20MBA2CC - Core IX -

Financial Management
 Unit I

1
Financial Management – Introduction to Financial Management - Time value of money, risk
and return analysis. Indian financial system – Introduction to Primary market, Secondary
market – Stocks & commodities, Money market, Foreign exchange markets
Introduction to Finance

• Art and Science of managing money.

• Part of Planning and cost controlling of Firms Financial resources.

• Branch Of Economics till 1890 & Separated recently. Theory of Financial Mgt Provide the Managers
with Conceptual & Analytical Insight.
Definition :-
Business finance or Financial Mgt is that “ Business Activity which is concerned with the acquisition &
conservation of Capital Funds in meeting financial needs & Overall Objectives of business enterprises

Financial Services: Design Financial Management is Financial managers actively

and delivery of advice and concern with the duties manage the financial affairs
financial products to of the financial of any type of business either
individuals, businesses and managers in the private and public , profit-
govt., business firm seeking or not-for- profit
 Finance function
Function of raising funds, investing them in assets and distributing returns to shareholders are
respectively known as Financing , Investment and Dividend decision. A firm attempt to balance
cash inflow and outflows while performing these functions which is called as liquidity decisions.
Finance function are divided into long term short-term decisions and include

Long-term financial decision Short-term financial decision

 Long term asset mix or Investment • Short term asset mix or liquidity
decision decision
 Capital mix or Financing decision
 Profit allocation or Dividend decision

1. Investment decision or capital budgeting involves the decision of allocation of capital or

commitment of funds to long term assets.
- evaluation of prospective profitability.
- measurement of a cut-off rate against that the prospective return of new investment
could
be compared based on expected return & risk.
 2.Finance decision deals with when, where and how to acquire funds to meet firms
investment needs. Central issue is to determine the proportion of equity and debt mix
known as capital structure.

3.Dividend Decision :A firm should decide whether to distribute all profits or retain them,
or distribute a portion. The optimum dividend policy is one that maximizes the market
value of the firm shares. Most profitable companies pay cash dividend regularly.

Current assets should be managed efficiently for safeguarding the firm against the
dangers of illiquidity and insolvency.

Objectives of financial management

Investment and financing decisions are unavoidable and continuous, in order to make rationally
the firm goal is must. Widely accepted financial goal of the firm is to maximization of owners
economic wealth.
Profit maximization
• Profit maxi. mean maximizing the rupee income of firm.
• Market economy indicate goods and service society needed.
 Point favor of profit

Where goods with greater demand will command higher price, result higher profit. Ultimately
attract competitor to start and equilibrium price reached. Price system directs managerial effort
and determine profitability.

The economic theory explained by Adam Smith explain the behavior of a firm is analyzed in terms
of profit maximization. While maximizing profit, a firm either produce maximum output for given
amount of input to uses minimum input for producing given output.

Profit is a yardstick of efficient on the basic of which economic efficiency of a business can be
evaluated.
It helps in efficient allocation and utilization of scarce means because only such resources are
applied which maximize the profit.
The rate of return on capital employed is considered as the best measurement of the profit.
Profits act as motivator which helps the business organizations to be more efficient through hard
work.
By maximizing the profit, social and economic welfare is also maximized.
 Time value of Money
Investment decisions such as purchase of assets or fin, decision procurement of funds affects
the firms cash flows in different time periods. If firm borrows, it receives fund now and
commits an obligation to pay interest and repay principal in future. Even during issue of
equity, the cash balance increases, but as firm pays dividend in future outflow occurs. Cash
flows become logically comparable when they are appropriate adjusted for their different in
timing and risk.

The welfare of owners would be maximised when net worth or net present value is created.
The net present value is the time value concept.

Meaning of time value of money (TVM)

TVM is defined as the value derived from the use of money over time as a result of
investment. i.e the “worth of a rupee received today is different from the worth of
rupee to be received in future”
Reason for time preference of money

(i) Risk : There are financial and non-financial risks involved over time. Future there is
uncertainty about the receipt of money in future. Longer the time period of return, the
greater is the risk. Hence, present money is preferred.

(ii) Preference for present consumptions : Most of the persons and companies prefer
present consumption due to urgency of need e.g. consumer durables or otherwise.

(iii) Inflations : Inflations erodes the value of money. In an inflationary situations, rupee
todays represents a greater purchasing power than a rupee one year later. For eg. If the
present petrol price is Rs.50 p.lt., 10 litre cqn be purchased with Rs.500. if it increases to
60, we can buy only 8.33 litres.

(iv) Investment opportunities : Individuals and companies have preference for present
money because of availabilities of opportunities of investment
Methods of analysis of Time value of Money

Concept of time value of money gives comparable values of different rupee amounts at
different point of time into equivalent values at a particular point of time. This can ne either

(i) Compounding or (ii) Discounting

Compounding refers to ascertainment of future value of present money . It is same as

the concept of compounding interest, wherein the interest earned in the preceding year is
reinvested at the prevailing rate of interest for the reaming period. The accumulated (principal
+ interest) at the end of period becomes the principal amount for calculating the interest for
the next period.

