Financial management

Module - 1

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Unit 1: Nature and Scope of Financial Management
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Objectives
• to give an insight into the Financial Management
• To identify major areas of decision making in financial management
• To give a overall view of the scope of financial management.

Unit Outline
1.1 Introduction

1.2 Meaning of Business Finance.

1.3 Definitions of Financial Management

1.4 Which are the major areas of decision making in financial management?

1.5 Scope of financial management

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1.1INTRODUCTION
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Finance is the lifeblood of business organisations, without finance the
formation, establishment, production, functioning or operating of big, medium or
small business enterprise is not possible. Finance may be defined as the art and

science of managing money. The major areas of finance are 1) financial services

and 2) financial management. Financial Services is concerned with the design
and delivery of products to individuals, business and government within the areas

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of financial institutions, personal financial planning, investments, real estate, and
so on. Financial management is concerned with the duties of the financial
mangers in the business firm. The subject of finance is traditionally classified into
two classes
1) Public Finance and 2) Private Finance.
Public finance deals with the requirements, receipts, and disbursement
of funds in the government institutions like states, local self-governments and
central governments. Whereas the private finance deals with the requirements,
receipts and disbursement of funds by the individual, a business organisation and
non-business organisation. The private finance from the above we can once again
classified into personal finance and business finance and finance of non-business
organisation.

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1.2 MEANING OF BUSINESS FINANCE
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To understand the meaning of business finance there is a need to
understand the concepts business and finance. Business may be understood as the
organised efforts of enterprises to supply consumers with goods and services for
satisfying these needs and wants and in the process. All businesses share the
same purpose that is to earn profits. Broadly speaking, the term business includes
industry, trade and commerce.
Finance refers to provisioning of money at the time when it is required. Here
finance refers to management of flows of money through an organisation. Hence
Business Finance concerned with acquisition of funds, use of funds and
distribution of profits by a business firm.
The business finance can be further classified in to sole proprietary finance,
partnership finance and company or corporate finance. The principle of business
finance can be applied to any of the forms of business organisations. But since the

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business in an economy in terms of value in companies is more hence the
emphasis to the financial practices and problems of the incorporated enterprises
are studied much in business finance. So most of the authors use corporate
finance interchangeably with business finance.
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1.3 DEFINITIONS OF FINANCIAL MANAGEMENT
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Financial management refers to that part of the management activity which
is concerned with the planning and controlling of firm's financial resources. It deals
with finding out various sources for raising funds for the firm.

Accoding to Soloman, 'Financial Management is concerned with the efficient use
of important economic resource, manely, Capital Funds.'

According to Prather & Wert, "Business finance deals primarily with raising
administering and disbursing funds by privately owned business units operating in
non-financial fields of industry."

Wheeler defines Business Finance as "that business activity which is concerned
with the acquisition and conservation of capital funds in meeting the financial
needs and administering the funds used in the business."

According to Guthmann and Dougall, business finance can be broadly defined as
the activity concerned the planning, raising, controlling and administering the
funds used in the business.

According to James C. Van Horne 'Financial Management is concerned with the
acquisition, financing, and management of assets with some overall goal in mind.'

------------------------------------------------------------------------------- MAJOR
AREAS OF DECISION MAKING IN FINANCIAL MANAGEMENT

