Financial Management -II

What is Finance
• Every decision that a business makes has financial implications and any
decision that affects the finances of a business is a corporate finance
decision.
• Defined broadly, everything that a business does can be viewed with a
corporate finance lens—Its all about Cost and Benefits AND Risk Return
Trade offs
Why do you have assets and
Liabilities?
Real Assets and Financial Assets
Investment =Purchase Real Assets
Financing= Sell Financial Assets
Financing decision
Financing Octagon
Financing
• Equity
-- Cash Flow rights – Residual
-- Control Rights – Board and Ownership
--Dual class voting shares and REITs

Debt
• Debt – Long term or short term?; Fixed or Floating? Rupee or
some other currency? Covenants? Straight or convertible? On
balance sheet/off balance sheet
• Financial Markets and Intermediary
Patterns of Corporate Financing
• What fraction of profits should be ploughed back?- Data suggest that
3.1 trillion of internal funds. Fresh capital is 0.5 trillion
• What fraction of deficit should be met by debt?-3 trillion was borrowing
• Net Fixed assets consumed only 1.2 trillion and 0.8 trillion in Capital
WIP.
• 1.5 trillion is investment in financial assets/instruments.
• 4 trillion worth of Current Assets
• Gross fixed capital formation grew at 10.4% .
• Net Fixed assets of corporate grew at 3.5%
• Average debt equity for non finance companies in India (CMIE database)
is 0.47 ( Dominated by PSUs)
• Promoters hold 51% of shares, general public 31% and balance 18%
Debt Ratios
Industry Median Debt Ratio
Online Market Place 0.01
ITES 0.10
Education 0.13
Computer Software 0.17
Automobiles 0.28
Capital Goods Trading 0.27
FMCG 0.16
Healthcare 0.42
Hotels 0.35
Metal 0.46
Highway 0.61
Steel 0.64
Power 0.47
Financing Choices across the Life Cycle
CAPITAL STRUCTURE
The Debt Riddle?
Corporate Taxes
Income Statement of Income Statement of
Firm A Firm B

EBIT 1000 1000

Interest paid to 0 80
Bondholders@8%

PreTax Income 1000 920

Tax @25% 250 230
Net Income to Stock 750 690
Holders

Total Income to Bond 750 690+80=770

Holders and
Stockholders
Tax Shield@25% 0 20
Corporate Taxes-Reduces the pie of the Government

• Risk of the cash flows to debt is less than risk of

operating assets.
• Earning stable cash flows is pretty certain otherwise
its interest rate would have gone up.
• So if it maintains the debt, cash flow stream is infinite.
• So the Present value is 250/=
• Interest Payment is k*D
• PV is T *k*D/k= T*D
So Whats the Tax Advantage
• Does it contribute to shareholders value?
• Value of Firm = Value if all equity + PV ( Tax Shield)
• However its evident that you cant use tax shields , if
you don’t get future profits.
• There must be something in Indian Tax system which
offsets the present value of tax shield or something
else?
 Value of the levered firm
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Corporate and Personal Taxation
Interest / Income to debt Equity Income

Income before taxes 1.00 1.00

Income for distribution 1.00 0.75

Personal Tax 0.34 .04

Income after Taxes .66 .71

 Why do companies not employ extreme level of
debt in practice?
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 First, we need to consider the impact of both corporate and

personal taxes for corporate borrowing. Personal income tax
may offset the advantage of the interest tax shield.