Discounting means ascertaining the present value for the future cash flow. “Discounting
Factor”
 Future Value

• Compounding is the process of finding the future values of cash flows by applying the
concept of compound interest.
• Compound interest is the interest that is received on the original amount (principal) as
well as on any interest earned but not withdrawn during earlier periods.
• Simple interest is the interest that is calculated only on the original amount (principal),
and thus, no compounding of interest takes place.

The general form of equation for calculating the future value ( Fn ) of a lump sum after n
periods may, therefore, be written as follows: where (P) = Present value

or

The term (1 + i)n is the compound value factor (CVF) of a lump sum of Re 1, and it
always has a value greater than 1 for positive i, indicating that CVF increases as i and n
increase.
compound value factor Table No :
 If you deposited Rs 55,650 in a bank, which was paying a 15 per cent rate of interest on a ten-
year time deposit, how much would the deposit grow at the end of ten years?

We will first find out the compound value factor at 15 per cent for 10 years which is 4.046.
Multiplying 4.046 by Rs 55,650, we get Rs 225,159.90 as the compound value:

Present Value

• Present value of a future cash flow (inflow or outflow) is the amount of current cash that
is of equivalent value to the decision-maker.
• Discounting is the process of determining present value of a series of future cash flows.
• The interest rate used for discounting cash flows is also called the discount rate.
 Present Value of a Single Cash Flow

• The following general formula can be employed to calculate the present value of a lump sum
to be received after some future periods:

• The term in parentheses is the discount factor or present value factor (PVF), and it is
always less than 1.0 for positive i, indicating that a future amount has a smaller present
value.

Example

Suppose that an investor wants to find out the present value of Rs 50,000 to be received after
15 years. Her interest rate is 9 per cent. First, we will find out the present value factor, which
is 0.275. Multiplying 0.275 by Rs 50,000, we obtain Rs 13,750 as the present value:
 Indian Financial System
Financial System deals about (a) Various financial institution (b) With their financial services
(c) Financial market which enable individual , business and government concern to raise
finance and (d) Various instruments issued in the financial market for the purpose of raising
financial resources

Fin.
Institution

Fin. Financial Fin

System
Market Instrument

Fin.
Services
Financial Market
Financial Market is a place used for buying and selling securities. Types of securities traded are
Ownership Securities, Debt securities, short-term securities, long- term securities, government
securities, non-government or corporate securities.
Segments of financial Markets
Money Market : Market for Short term financial assets with maturities
of one year or less. Main Sources of working capital
fund for business and industry's– Bills, Commercial Bill.
In India participants are mostly financial institutions.
Capital Market : Securities with maturities of more than one year are
bought and sold.
Types of financial Market
Primary Market : Market Mechanism for buying and selling of new issue securities
Secondary market : Securities already issues are bought and sold between Individual and
Institutions.
 Commodities market
MCX – Multi commodity exchange

The started November 2003 Multi Commodity Exchange of India Limited (MCX), India’s first
listed exchange for commodity derivatives exchange that facilitates online trading of
commodity derivatives transactions. The Exchange, which operations in, operates under the
regulatory framework of Securities and Exchange Board of India (SEBI).

MCX offers trading in commodity derivative contracts across varied segments including bullion,

• Industrial metals,

• Energy and

• Agricultural commodities, as also on indices constituted from these contracts.

MCX is India’s leading commodity derivatives exchange with a market share of 96.04 per cent in terms of
the value of commodity futures contracts traded in the financial year 2020-21.
 NCDEX – National commodities and derivative exchange Ltd.,

National Commodity & Derivatives Exchange Limited (NCDEX) (NCDEX/the Exchange) is a leading agricultural
commodity exchange in India, with a market share of 78.0%, 81.5%, 79.9% and 78.1% in the agricultural commodity
segments, based on average daily turnover (by value) for the six month period ended September 30, 2019, Fiscal 2019,
Fiscal 2018 and Fiscal 2017, respectively. The Exchange has maintained its leadership position since 2005, in the
agricultural commodity derivatives market, in terms of ADTV. Further, the Exchange is a professionally managed
company, which is driven by technology.
Current ShareholdersLife Insurance Corporation of India (LIC), National Bank for Agriculture and Rural Development
(NABARD), National Stock Exchange of India Limited (NSE), Canara Bank, Punjab National Bank (PNB), CRISIL Limited,
Indian Farmers Fertiliser Cooperative Limited (IFFCO), Shree Renuka Sugars Limited, Jaypee Capital Services Limited,
Build India Capital Advisors LLP, Oman India Joint Investment Fund, Invest corp Private Equity Fund I (formerly known as
IDFC Private Equity Fund III), Star Agri warehousing and Collateral Management Limited and shareholding by
individuals.
 Role of financial manager
Financial manger is a person who significantly responsible for all finance functions. Being the member of
top management he is responsible for shaping the future of enterprises.

Raising of funds : In the modern approach role of Fin Mgr. is not limited to fund raising activity, he has
to raise from combination of various sources and more intensely felt in the case of an episodic event like
mergers, consolidations, reorganizations and recapitalizations.