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Therefore the decision function of financial management can be broken down
into three major areas: the investment, financing, and asset management
decisions.
Investment Decision
The investment decision is the most important of the firm's three major
decisions when it comes to the value creation. Investment decision relates to the
determination of total amount of assets to be held in the firm, the composition of
these assets like the amount of fixed assets, current assets and the extent of
business risk involved by the investors.
The investment decisions can be classified in to two groups: (1) Long-term
investment decision or capital budgeting and (2) Short-term decision or Working
capital decision.
Financing Decision
Financing decision follows the Investment decision. The Finance manager
now has to decided how much of finance is required to meet the long-term and
short-term investment decisions, what are the sources of financing these
investment decisions, what is the composition of these finance and what should be
the financial mix and so on.
Asset Management Decision
The third important decision of the firm is the asset management decision.
Once assets have been acquired and appropriate financing provided, these assets
must still be managed efficiently. The finance manager has more responsibility in
managing the current assets than fixed assets. A large share of the responsibility
of managing the fixed assets would reside in the hands of operating managers of
the company.
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1.5 SCOPE OF FINANCIAL MANAGEMENT
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Financial management is concerned with acquisition, proper utilisation or
allocation of these funds. It is an activity concerned with the planning, raising,
controlling and administering the funds used in the business. Hence the finance
manager have to concentrate on the following areas of finance function.
1. Estimating Financial Requirements. The finance manager has to
estimate what would be the short term and long-term financial requirement
of his business. For this he has to prepare financial plan for present as well
as for future. He should make correct estimate of finance for purchasing of
fixed assets and current assets. The estimate should be accurate other wise
it leads to either excess of funds or inadequacy both these situations will
have adverse impact on the profitability of an organisation.
2. Deciding Capital Structure. The capital structure refers the composition
and proportion of different securities for raising funds. After deciding the
estimate of financial requirements for fixed and current assets of his
business the finance manager must decide what should be composition of
long-term funds like capital and debt ratio. Then he has to plan what should
be its proportion by taking in to consideration the cost of funds. Similarly for
short-term funds.
3. Selecting a Source of Finance. After selecting the capital structure the
finance manager must select the sources of finance by considering the cost
of capital and availability of funds in the market.
4. Selecting a pattern of investment. After procurement of funds, he has to
decide the pattern of investment. He should decide about which assets
should be purchased among fixed assets and which is the method of
selecting the fixed assets or capital budgeting techniques to be used and
cost analysis etc.,
5. Proper Cash Management. Proper cash management is another important
function of finance manager. He has to asses the cash needs of the
organisation like for purchasing of raw materials, making payment to the

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creditors, wages, rent and other day-today expenses. He must identify the
sources of raising cash like from cash sales, collection of debts, short-term
loans from banks and so on. The cash in an organisation neither excess nor
shortage. Excess cash will increase the idle funds in the organisation,
whereas shortage of funds or cash will affect the creditworthiness of the
company, hence it should be adequate.
6. Implementing Financial Controls. Efficient financial management
requires implementation of some financial controls like ratio analysis, return
on capital employed, return on assets, budgetary control, break-even
analysis, return of investment, internal audit etc., to evaluate the
performance of various financial policies of the organisation.
7. Proper use of surpluses. Proper use of profits or surpluses is also
essential for the expansion and diversification plans and also protecting the
interests of shareholders. Issue of bonus shares or ploughing back of capital
etc., will increase the value of the shares of the company hence judicious
utilisation of these surpluses is very important.

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UNIT 2 OBJECTIVES OR GOALS OF FINANCIAL
MANAGEMENT
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Objectives
• To study the objectives of financial management
• To analyse the relevance of each objective with the present scenario
• To know other objectives of financial management

Unit outline

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2.1 Objectives of financial management

2.2 Profit maximisation

2.3 Arguments in favour of Profit maximisation

2.4 Criticisms on Profit maximisation objective

2.5 Wealth maximisation

2.6 Criticisms on wealth maximisation objective

2.7 Other objectives

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2.1 OBJECTIVES OR GOALS OF FINANCIAL MANAGEMENT
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Financial management is concerned with procurement and use of funds. Its
main aim is to use business funds is such a way that value or earnings of the
firm's are maximised. There are various alternative ways of using business funds.
The organisation should go through the pros and cons of each alternative way of
using these business funds before final selection. The financial management
provides a framework for selecting a proper course of action and deciding a viable
commercial strategy.
The following are the objectives of financial management.
1. Profit Maximisation
2. Wealth Maximisation, and
3. Other objectives.
---------------------------------------------------------------------------PROFIT
MAXIMISATION
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The main objective of a business firm is profit maximisation because the business
firm is a profit-seeking organisation. Hence the objective of the financial
management of business organisation is profit maximisation. There are some
arguments in favour of this objective of business. They are.

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a) When profit earning is the aim of business then profit maximisation should be
the obvious objective.
b) Profitability is a barometer for measuring efficiency and economic prosperity of
a business enterprise, therefore, profit maximisation is justified on the grounds
of rationality.
c) The economic and business conditions do not remain same at all the times like
recession, depression, cut throat competition and so on. Hence the business
organisations should earn more and more profits when the situations are
favourable.
d) Since profit is the main source finance for growth and development of a
business organisation hence, keeping profit maximisation of profit, as an
objective of the business is justifiable.
e) Through maximisation of profitability of a business it is possible to contribute
more and more funds for social activities to meet social goals.

