Module 1 – Cost of Capital

CoC – Meaning, Definition, Significance and

Types of capital
Problems on Specific CoC:
• Debt – Redeemable & Irredeemable
• Preference – Redeemable & Irredeemable
• Equity – Dividend Growth Model, Constant
Dividend Model, Constant Growth Model,
Constant Earnings, Constant Growth, CAPM Model
• WACC – Book Value Weights, Market Value
Weights
• Capital Structure Theories - NI, TT, NOI & MM
Hypothesis -
• Problems on NI & NOI Only

Note: Simple Problems on MMH

 Net Income Approach
Concept:
• Direct relationship b/w the Capital Structure and Value of
Business.
• Lowering the CoC can increase the VoB
• Debt is cheaper as its interest is deductable and by which
lower the tax burden
• Debt is cheaper than equity
• Increase in FL (Debt Proportion) – Decline in WACC, while the
VoB & Market price of ES will increase.
 Traditional Approach
• The result of financial leverage decreases the CoC
and increases the VoB to certain point and beyond
that it result in reverse trend
• CoD, CoE, CoC, MV of Eq and MV of Firm are
Variable
• Co has to select CS with lowest CoC or highest MV
of Firm
 Net Operating Income
Concept:
• The CS decisions are irrelevant to the value
• No relationship exists b/w the CS & VoB
• WACC will be constant if the company takes on more debt
• Increased debt increases the shareholder’s risk and thereby CoE
• Increase in CoE wipeout the cheaper of CoD
• A change in debt or leverage does not affect the VoB
• Without Tax structure CoD, CoC and MV of Firm remains Constant
• With Tax structure, CoD remains constant, the Debt and MV of
Firm will increase while CoC will decrease
 MM Approach
Franco Modigiliani and Merton Miller
Concept:
• The market value of a firm is determined by its earning
power and the risk of its underlying assets – the CS is
irrelevant in case of perfect markets
• Value is independent of the method of financing used
and the Co’s investments.
• Value of the firm is dependent on the expected future
earnings
• The financial leverage boosts the VoB and reduces
WACC
 Assumptions - MMA
• Capital markets are perfect.
• All info are available freely
• No transaction cost
• Investors are rational
• Firms are grouped into “Equivalent risk classes”
• Non-existence of corporate taxes
 Module 2
Risk Analysis in CB
• RA – Types of Risks, Risk & Uncertainty.
• Risk Evaluation Measurement Techniques
– Sensitivity Analysis
– Standard Deviation
– Co-efficient of Variations
Risk Evaluation Techniques:
• Risk Adjusted Discount Rate
• Certainty Equivalent
• Decision Tree
• Normal Probability Distribution
 Risk Analysis
Concept:
• Assessment process that identifies the potential for any adverse events
that may negatively affect organisations and the environment.
• Helps to undertake a project or approve a financial application, actions
required to protect their interest etc.
• Balance b/w risk and risk reduction
• It often work in with forecasting to minimise future negative unforeseen
effects
• It seeks to identify, measure and mitigate various risk exposures or
hazards facing a business, investment or project.
• Include Risk benefit, need assessment, root cause analysis
• Identifying risk, defining uncertainty, completing analysis models,
implementing solutions
 Types of Risk
• Business Risk:
Stand-alone|Portfolio|Systematic|Unsystamatic|
Mgt|Competitive|Specific
• Non-Business Risk – Political|EconomicalSocial|
Environmental|
International|
• Financial Risk – Market|Credit|Liquidity|Operational
Strategic|Event
• Legal Risk
 Techniques of Measuring Risks
• Sensitivity Analysis:
 Assess how changes in specific variables (sales/CoC/project
duration) affect key financial metrics (NPV, IRR), identify the factors
having the most significant effect on project outcome.
 Through insights into sensitivity of project outcomes to changes in