Allocation of funds : the central issue of financial policy is the wise use of funds, and the central process
involved is a rational matching of advantages potential uses against the cost of alternative potential
sources so as to achieve the broad financial goals which an enterprise sets for itself.

Profit Planning : Functions of financial manager include profit planning. It refers to the operating
decisions in the area of pricing, costs, volume of output and the firm’s selection of product lines. Profit
planning is a pre-requisite for optimizing investment and financing decisions.

Understanding Capital Markets: Fin mgr has to deal with capital market where the firm’s securities are
traded. Risk measurement, valuation , dividend distribution should be understood by him. It is through
their operations in capital market the investor continuously evaluate the actions of the financial manager.
 Unit II:

2
Investment Decision: Appraisal of project; Concept, Process & Techniques of Capital
Budgeting and its applications; Risk and Uncertainty in Capital Budgeting; Leverage
Analysis – financial, operating and combined leverage along with implications; EBIT ‐EPS
Analysis. Capital budgeting practices in Indian companies.
The investment decisions of a firm are generally known as the capital budgeting, or capital
expenditure decisions.

The firm’s investment decisions would generally include expansion, acquisition, modernisation
and replacement of the long-term assets. Sale of a division or business (dis-investment) is also
as an investment decision.

Decisions like the change in the methods of sales distribution, or an advertisement campaign or a
research and development programme have long-term implications for the firm’s expenditures
and benefits, and therefore, they should also be evaluated as investment decisions.

Features of Investment Decisions • Growth  

• Risk 
• The exchange of current funds for future benefits.
• Funding  
• The funds are invested in long-term assets. • Irreversibility
• Complexity 
• The future benefits will occur to the firm over a series of years.
 Types of Investment Decisions
• One classification is as follows:
•  Expansion of existing business
•  Getting in to new business
•  Replacement and modernisation a unit
• Yet another useful way to classify investments is as follows:
•  Mutually exclusive investments
•  Independent investments
•  Contingent investments
Discounted Cash Flow (DCF) Criteria
•   Net Present Value (NPV)
•   Internal Rate of Return (IRR)
Capital Budgeting techniques
•   Profitability Index (PI)
Non-discounted Cash Flow Criteria
•   Payback Period (PB)
•   Discounted Payback Period (DPB)
•   Accounting Rate of Return (ARR)
 Net Present Value Method

• Cash flows (Out and Inflow) of the investment project should be forecasted based on realistic
assumptions.
• Appropriate discount rate should be identified to discount the forecasted cash flows. The
appropriate discount rate is the project’s opportunity cost of capital.
• Present value of cash flows should be calculated using the opportunity cost of capital as the
discount rate.
• The project should be accepted if NPV is positive (i.e., NPV > 0).

Net present value should be found out by subtracting present value of cash outflows from
present value of cash inflows. The formula for the net present value can be written as
follows:
 Acceptance Rule
• Accept the project when NPV is positive NPV > 0
• Reject the project when NPV is negative NPV < 0
•  May accept the project when NPV is zero NPV = 0
• The NPV method can be used to select between mutually exclusive projects; the one with the
higher NPV should be selected.
Evaluation of the NPV Method

NPV is most acceptable investment rule for the following reasons:

• Time value
• Measure of true profitability
• Value-additivity
Limitations:
• Shareholder value Involved cash flow estimation
Discount rate difficult to determine
Mutually exclusive projects
Ranking of projects
Calculating Net Present Value

Assume that Project X costs Rs 2,500 now and is expected to generate year-end cash inflows
of Rs 900, Rs 800, Rs 700, Rs 600 and Rs 500 in 5 years. The opportunity cost of the capital
may be assumed to be 10 per cent.
 Internal Rate of Return Method
The internal rate of return (IRR) is the rate that equates the investment outlay with the present
value of cash inflow received after one period. This also implies that the rate of return is the
discount rate which makes NPV = 0.

Calculation of IRR

Uneven Cash Flows: Calculating IRR by Trial and Error

The approach is to select any discount rate to compute the present value of cash inflows. If the
calculated present value of the expected cash inflow is lower than the present value of cash
outflows, a lower rate should be tried. On the other hand, a higher value should be tried if the
present value of inflows is higher than the present value of outflows. This process will be repeated
unless the net present value becomes zero.
Evaluation of IRR Method

• Accept the project when r > k.

• Reject the project when r < k.
• May accept the project when r = k.
• In case of independent projects, IRR and NPV rules will give the same results if the firm
has no shortage of funds.