However, the concept of profit maximisation has been criticised and rejected as
the objective of financial management of a business organissation on account of
the following reasons:
a) It is vague. The term 'profit' is vague and it cannot be precisely defined. It
means the term profits if different to different people. Which profits are to be
maximised, short term or long term profit, profits before tax or after tax, or
total profits or profit per share and the like.
b) It ignores timings. Profit maximisation objective ignores the time value of
money and does not consider the magnitude and timing of earnings.
1. It overlooks quality aspects of future activities. The business is not solely
run with the objective of earning maximum profits. Some organisations give
more emphasis to sales growth, by increasing its volume of sales by decreasing
the profits or gain margin. Some organisations make more profits and
contribute more amounts to the development of the society.

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-------------------------------------------------------------------------------WEALTH
MAXIMISATION
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Wealth or net worth is the difference between gross present worth and the
amount of capital investment required to achieve the benefits. Any financial action
which creates wealth or which has a net present worth above zero is a desirable
one and should be undertaken. The operating objective for financial management
is to maximise wealth or net present worth. Wealth maximisation is, therefore,
considered to be the main objective of financial management. The objective of
wealth maximisation is to maximise the economic welfare of the shareholders of a
company. The value of a company's shares depends largely on its new worth
which itself depends on earning per share (EPS). A stockholder's current wealth in
the firm is the product of the number of shares owned, multiplied with the current
stock price per share.
Stockholder's current wealth in the firm = (Number of shares owned) x (current
stock price per share)
It is symbolically represented
W o = NP o
Thus the business organisation should strive for the increase in the current stock
price per share or EPS, so that the current wealth of a firm will increases. This in
turn depends upon the proper financial management.

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CRITICISM OF WEALTH MAXIMISATION
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The wealth maximisation objective has been criticised by certain financial
theorists mainly on the following grounds.

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a) It is a prescriptive rather than descriptive. The objective should tell what the
firm should actually do.
b) The objective of wealth maximisation is not necessarily socially desirable.
c) There is controversy as to whether the objective of a firm is maximise the
stockholders wealth or wealth of the firm, since the firm includes stockholders,
debenture-holders, preference shareholders etc.
d) Since the management and ownership are separated in large corporate form of
organisations, the managers will act in such a manner, which maximises the
managerial utility rather than the wealth maximisation of stockholders of the
firm. This is a controversial argument.
In spite of all the criticism, we are of the opinion that wealth maximisation is
the most appropriate objective of a firm.
-------------------------------------------------------------------------------OTHER
OBJECTIVES
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Besides the above basic objectives, the following are the other objectives of
financial management.
(a) Ensuring fair return to shareholders.
(b) Building up reserves for growth and expansion.
(c)Ensuring maximum operational efficiency by efficient and effective utilisation of
finances.
(d) Ensuring financial discipline in the organisation.

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Unit 3 FINANCIAL ENVIRONMENT
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Objectives
• To study the environment under which the financial management is studied

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• To give a brief outline of functions of financial manager and organisation of
finance function.

Unit outline
FINANCIAL ENVIRONMENT

3.1 Functional areas of Financial Management
3.2 Organisation of Finance function
3.3 Functions of Controller
3.4 Functions of Treasurer

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3.1 FUNCTIONAL AREAS OF FINANCIAL MANAGEMENT
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Financial management is an applied field of business administration.
Principles developed by the financial mangers from accounting, economics and
other fields are applied to the problems of managing finances. Moreover, every
business activity requires money and hence financial management is closely
related with all other areas of management. The relationship between financial
management and other areas of management has been explained briefly.

Financial Management and Cost Accounting
Most of the large companies have a separate cost accounting department to
monitor expenditures in their operational areas. The cost information is regularly
supplied to the management to control the costs. The finance manager is
concerned with proper utilization of funds and therefore he is concerned with the
operational costs of the firm.

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Financial Management and Marketing
The success or failure of a firm is greatly depends upon the marketing. One
of the important elements of marketing mix is price. The fixation of price for a
product plays very important role. There are various policies of pricing. The
marketing department must observe the best pricing policy when compared to the
competitors in the industry. Hence he collects the financial information from the
finance department, here the role of finance manager is very important.

Financial Management and Assets Management
The current assets and the fixed assets of the firm constitute the total assets
of a firm. The firm's assets should be properly managed. Proper management of
assets refers to systematic acquisition and maintenance or better utilization of
assets. The finance manager plays very important role in the proper maintenance
of composition of these assets.

