the firm and market price of shares as well
as the overall cost of capital.
Cont…
NI approach is based on the following important assumptions;
The overall cost of capital remains constant and depends upon the
business risk which also is assumed to be unchanged
There are no corporate taxes;
The market capitalizes the value of the firm as a whole;
The use of more and more debt in the capital structure increases the risk of
the shareholders and thus results in the increase in the cost of equity
capital(Ke)
Value of the firm (V) can be calculated with the help of the following
formula
V =EBIT/Ko
Where,
V = Value of the firm
EBIT = Earnings before interest and tax
Ko = Overall cost of capital