Acceptance Rule

• IRR method has following merits: IRR method may suffer from:
• Time value Multiple rates
• Profitability measure Mutually exclusive projects
• Acceptance rule Value additivity
• Shareholder value
Level Cash Flows
Let us assume that an investment would cost Rs 20,000 and provide annual cash inflow of Rs
5,430 for 6 years.
The IRR of the investment can be found out as follows:
 Payback Period

Payback is the number of years required to recover the original cash outlay invested in a
project.
If the project generates constant annual cash inflows, the payback period can be computed by
dividing cash outlay by the annual cash inflow. That is:

Assume that a project requires an outlay of Rs 50,000 and yields annual cash inflow of Rs
12,500 for 7 years. The payback period for the project is:

• The project would be accepted if its payback period is less than the maximum or standard
payback period set by management.
• As a ranking method, it gives highest ranking to the project, which has the shortest payback
period and lowest ranking to the project with highest payback period.
 Risk Analysis in Capital Budgeting
Nature of Risk

• Risk exists either because of the inability of the decision-maker to make perfect forecasts
• Change in Business environment / Market Condition change (e.g. Pandemic)
• In formal terms, the risk associated with an investment may be defined “as the variability
that is likely to occur in the future returns from the investment”
• Events influencing the investment forecasts:
• General economic conditions – inflation / deflation / change in currency exchange
• Industry factors -
• Company factors -

Statistical Techniques for Risk Analysis Conventional Techniques of Risk Analysis

Probability Payback
Variance or Standard Deviation Risk-adjusted discount rate
Coefficient of Variation Certainty equivalent
 Probability
• A typical forecast is single figure for a period. This is referred to as “best estimate” or
“most likely” forecast:
• Firstly, we do not know the chances of this figure actually occurring, i.e., the
uncertainty surrounding this figure.
• Secondly, the meaning of best estimates or most likely is not very clear. It is not
known whether it is mean, median or mode.
• For these reasons, a forecaster should not give just one estimate, but a range of associated
probability–a probability distribution.
• Probability may be described as a measure of someone’s opinion about the likelihood that
an event will occur.

Assigning Probability  
• The probability estimate, which is based on a very large number of observations, is known as
an objective probability.
• Such probability assignments that reflect the state of belief of a person rather than the
objective evidence of a large number of trials are called personal or subjective probabilities.

29
Expected Net Present Value
Once the probability assignments have been made to the future cash flows the next step is to
find out the expected net present value.

Expected net present value = Sum of present values of expected net cash flows.

Variance or Standard Deviation

Simply stated, variance measures the deviation about expected cash flow of each of the possible
cash flows.
Standard deviation is the square root of variance.
Absolute Measure of Risk.

30
 Coefficient of Variation
• Relative Measure of Risk
• It is defined as the standard deviation of the probability distribution divided by its expected
value:

Coefficient of Variation

• The coefficient of variation is a useful measure of risk when we are comparing the projects
which have
• (i) same standard deviations but different expected values, or
• (ii) different standard deviations but same expected values, or
• (iii) different standard deviations and different expected values.

31
Risk Analysis in Practice
• Most companies in India account for risk while evaluating their capital expenditure decisions.
The following factors are considered to influence the riskiness of investment projects:
• price of raw material and other inputs
• price of product • government policies
• product demand • technological changes
• project life
• inflation

Out of these factors, four factors thought to be contributing most to the project riskiness
are: selling price, product demand, technical changes and government policies.
The most commonly used methods of risk analysis in practice are:
• sensitivity analysis
• conservative forecasts
Sensitivity analysis allows to see the impact of the change in the behaviour of critical
variables on the project profitability. Conservative forecasts include using short payback or
higher discount rate for discounting cash flows.
Except a very few companies most companies do not use the statistical and other
sophisticated techniques for analysing risk in investment decisions.

32
 Payback
• This method, as applied in practice, is more an attempt to allow for risk in capital budgeting
decision rather than a method to measure profitability.
• The merit of payback
• Its simplicity.
• Focusing attention on the near term future and thereby emphasising the liquidity of the
firm through recovery of capital.
• Favouring short term projects over what may be riskier, longer term projects.
• Even as a method for allowing risks of time nature, it ignores the time value of cash flows.

Risk-Adjusted Discount Rate

• Risk-adjusted discount rate, will allow for both time preference and risk preference and
will be a sum of the risk-free rate and the risk-premium rate reflecting the investor’s
attitude towards risk.

• Under CAPM, the risk-premium is the difference between the market rate of return and
the risk-free rate multiplied by the beta of the project.

33
Evaluation of Risk-adjusted Discount Rate

• The following are the advantages of risk-adjusted discount rate method:

•  It is simple and can be easily understood.
•  It has a great deal of intuitive appeal for risk-averse businessman.
•  It incorporates an attitude (risk-aversion) towards uncertainty.

• This approach, however, suffers from the following limitations:

• There is no easy way of deriving a risk-adjusted discount rate. As discussed earlier,
CAPM provides for a basis of calculating the risk-adjusted discount rate. Its use has
yet to pick up in practice.
• It does not make any risk adjustment in the numerator for the cash flows that are
forecast over the future years.
• It is based on the assumption that investors are risk-averse. Though it is generally
true, there exists a category of risk seekers who do not demand premium for
assuming risks; they are willing to pay a premium to take risks.

34
Certainty—Equivalent

• Reduce the forecasts of cash flows to some

conservative levels.
• The certainty—equivalent coefficient assumes a
value between 0 and 1, and varies inversely
with risk.
• Decision-maker subjectively or objectively
establishes the coefficients.
• The certainty—equivalent coefficient can be
determined as a relationship between the
certain cash flows and the risky cash flows.