Financial Management and Personnel Management
Personnel management is concerned with selection, recruitment, training
and placement of personnel department. The proper functioning and the above
said functions of personnel departments depend upon the decisions taken in
finance department. Hence the functioning of finance department in an
organisation plays a vital role.

Financial Management and Financial Accounting
Financial management and financial accounting are quite distinct from each
other. Financial accounting is concerned with the systematic recording, analysing,
reporting and measuring the business transactions. The objective of financial
accounting is measurement of funds and the objective of financial management is
to management of funds. The management of funds depends on the measurement
of financial accounting through profit and loss account and balance sheet.

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3.2 ORGANISATION OF THE FINANCE FUNCTION
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A firm must give proper attention to the structure and organisation of its
finance department. If financial data are missing or inaccurate, the firm may not
be in a position to identify the serious problems confronting the firm at any time
for correcting. The roles of different finance executives should be clearly defined in
order to avoid conflict and overlapping of functions.
Organisation of the finance function differs from company to company
depending on their respective needs and the financial philosophy. The titles used
to designate the key finance official are also different viz., vice-president
(Finance), Chief Executive (Finance), General Manager (Finance), etc. however, in
most companies, the vice-president (Finance) has under him two officers carrying
out the two important functions - the accounting and the finance functions. The
former is designated as Controller and the latter as the Treasurer.
The controller is concerned with the management and control of the firm's
assets. His duties include providing information for formulating the accounting and
financial policies, preparation of financial reports, direction of internal auditing,
budgeting, inventory control, taxes, etc. while the treasurer is mainly concerned
with managing the firm's funds, his duties include the following:
Forecasting the financial needs; administering the flow of cash; managing
credit; floating securities; maintaining relations with financial institutions and
protecting funds and securities.

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3.3 FUNCTIONS OF CONTROLLER
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Planning and control. To establish, coordinate and administer, as part of
management, a plan for the control of operations.

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1. Reporting and interpreting. To compare performance with operating plans and
standard's and to report and interpret the results of operations to all levels of
management and to the owners of the business.
2. Tax administration. To establish and administer tax policies and procedures.
3. Government reporting. To supervise or co-ordinate the preparation of report to
the government.
4. Protection of assets. To ensure protection of assets for the business through
internal control, internal audit and proper insurance coverage.
5. Economic appraisal. To appraise continuously economic and social forces and
Government influences, and to interpret their effect upon the business.
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3.4 FUNCTIONS OF TREASURER
---------------------------------------------------------------------------Provision of
finance. To establish and execute programmes for the provision of capital required
by the business.
1. Investor relations. To establish and maintain an adequate market for the
company's securities and to maintain adequate contact with the investment
community.
2. Short-term financing. To maintain adequate sources for the company's current
borrowings from the money market.
3. Banking and custody. To maintain banking arrangement, to receive, have
custody of and disburse the company's monies and securities.
4. Credit and collections. To direct the granting of credit and the collection of
accounts receivables of the company.
5. Investments. To achieve the company's funds as required and to establish and
co-ordinate policies for investment in pension and other similar trusts.
6. Insurance. To provide insurance coverage as may be required.

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UNIT 4 FINANCING DECISIONS
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Objectives
• To study the financing of investment decisions
• To have the exposure of various leverages
• To identify how to arrive at optimum leverage for successful investment
decisions.

Unit Outline

4.1 What is financing decision?

4.2 Meaning of leverage

4.3 Types of leverage

Financial leverage

Operating leverage

Composite leverage

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4.1 FINANCING DECISIONS
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After the Investment decision is taken the firm has to decide upon the best
means of financing these investment policies. The investment decisions are
continuous in nature because the companies make the new investments in its
regular course of business since the business is ever expanding. Hence the firms
will make plan continuous its financial needs. The financial decision is not only

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concerned with how best to finance new assets, but also concerned with the best
overall mix of financing for the firm.

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4.2 MEANING OF LEVERAGE
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The term 'Leverage' refers to the ability of a firm in employing long term
funds having a fixed cost, to enhance returns to the owners; i.e. equity
shareholders. . In other words 'leverage is the employment of fixed assets or
funds for which a firm has to meet fixed costs or fixed rate of interest obligation
irrespective of the level of activities attained or the level of operating profit
earned'.
James Horne has defined leverage as " the employment of an asset or sources of
funds for which the firm has to pay a fixed cost or fixed return.,"
The higher the leverage higher is the risk as well as return to the owners. A higher
leverage obviously implies higher outside borrowings and hence riskier if the
business activity of the firm suddenly slows down. The leverage can have negative
or reversible effect also. It may be favorable or unfavorable.
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4.3 TYPES OF LEVERAGES
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There are basically two types of leverages, 1) operating leverage, and 2) financial
leverage. In addition to these two types of leverages there are composite leverage
and working capital leverage. The leverage associated with the employment of
fixed cost assets is referred to as operating leverage. While the leverage resulting
from the use of fixed cost/return source of funds is known as financial leverage.