individual variables, helps to focus on critical risk factors.
• Scenario Analysis: evaluates the impact of multiple future scenario on
a project by considering combinations of key variables.
 Measures risks by examining of different scenarios like optimistic,
pessimistic, baseline cases - the range of potential outcomes &
related risks.
 Facilitates contingency planning for different situations
• Decision Tree:
 Graphical representation of decision options & their
possible outcomes, incorporating probabilities and
pay offs
 Visualises decision making under uncertainty,
considering different paths and their associated
risks with rewards
 Facilitates systematic evaluation of decision
options, assess the impact of uncertainties on
outcomes and choose the most favorable course of
action.
• Risk Adjusted Discount Rate:
 Adjusts the DR used in traditional CB techniques
(NPV/IRR) to reflect the riskiness of the project
 More accurate assessment of NPV
• Beta Coefficient (CAPM): Capital Asset Pricing
Model – measures the sensitivity of a project’s
returns to market movements.
 A beta greater than 1 indicates higher volatility,
suggesting higher systematic risk.
 Quantifies the project’s exposure to market risk
 Integrates market risk consideration into the CoE
• Probability Impact Matrix:
 a qualitative tool to assess the probability and impact of identified
risks on outcomes.
 Categorizes the risks based on probability and impact
 Helps to prioritize risks and allocate resources for risk mgt.
 A simple visual way to assess and communicate the significance of
various risks, aiding in prioritization, mitigation and planning
• Certainty Equivalent:
 Reduce the forecasts of cash flows to some conservative levels.
 It assumes a value b/w 0 and 1, & varies inversely with risk
 Decision maker subjectively or objectively establishes the coefficients
 Equivalent coefficient can be determined as a relationship b/w the
certain cash flows and risky cash flows
 Module 3
Dividend Decisions & Theories
• DD - Meaning
• Types of DD – Cash Dividend & Stock Dividend
• Types of DDP – Constant DP, Constant Dividend Pay-out Policy, CD Plus
Policy & Residual Approach
• Determinants:
 External – Gen State of Eco, Industrial Trend, State of Capital Mkt, Legal
Restrictions, Contractual Restrictions, Tax Policy
 Internal – SH’s desire, Financial Needs, Nature of Earnings, Desire of Control,
Liquidity position etc
• Dividend Theories:
 Relevance T – Walter’s Model, Gordon’s Model, Graham & Dodd Model,
Lintner’s Model & Residual Payment Model
 Irrelevance T – MM T
 Problems on Walter’s Model, Gordon’s Model & MM T
 Module 4
Mergers & Acquisitions
• Meaning
• Reasons – Unlocking Synergies, Higher Growth, Stronger Market Power,
Diversification, Tax Benefits
• Types of Combinations – Friendly| Hostile| Buyout| Reverse Takeover
• Types of Mergers - Vertical| Horizontal| Conglomerate| Congeneric|
• Motives & Benefits of Merger – Elimination of Excess workforce, Growth acceleration,
Technology, Procurement of New talent, Overcoming Competition, Attain Economies of
Scale, Acquire Monopoly etc.
• Financial Evaluation of a Merger – Cost Approach| Market Approach| Discounted Cash
Flow Approach| Comparable Company Analysis| Accretion/Dilution Analysis| Sensitivity
Analysis Model| Merger Consequences Analysis Model
• Merger Negotiation – Assessment and Preliminary Review| Negotiation & Letter of
Intent| Due Diligence| Negotiations & Closing| Post-Closure Integration/Implementation
• Leverage Buyout & Mgt Buyout, P/E Ratio – Meaning & Significance
• Problems on Exchange Ratios – Assets Approach| Earnings Approach| Market Value
Approach
• Impact of merger on EPS, Market Price & Market Capitalisation
 THANK YOU ALL
Prof. Shankaracharya Dr. Ramamurthy B M
Principal, AIMS Institutes
VEIT Degree College Peenya, B’Lore - 58
Southend Circle
Jayanagar, B’Lore - 11