35
 Evaluation of Certainty—Equivalent

This method suffers from many dangers in a large enterprise:

• First, the forecaster, expecting the reduction that will be made in his forecasts, may
inflate them in anticipation.
• Second, if forecasts have to pass through several layers of management, the effect
may be to greatly exaggerate the original forecast or to make it ultra-conservative.
• Third, by focusing explicit attention only on the gloomy outcomes, chances are
increased for passing by some good investments.

36
Risk-adjusted Discount Rate Vs. Certainty–Equivalent

• The certainty—equivalent approach recognises risk in capital budgeting analysis by adjusting

estimated cash flows and employs risk-free rate to discount the adjusted cash flows. On the
other hand, the risk-adjusted discount rate adjusts for risk by adjusting the discount rate. It
has been suggested that the certainty—equivalent approach is theoretically a superior
technique.
• The risk-adjusted discount rate approach will yield the same result as the certainty—
equivalent approach if the risk-free rate is constant and the risk-adjusted discount rate is the
same for all future periods.

37
 Sensitivity Analysis
• Sensitivity analysis is a way of analysing change in the project’s NPV (or IRR) for a given
change in one of the variables.
• The following three steps are involved in the use of sensitivity analysis:
• Identification of all those variables, which have an influence on the project’s NPV (or IRR).
• Definition of the underlying (mathematical) relationship between the variables.
• Analysis of the impact of the change in each of the variables on the project’s NPV.
• The decision maker, while performing sensitivity analysis, computes the project’s NPV (or IRR)
for each forecast under three assumptions:
(a) pessimistic,
(b) expected, and
(c) optimistic.

DCF Break-even Analysis

• Sensitivity analysis is a variation of the break-even analysis.
• What shall be the consequences if volume or price or cost changes (Sensitivity analysis)? You can
ask this question differently: How much lower can the sales volume become before the project
becomes unprofitable? What you are asking for is the break-even point.
• DCF break-even point is different from the accounting break-even point. The accounting
break-even point is estimated as fixed costs divided by the contribution ratio. It does not
account for the opportunity cost of capital, and fixed costs include both cash plus non-cash costs
(such as depreciation). 38
Leverage Analysis – financial, operating and combined leverage along with implications
Leverages
Capital structure (combination of debt and equity) determines the types of fund a firm seeks to finance its
investment opportunity and the proposition in which these funds should be raised. If the
propositions of own capital is more than debt capital, the return and risk of the shareholders will be
much less.

• The leverage analysis is the technique used by business firm to quantify risk-return
relationship of different alternative capital structure.

• In finance, leverage is used to describe the firms ability to use “fixed cost asset” and funds
to magnify the return to its owners.

• When volume of sales changes, leverage helps in increasing the firms profit. A high degree of
leverage implies that there will be a large change in profit as result of relatively small
changes in sales and vice versa Types of leverage
- Operating leverage
- Financial leverage
- Combined Leverage
Operating leverage
Operating leverage implies use of fixed cost in the operating firm. Every firm has tin incur
fixed cost irrespective of volume of production or sales. Since fixed cost remains constant, even a
small change is sales brings about a more than propionate change in operating profit.
The firm’s ability to use fixed operating cost to magnify the effect of changes in sales on
its earnings before interest and tax.

Degree of Operating Leverage

Degree of operating leverage depends upon the amount of fixed cost element in the cost
structure. A firm is said to have a high degree of operating leverage it if employs a greater
amount of fixed cost and a smaller amount of variable cost.
• Operating leverage tell the impact of changes in sales in operating income.
• Firm having higher DOL can experience a magnified effect on EBIT for even a small
changes in sales level.
• Higher DOL can increases operating profit, but if there is decline in sales, EBIT may be wiped
out & loss may be occurred
• Operating leverage depends on fixed cost, if fixed cost is higher firms operating
leverage and operating risk will be higher
Financial Leverage

Financial Leverage occurs when a firm uses more fixed interest / dividend bearing
securities i.e debentures and preference share, along with equity to improve return on equity.
• Firm fixed financial charges will not vary with operating profit.
• The reaming EBIT, after paying fixed charges belongs to equity shareholders.
• Financial leverage is concerned with the effect of changes in EBIT on earnings available
to equity share holders (EPS).
• Financial leverage helps to plan appropriate capital structure, and maximize the ROE & EPS.
• Higher Fin. Leverage higher financial cost and higher financial risk,.

Combined leverage
Both Operating leverage and financial leverage closely concerned with firm’s capacity to
meet its fixed cost. If both this leverages are combined, the result obtained will reveal the
effect of changes in sales over changes in taxable profit or EPS

• Combined leverage establishes relationship between sales and corresponding variation in

taxable income.
• Firms ability of firm to use fixed financial charges to magnify the effect of changes in EBIT on the
firm’s EPS.

Degree of Financial Leverage (DFL)

Degree of financial leverage(DFL) is the percentage changes in taxable profit as a result of
percentage changes in operating profit.
• It explains the ability of the firm to utilize fixed financial cost in order to magnify the effect of
changes in EBIT on EPS of the firm. DFL computed by

• Financial Leverage is favorable when the firm earns more on the investment/ assets financed by
sources having fixed charges.
• Shareholder gain in a situation where firm earns a high rate of return and pay a lower gain on a
situation where the firm earns a high rate of return and pays a lower rate of return tp supplier of
long term funds
Calculate operating leverage and financial leverage under situations 1 and 2 and financial
plans A and B respectively from the following information relating to the operating and
capital structure of a company. What are the combinations of operating and financial
leverage which give highest and least value?