FINANCIAL LEVERAGE OR TRADING ON EQUITY

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The company can finance its investments by debt and/or equity. The company
may also use preference capital. The rate of interest on debt is fixed irrespective
of the company's rate of return on assets. The rate preference dividend is also
fixed; but preference dividends are paid when the company earns profits. The
ordinary shareholders are entitled to the residual income. That is, earnings after
interest and taxes (less preference dividends) belongs to them, this dividends also
depends on the dividend policy of the company.
The use of the fixed charge sources of funds, such as debt and preference
capital with the owner's equity in the capital structure, is described as financial
leverage or trading on equity.
The use of long term fixed interest bearing debt and preference share capital
along with equity share capital is called financial leverage or trading on equity. The
long term fixed interest bearing is employed by a firm to earn more from the use
of these resources than their cost so as to increase the return on owner's equity, it
is called trading on equity. A firm's earnings are more than what debt would
cost is known as favourable leverage and if the firm's earnings are less
than the debt cost then its is known as unfavourable leverage.
The impact of financial leverage is to magnify the shareholders earnings. It
is based on the assumption that the fixed charges can be obtained at a cost lower
than the firm's rate of return on its assets.

DEGREE OF FINANCIAL LEVERAGE
The degree of financial leverage measures the impact of a change in
operating income (EBIT) on change in earning on equity capital or share.

The formula to calculate the degree of financial leverage
Earnings before Interest and Taxes EBIT
Financial Leverage = ----------------------------------------- OR ------
Earnings before Taxes EBT

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1. Operating Leverage
The operating leverage occurs when a firm has fixed costs which must be
recovered irrespective of sales volume. The fixed costs remaining same, the
percentage change in operating revenue (EBIT) will be more than the percentage
change in sales. This is known as operating leverage. The degree of operating
leverage depends upon the amount of fixed elements in the cost structure. The
degree of operating leverage will be calculated as:
Contribution
Operating Leverage = -------------------
Operating profit
If a firm does not have fixed costs then there will be no operating leverage.
The percentage change in sales will be equal to the percentage change in profit.
When fixed costs are there, the percentage change in profits will be more than the
percentage in sales volume. The degree of operating leverage is calculated as:
Percentage Change in Profits
Degree of operating leverage = -------------------------------
Percentage Change in Sales

Risk Factor

In a high leveraged situation will magnify the operating profits but it brings
in the risk element too. The percentage change in profits will be more in a
situation with higher fixed costs as compared to that where fixed costs are lower.
The higher degree of leverage brings in more decrease in operating profits.

2. Composite Leverage
The operating leverage measures the degree of operating risk and it is
measured by percentage change in operating profit due to percentage change in
sales. The financial leverage measures the financial risk by measuring the
percentage change in taxable profit or EPS with the percentage change in
operating profit or EBIT. Both these leverages are closely concerned with the firm's
capacity to meet the fixed costs.

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Composite leverage expressed the relationship between revenue on account
of sales (Contribution) and the taxable income (PBT) on account of change in
sales. The composite ratio is calculated as follows:

Composite Leverage = Operating leverage X Financial leverage

Or

Contribution EBIT Contribution
= --------------- X -------- = -------------
EBIT PBT PBT

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UNIT 5 PROBLEMS FINANCIAL LEVERAGES
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Objective

• To understand the practical application of various leverages in the firm for
better financial decisions

Unit outline

5.1 Problems on:

• Operating leverage

• Financial leverage

• Composite leverage

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5.1 PROBLEMS OF LEVERAGES
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1. From the following data calculate the operating leverage, financial leverage and
combined leverage:
Sales: 10,000 units at Rs 25 per unit as selling price. Variable cost = Rs 5 per
unit
Fixed cost = Rs 30,000. Interest = Rs 15,000.