 Second, borrowing may involve extra costs (in addition to

contractual interest cost)—costs of financial distress—that may
also offset the advantage of the interest shield.
Though the advantage is moderate, estimates suggest that
corporation could save upto 7.5% by levering up a
conservative debt ratio
Static Tax Theory/Trade off: Tax Advantage of Debt
• The debt ratios of entities facing higher tax rates should be higher
than the debt ratios of comparable entities facing lower tax rates.
• Firms that have substantial non debt tax shields , such as
depreciation, should be less likely to use debt than firms that do
not have these tax shields.
• If tax rates increase over time we would expect debt ratios to go
up over time as well, reflecting the higher tax benefits of debt.
• Countries having a higher tax rate may have a larger debt ratio.
• Companies choose a target rating rather than target debt
• Target Debt depends on nature of assets.
• Which debt policy would you advice a non profit organisation to
follow?
Agency cost of Equity: The Discipline of Debt
• Jensen expounded a new rationale for borrowing based on
improving the firm’s efficiency in utilizing its FCF.
• Borrowing creates commitment to make interest and principal
payments increasing the risk on default on projects with
substandard returns.
• Managers will not maximise shareholders wealth without
prodding of debt.
• But it may induce fear of not taking any risk after a certain
period of time.
• Why would any manager want to have dent when they have to
pay higher prices for their failures.
• Countries wherein stockholders are more powerful they push
the firms to borrow money and increase stock prices.
Does increasing leverage increase efficiency?
• Bhide argues that firms that are taken over in hostile
takeovers are characterised by poor performance in
profitability and stock returns. ROE is 2.2 % below
their peer group ( Bhide)
• Target firms in acquisitions are almost every time
underleveraged. (Palepu)
• Operating efficiency of firms improve after leveraged
buyouts. ( Kaplan)
• You are examining two firms one in a sector with
high returns and one in a sector with low returns.
Which one do you think will benefit more from the
discipline of debt and why?
Bankruptcy Costs
• Bankruptcy costs are the probability of bankruptcy
multiplied with direct and indirect costs of
bankruptcy.

• Probability of bankruptcy is the likelihood that a firms

cash flow will be insufficient to meet its promised
debt obligations. It’s a function of

• Size of operating cash flows relative to the size of cash

flows on debt obligations
• Variance on operating cash flows.
Bankruptcy Costs
• Costs of Bankruptcy are:
- Direct Costs: Cash outflows at the time of bankruptcy . Legal
and administrative expenses. May be 5.3 % of the total costs.
• - Indirect Costs: Perceptions examples…….
- Suppliers start demanding more to protect themselves
- Difficulty to raise fresh capital.
Indirect costs will be higher for these firms:
-- Firms that sell durable products with long lives that require
replacement parts. Personal computers
--- Firms that provide goods and services where quality is an
input.
--Firms whose products require continuous service.
Implications of Bankruptcy costs
• Firms operating in businesses with volatile earnings and cash
flows should use debt less than should otherwise similar firms
with stable cash flows.
Type of assets:
• Protection on debt.
• Assets are not divisible or marketable.
- A firm that has traditionally operated in a regulated
environment decides to enter a high return but unregulated
business. What are the consequences on leverage?
-- Some argue that bankruptcy costs are huge, especially when
one considers the loss in the value of securities of firms that
go bankrupt. Do you agree ? Why? Why not?
Debt and Incentives: Agency Costs
• Games consenting adults play:

-- Choosing which project to take. Risk shifting

-- Determining how to finance these projects – Under Investment
-- Determining how much to pay as dividends – Cash in and run, Playing for
time, bait and switch.

1. If bondholders believe that there is a significant chance that stockholders

actions may make them worse off, they can build this expectation into bond
prices by demanding much higher rates of return.
2. If they write restrictive covenants two costs are there:
--Direct costs of monitoring the covenants
-- Indirect cost of losing flexibility. Financial Flexibility refers to the capacity of
firms to meet any unforeseen contingencies that may arise and take
advantage of unanticipated opportunities using the funds they have on
hand and any excess debt capacity they might have nurtured.
Loss of Flexibility
• Firms with substantial investment opportunities should value
flexibility more highly than stable firms without these opportunities.
• Greater the uncertainty the bigger the need for flexibility
• Firms having large and unpredictable demand on cash flows value
flexibility more.
• Isnt Loss of flexibility in direct contrast with Discipline of Debt??
Debt Ratios and Fundamentals
• Marginal Tax Rate: As marginal tax rate increases, debt ratio increases
• Separation of ownership and management: The greater the separation the higher
the debt ratio
• Profitability/Variability of operating cash flows: As operating cash flows become
more variable, the bankruptcy risk increases resulting in lower debt ratios.
• Debt holders difficulty in monitoring firm action: the lower the optimal debt ratio.
• Need for flexibility: The greater the need, the lower the optimal debt ratios.
• Size /Tangible Assets