Installed capacity 2000 units

Annual production and 50 % of installed capacity
sales
Selling price per unit Rs.20
Variable cost per unit Rs.10
Fixed cost
Situation 1 : Rs.4000
Situation 2 : Rs.5000

Capital structure : A (rs) B(rs)

Equity 5000 15000
Debt(cost 10%) 15000 5000
• Combined leverage shows combined effect of financial and operating leverages.

• A high operating leverage and high financial leverage combines very risky, if firm is producing
and selling at high level, it will make extremely high profit for its shareholders. But even a
small fall in the level of operations, would result in a tremendous fall in EPS.

• High operating leverage and low financial leverage indicate that the management is careful
since higher amount of risk involved in high operating leverage has been sought to be balanced
by low financial leverage.

• More preferable situation would be to have a low operating leverage and high financial
leverage. As low operating leverage would automatically imply that the firm reaches its break-
even point at a low level of sales.
 Financial Leverage and shareholders return

Primary motive of firm in using fin. Leverage is to magnify shareholders return under favorable
economic condition.

• Its based in the assumption that fixed charges funds can be obtained at a lower cost than firms
required rate of return.

• When difference between earnings generated by assets financed by the fixed-charges funds and
cost of these funds is distributed to the shareholders by which EPS & ROE increases.

• EPS & ROE will fall if the company obtains fixed charges funs at a higher cost thane required rate of
return. Thus EPS, ROE & ROI are influenced by financial leverage.

Interest tax shield

The effect of debt is to see the impact of the interest charges on the firm’s tax liability. The interest
charges are tax deductible and therefore, provided tax shield which increases the earnings of the
shareholder.
Financial leverage magnifies the shareholders earnings. Variability of EBIT causes EPS to
fluctuate within the wider ranges with debt in the capital structure. With more debt EPS raises
and falls faster than the rise and fall in EBIT. Thus financial leverage not inly magnifies EPS but
also increases its variability.
Variability of EBIT and EPS distinguish between two types of risk
- Operating risk
- Financial Risk
Operating Risk can be defined as the variability of EBIT (return on total asset). The
environment internal or external in which a firm operates determines the variability of EBIT.
Operating risk is an unavoidable risk. A firm is better placed to face such risk if it can predit it
with a fair degree of accuracy. Variability of EBIT has two components Variability in sales &
Variability in expenses
Financial Risk
For a given degree of variability of EBIT, the variability of EPS( & ROE) increases with more
financial leverage. The variability of EPS caused by the use of financial leverage is called financial
risk
Operating Leverage
• Operating leverage affects a firm’s operating profit (EBIT).
• The degree of operating leverage (DOL) is defined as the percentage change
in the earnings before interest and taxes relative to a given percentage
change in sales.
 Combining Financial and Operating Leverages
• Operating leverage affects a firm’s operating profit (EBIT), while financial leverage affects
profit after tax or the earnings per share.
• The degrees of operating and financial leverages is combined to see the effect of
total leverage on EPS associated with a given change in sales.
Combining Financial and Operating Leverages

• The degree of combined leverage (DCL) is given by the following

equation:

• another way of expressing the degree of combined leverage is as

follows:
Financial Leverage and the Shareholders’ Risk
• The variability of EBIT and EPS distinguish between two types of risk—
operating risk and financial risk.
• Operating risk can be defined as the variability of EBIT (or return on total
assets). The environment—internal and external—in which a firm
operates determines the variability of EBIT
• The variability of EBIT has two components:
• variability of sales
• variability of expenses
• The variability of EPS caused by the use of financial leverage is called
financial risk.
 3
Unit III:

Financing Decision: Long‐term sources of finance - equity shares, preference shares, debentures and bonds –
Valuation of securities. Concept and Approaches of capital structure decision: NI, NOI, Traditional and Modigliani
Miller Approach.
Long Term Finance: Shares, Debentures and Term Loans

Ordinary Shares–Features

• Claim on Income Advantages

• Claim on Assets • Permanent Capital
• Borrowing Base
• Right to Control • Dividend Payment Discretion
• Voting Rights
• Pre-Emptive Rights Disadvantages
• Limited Liability • Cost
• Risk
• Earnings Dilution
• Ownership Dilution
Right Shares - Selling of Ordinary Shares to
Debentures–Features
the existing shareholders of the company
• Interest Rate
• Maturity
Advantages • Redemption
1. Control is maintained
2. Less flotation cost
• Sinking Fund
3. Issue more likely to be successful • Buy-back (call) provisions
• Indenture
Disadvantages
• Security
4. Shareholders lose if fail to exercise their
right • Yield
5. If shareholding concentrated in hands of • Claim on Assets and Income
FI

Types of Debentures
• Non – Convertible Debentures
• Fully – Convertible Debentures
• Partly – Convertible Debentures
 Preference Shares Preference Shares–Features

Similarity to Ordinary Shares:

• Claim on Income and Assets
1. Non payment of dividends does not force
• Fixed Dividend
company to insolvency.