Solution:
Table to calculate OL, FL and CL
Sales 2,50,000
Less Variable 50,000
cost
Contribution 2,00,000
Less Fixed cost 30,000
EBIT 1,70,000
Less Interest 15,000
EBT 1,55,000

Contribution
Operating profit (EBIT)

2, 00,000
= ------------
1, 70,000

= 1.17 times

Financial Leverage = --------------------------------------- OR ------

1, 70,000
= ------------

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1, 55,000

= 1.10 times

= 1.17 X 1.10

= 1.29 times

2. Evaluate two companies firm A and firm B in terms of the financial and
operating leverage.
Firm A Firm B
Sales Rs 20,00,000 Rs
30,00,000
Variable cost 40% of Sales 30% of Sales
Fixed cost Rs 5,00,000 Rs 7,00,000
Interest Rs 1,00,000 Rs 1,25,000

Solution:
Table to calculate OL, FL and CL
Firm A Firm B
Sales 20,00,000 30,00,000
Less Variable cost 8,00,000 9,00,000
Contribution 12,00,000 21,00,000
Less Fixed cost 5,00,000 7,00,000
EBIT 7,00,000 14,00,000
Less Interest 1,00,000 1,25,000
EBT 6,00,000 12,75,000

Contribution

Firm A Firm B
12, 00,000 21, 00,000
= --------------- = ----------------

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7, 00,000 14, 00,000

= 1.71 times = 1.50 times

Financial Leverage = ------------------------------- OR ---------

Firm A Firm B
7, 00,000 14, 00,000
= ---------- ------------
6, 00,000 12, 75,000



Firm A Firm B
=1.17 X 1.16 = 1.50 X1.1

= 2 times = 1.63 times

Firm A has more business and financial risk when compared to Firm
B.

3. The following data are available for X Ltd.,:
Selling price per unit Rs 120
Variable cost Rs 70
Fixed cost Rs 2, 00,000
a) What is the operating leverage when X Limited sells 6,000 units.
b) What is the % change that will occur in the EBIT of X limited if output
increases by 5%.

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Solution:

a) Table to calculate OL, if sales is 6,000 units

Sales 7,20,000
Less variable cost 4,20,000
Less Fixed cost 2,00,000
EBIT 1,00,000

Contribution

3, 00,000
= ------------
1, 00,000

= 3 times
b) When the output increases by 5%.

Now the total output increases to 6,300 units

Therefore the change in EBIT is

Sales 7,56,000
Less variable cost 4,41,000
Less Fixed cost 2,00,000
EBIT 1,15,000

The change in EBIT = 1, 15,000 - 1, 00,000
= 15,000

Therefore the % change in EBIT = 15,000/1, 00,000 x 100 = 15%

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4. Calculate the Financial leverage and Operating leverage under situation A and
situation B, under financial plans II and I from the following information relating
to operations and capital structure of ABC Limited.
Installed capacity = 1000 units. Actual production and Sales = 800 units.Selling
price per unit = Rs 20. Variable cost = Rs 15.
Fixed cost:
Situation A Rs 800
Situation B Rs 1,500.
Capital Structure:
Particulars Plan I Plan II
Equity share 5,000 7,000
capital
Debt 5,000 2,000
Cost of debt 10% 10%

Solution:

Situation A Plan I Plan II
Sales 16,000 16,000
Less Variable 12,000 12,000
cost
Contribution 4,000 4,000
Less F. C 800 800
EBIT 3,200 3,200
Less interest 500 200
EBT 2,700 3,000

Plan I Plan II
Contribution
O. L = ------------------- =4,000/3,200 4,000/3,200

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EBIT
F.L = --------- = 3200/2700 = 3200/3000
EBT

Situation B Plan I Plan II
Sales 16,000 16,000
Less Variable 12,000 12,000
cost
Contribution 4,000 4,000
Less F. C 1,500 1,500
EBIT 2,500 2,500
Less interest 500 200
EBT 2,000 2,300

Plan I Plan II
Contribution
O. L = ------------------- =4,000/2,500 =4,000/2,500

F.L = EBIT
------- = 2,500/2,000 = 2500/2300
EBT

Conclusion: It is advisable to the management that the OL should be less and FL
should be more in order to maximise the returns. Therefore OL under situation A is
1.25 times and FL under situation B (Plan I) is 1.25 times, which is considered as
an ideal situation.

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5. From the following data of A,B and C companies prepare their income
statement:
Particulars A B C
VC as a % of 66 2/3 75 50
sales
Interest Rs 200 Rs 300 Rs 1,000
OL 5:1 6:1 2:1
FL 3:1 4:1 2:1
Income Tax rate 50 % 50 % 50 %

Solution:
We knew,
EBIT EBIT
F.L = --------- = ---------
EBT EBIT - Interest
In Company A

3 EBIT
--- = -----------
1 EBIT-200
3 EBIT - 600 = EBIT
2 EBIT = 600
EBIT =Rs 300

In Company B

4 EBIT
---- = -----------
1 EBIT-300

4 EBIT - 1200 = EBIT
3 EBIT = 1200
EBIT = Rs 400

In Company C

2 EBIT
--- = -----------
1 EBIT-1000

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2 EBIT - 2000 = EBIT
EBIT = Rs 1000

Operating Leverage

Contribution
OL = ----------------
EBIT

In Company A In company B

Contribution
OL = ----------------
EBIT

5 Contribution 6 Contribution
--- =---------------- --- =---------------
1 300 1 400

Contribution = Rs 1500 Contribution = Rs 2400

In company C

2 Contribution
-- = ----------------
1 1000

Contribution = Rs 2000

Computation of Sales:

Contribution = Sales - VC

Company A
Let Sales = 100
VC = 66 2/3

Therefore Contribution = 100 -200/3 = 100/3

27

= Rs 1,500

Therefore Sales = 1500 x 100 x 3 / 100
= Rs. 4,500
Variable Cost = Rs 3,000



Company B
Let Sales = 100
VC = 75%

Therefore Contribution = 100 -75 =25

Therefore Sales = 2400 x 100/25 = Rs. 9,600


Company C
Let Sales = 100
VC = 50

Therefore Contribution = 100 -50 = 50

Therefore Sales = 2,000 x 100/ 50
= Rs. 4,000

6. PQR and Co’s latest Balance Sheet is as follows;

Balance Sheet of PQR & Co.
Liabilities Amount Assets Amount
(In Rs.) (In Rs.)

28

Equity Capital 60,000 Fixed Assets 150,00
(Rs 10/- each) 0
Current
10% Long term 80,000 Assets 50,00
debt 0
20,00
Retained 0
earnings
40,00
Current 0
Liabilities

Total 200,000 Total 200,00
0

The Company’s total assets turnover ratio=3, Fixed cost=Rs1, 00,000/-
and Variable Cost=40% of Sales, Tax=50%. Find OL, FL and CL.

Solution

Total Assets Turnover Ratio = Sales/Total Assets
3 = Sales/2,00,000
Therefore Sales = Rs.6, 00,000/-

Therefore V.C=40% of Sales = 40/100 x 600000
=Rs. 240000

Interest = 10%Long term debt=10/100 x 80000
=Rs.48000/-

Income Statement
Sales 600000
(-)V.C 240000
Contribution 360000
(-)FC 100000
EBIT 260000
(-)Interest 800
(10%on80,000) 0

29

EBT
(-)Tax50% 252000
126000
EAT
126000

Operating Leverage = Contribution/EBIT
= 360000/260000=1.38 times

Financial Leverage = EBIT/EBT =260000/252000=1.03 times

Combined Leverage = OL X FL= 1.38X1.03=1.42 times

7. X Limited has estimated that for a new product, its BEP is 2000 units of the
item is sold for Rs 14per unit., the cost accounting department has currently
identified VC of Rs. 9/- per unit. Calculate OL for sales volume of 2500 units and
3000 units. [BEP = Break Even Point]. Fixed cost not given.
Solution

Selling Price=Rs14/-per unit
Variable cost =Rs9/- per unit

Calculation of Fixed cost.

Sales 28000
(-)VC 18000
Contribution 10000
(-)FC - 10000
EBIT = 0

Therefore Contribution will be considered as Fixed cost i.e. Rs. 10,000/-

Income Statement

30

Particulars 2500Uni 3000Uni
ts ts
Sales 35000 42000
(-)VC 22500 27000
Contributi 12500 15000
on 10000 10000
(-)FC 2500 5000
EBIT

Therefore OL (2500Units) = Contribution/EBIT= 12500/2500=5 times

OL (3000Units) = Contribution/EBIT=15000/5000=3 times

If sales volume is increased by 25 %(from 2000 to 2500Units) the EBIT
increases unto Rs2500/- from BEP. If sales volume increases up to Rs 5000/-
(doubled: 2500 to 5000)