2. Dividends are not deductible for tax purposes. • Cumulative Dividend

3. In some cases it has no fixed maturity dates. • Redemption

Similarity to Debentures: • Sinking Fund

4. Dividend rate is fixed. • Call Feature

5. Do not share in residual earnings. • Participation Feature

6. Usually do not have voting rights. • Voting Rights

Advantages
1. Risk less Leverage advantage • Convertibility
Disadvantages
2. Dividend postponability 1. Non-deductibility of Dividends
3. Fixed dividend 2. Commitment to pay dividends
4. Limited Voting Rights
Valuation of securities
Valuation of securities
• The value of a firm depends on the expected cash flows and the discount rate.
• Value of the firm is given as follows:

where FCF is the free cash flow and k0 is the weighted average cost of capital (WACC).
• If we assume constant relations of earnings, working capital and capital expenditure to
sales, we can write the equation for the free cash flows as follows:
 Theories of Capital structure

Capital Structure is Combination of debt and equity.

The objectives of a firm should be directed towards the maximization of the value of the
firm. The capital structure decision should be examined from the point of view of its impact
on the value of the firm. If the value of the firm can be affected by capital structure or
financing decisions, a firm would like to have a capital structure which maximize the
market value of firm.

Theories of Capital structure

(i) Net Income (NI) approach -

(ii)Net Operating income approach -

(iii)Traditional approach -

(iv)Modigliani and Miller approach

These approached analyze the relationship between the leverage, cost of capital and value of
firm in different ways.
 Assumptions for capital structure theories
(i) There are two sources of finance debt & equity
(ii) Total asset of the firm and its capital employees are constant. However, debt & equity mix
can be changes either by borrowing to repurchase equity or raising equity to repay debt.
(iii) All residual earnings are distributed to equity shareholders.
(iv) The firm earns operating profit and it is expected to grow.
(v) The business risk is assumed to be constant and is not affected by the financing mix
decisions ( No changes in fixed cost or operating risks)
(vi) There are no corporate or personal taxes
(vii) The investor have the same subjective probability distribution of expected earnings (No
difference in investor expectations)
(viii) Cost of debt (Kd) is less than cost of equity (Ke)
 Net Income Approach (relevance)
This approach has been suggested by Durand. According to this approach, “a firm can
increase its value or lower the overall cost of capital by increasing the proportion of
debt in the capital structure. i.e.

“If the degree of financial leverage increases, the weighted average cost of capital
(WACC) will decline with every increase in the debt content in total capital employed, while
the value of firm will increase. Reserve will happen in a converse situation”

Assumption

(i) No Corporate taxes

(ii) Cost of debt (Kd) is less than cost of equity (Ke)

(iii) The use of debt content does not change the risk perception of investors. As result both
the Kd and Ke remain constant.
the total market value of firm (V) under the NI approach is
determined with the help of the following formula

V=S+D V= Total mkt value ; S= Mkt Value

equity share ; D= Mkt value of debt
 Net Operating Income approach (Irrelevant)
The approach has been suggested by Durand. According to this approach, the mkt value of the firm
is not affected by the capital structure changes. The market value of the firm is ascertained by
capitalizing the net operating income at the overall cost of capital which is constant. The Mkt
value of the firm is determined as follows

Assumptions
(i) The overall cost of capital remains constant for all degree of debt-equity mix
(ii) The market capitalizes the value of firm as a whole. Thus split between debt equity is not
important
(iii) The use of less costly debt funds increases the risk of shareholders. This causes the equity
capitalization rate to increase. Thus the advantage of debt is set off exactly capitalization
rate.
(iv) There are no corporate taxes
(v) The cost of debt is constant
Traditional Approach: This approach is also known as intermediate approach as it takes a
midway between NI & NOI. According to this approach the use of debt up to a point is
advantageous. It can help to reduce the overall cost of capital and increase the value of the
firm, beyond this point, the debt increases the financial risk of shareholders. As a result, cost of
equity also increases, the benefit of debt is neutralized by the increased cost of equity. Thus up
to a point, the content of debt in capital structure will be favorable. Beyond that point the use
of debt will adversely affect the value of the firm. At the point the capital structure is optimal
and the overall cost of capital will be the least.

Modigliani and Miller approach: Modigliani and Miller have explained the relationship
between cost of capital, capital structure and total value of the form under two conditions

(a) When there are no corporate tax

(b) When there are corporate tax

When there are NO Corporate tax : the MM, approach is identical to NOI approach, when
there are no corporate taxes. MM argues that in the absence of taxes the cost of capital and value
of the form are not affected by capital structure or debt equity mix. They gave a simple argument
in support of their approach.

- According to traditional approach, cost of capital is the weighted average of cost of debt and
cost of equity etc. The cost of equity, they argued, is determined by level of shareholders
expectations Now if shareholder expect 15% from a particular firm, they do take into account
the debt-equity ratio and they expect 15% merely because cover particular risk which the firm
entails. If debt increases further the risk of the firm as it is risky finance. Thus share holder will
expect a higher return. Thus the change in debt equity mix is automatically offset t=by a
change in the expectation of the shareholders.

- MM argues that financial leverage has noting to do with the overall cost of capital and the
overall cost of capital is equal to the capitalization rate of pure equity stream of its class of risk.
MM make following proposition
(a) The total Mkt value of a firm & its coat of capital are independent of tis capital structure. The
total market value of firm is given by capitalizing the expected stream of operating earnings at a
discount rate considered appropriate for its risk class
(b) The cost of (Ke) is equal to capitalization rate of purely equity stream plus a premium for
financial risk. The fin risk increases ina manner to offset exactly the use of less expensive source
of funds
(c) The cut of rate for investment purpose is complete independent of the way in which the
investment is financed

Assumptions
(d) Capital Mkt are perfect. Investor are free to buy and sell securities. They are well informed
about risk-return on all type of securities. No transaction cost. The investor behave rationally.
They can borrow without restrictions on the same terms as the firms do.
(e) The firms can be classified into homogenous risk classes. All firms with in the same class will
have the same degree of business risk.
(f) All investor have the same expectations from firm’s net operating income EBIT which are
necessary to evaluate the value of the firm
Arbitrage process MM hypothesis reveals that the total value of firm is determined by its
operating income or EBIT. It is independent of the debt equity mix. Two firm which are identical
in all aspects expect their capital structure cannot have different market value or different cost
of capital. If the market value of the firm differ, arbitrage process will take place and make
them equal.

II. When there are corporate tax :

MM agreed that the capital structure will affect the value of the firm and the cost of capital when
taxes are applicable to corporate income. If a firm uses debt in its capital structure, the cost of
capital will decline and market value of the firm will increase. This because interest is detectable
expenses for tax purpose and therefore, the effective cost od debt is less than the contractual
rate of interest. A levered firm can therefore have more earnings to its equity shareholder than
an unlevered firm. This make debt financing advantageous and value of the levered firm will be
higher that of an unlevered firm.
Measuring Operating and Financial Risk

• We can use two measures of risk:

• Standard deviation and
• Coefficient of variation.
 Unit IV:

4
Dividend policy – Factors affecting the dividend policy - dividend policies‐ stable dividend,
stable pay-out. Relevance and Irrelevance. Theory of dividend decision: Walter’s Model,
Factors affecting dividend decision
Relevance Vs. Irrelevance

• Walter's Model
• Gordon's Model
• Modigliani and Miller Hypothesis
• The Bird in the Hand Argument
• Informational Content
• Market Imperfections
Practical Consideration in Paying Dividends Stability of Dividends

• Financial Need of company. • Constant Dividend per Share or Dividend Rate.

• Shareholders Expectations. • Constant Payout.
• Closely / Widely Held Company. • Constant Dividend per Share Plus Extra Dividend.
• Constraints on Paying Dividends.
• Legal Restrictions
• Liquidity
• Borrowing Capacity
• Access to the Capital Markets Significance of Stability of Dividends
• Restrictions in Loan Agreements

• Resolutions of investors uncertainty.

• Investors’ desire for current income.
• Institutional Investors’ Requirement.
• Raising Additional Finances.
 Forms of Dividends

• Cash Dividends
• Bonus Shares (Stock Dividend).
• Advantages for Shareholders and Company.
• Limitations of Bonus Issue.
• Conditions for Issue of Bonus Shares.
 • Assumptions
• Internal Financing
Walters Model • Valuation
• Constant Return and Cost of Capital
• Optimum Payout Ratio
• Criticism
• 100% Payout or Retention
• Constant EPS and DIV
• Infinite Time

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.
 5
Unit V

Overview of Working Capital Decision: Concept, components, factors affecting working capital
requirement, Working Capital Management: Management of cash, inventory and receivables;
Working Capital Financing.
Principles of Working Capital Management

Gross working capital (GWC)

GWC refers to the firm’s total investment in current assets.
Current assets are the assets which can be converted into cash within an accounting
year (or operating cycle) and include cash, short-term securities, debtors, (accounts
receivable or book debts) bills receivable and stock (inventory).

• Net working capital (NWC).

• NWC refers to the difference between current assets and current liabilities.
• Current liabilities (CL) are those claims of outsiders which are expected to mature for
payment within an accounting year and include creditors (accounts payable), bills payable,
and outstanding expenses.
• NWC can be positive or negative.
• Positive NWC = CA > CL
• Negative NWC = CA < CL
 Concepts of Working Capital

• Net working capital (NWC).

• NWC refers to the difference between current assets and current liabilities.
• Current liabilities (CL) are those claims of outsiders which are expected to mature for payment
within an accounting year and include creditors (accounts payable), bills payable, and
outstanding expenses.
• NWC can be positive or negative.
• Positive NWC = CA > CL
• Negative NWC = CA < CL

Concepts of Working Capital

• GWC focuses on
• Optimisation of investment in current
• Financing of current assets
• NWC focuses on
• Liquidity position of the firm
• Judicious mix of short-term and long-tern financing