8. Following information is obtained from a hypothetical company which has the
three different situations X,Y and Z and Financial plans I, II and III. You are
required to calculate OL, FL and CL. The total capacity of the project=10000
Units,
Explored capacity of sales=7500 Units
S.P Per Unit=Rs.20/-
V.C Per Unit=Rs15/-
Fixed Cost;
X=Rs10000
Y=Rs20000
Z=Rs25000

Financial Plans;
1) Rs50000/-Equity and Rs40000/-debt at 10% interest
2) Rs60000/- Equity and Rs30000/-debt at 10% interest
3) Rs30000/- Equity and Rs60000/- debt at 10% interest

31

Solution

Situation Plan-I Plan-II Plan-III
Sales 1,50,000 1,50,000 1,50,000
(-)VC 1,12,500 1,12,500 1,12,500
Contribution 37,500 37,500 37,500
(-)FC 10,000 10,000 10,000
EBIT 27,500 27,500 27,500
(-)Interest 4000 3000 6000
EBT 23500 24500 21500

Operating Leverages

(I) OL=37500/27500=1.36 times
(II) OL=37500/27500=1.36 times
(III) OL=37500/27500=1.36 times

Financial Leverages

(I) FL=27500/23500= 1.17 times
(II) FL=27500/24500= 1.12 times
(III) FL=27500/21500= 1.28 times

Combined Leverages
(I) CL=1.36 x 1.17 = 1.59 times
(II) CL=1.36 x1.12 = 1.52 times
(III) CL=1.36 x 1.28 = 1.74 times

Situation-Y Plan-I Plan-II Plan-III
Sales 1,50,000 1,50,000 1,50,000
(-)VC 1,12,500 1,12,500 1,12,500
Contribution 37,500 37,500 37,500
(-)FC 20,000 20,000 20,000
EBIT 17,500 17,500 17,500
(-)Interest 4000 3000 6000

32

EBT 13500 14500 11500

Operating Leverages

(I) OL=37500/17500=2.14 times
(II) OL=37500/17500=2.14 times
(III) OL=37500/17500=2.14 times

Financial Leverages

(I) FL=17500/13500=1.30 times
(II) FL=17500/14500=1.21 times
(III) FL=17500/11500=1.52 times

Combined Leverages

(I) CL=2.14X1.30=2.78 times
(II) CL=2.14X1.21=2.59 times
(III) CL=2.14X1.52=3.25 times

Situation-Z Plan-I Plan-II Plan-III
Sales 1,50,000 1,50,000 1,50,000
(-)VC 1,12,500 1,12,500 1,12,500
Contribution 37,500 37,500 37,500
(-)FC 25,000 25,000 25000
EBIT 12,500 12,500 12,500
(-)Interest 4000 3000 6000
EBT 8500 9500 6500

Operating Leverages;
(I) OL=37500/12500=3 times
(II) OL=37500/12500=3 times
(III) OL=37500/12500=3 times

Financial Leverages;

(I)FL=12500/8500=1.47 times
(II)FL=12500/9500=1.32 times
(III)FL=12500/6500=1.92 times

33

Combined Leverages;

(I)CL=3X1.47=4.41 times
(II)CL=3X1.32=3.96 times
(III)CL=3X1.92=5.76 times

The OL is least in situation X (all plans) and the FL is highest in situation Z
Plan III.

-------------------------------------------------------------------------------
Unit 6 CAPITAL STRUCTURE
-------------------------------------------------------
Objectives
• To bring clarity in concepts of capital structure, differentiating with financial
structure and decide about the optimum capital structure.
• To bring out the essential features for appropriate capital structure
• To identify the factors which determines the capital structure.

Unit Outline
5.1 Introduction

6.2 Meaning of capital structure

6.3 Difference between capital and financial structure

6.4 Optimum Capital structure

6.5 Features of Appropriate Capital Structure

6.6 Factors determining Capital Structure

--------------------------------------------------
6.1 INTRODUCTION
-------------------------------------------------

34

The funds required by the business organisation are raised through the
ownership securities i.e., by equity shares, preference shares and creditorship
securities i.e., debentures and bonds. But the business organisation must raise
these funds by a proper mix of both these securities in such a way that the cost
and the risk of both these securities should be minimum. The mix of different
securities is disclosed by the firm's capital structure.
------------------------------------------------------------------------------
5.2 MEANING OF CAPITAL STRUCTURE
--------------------------------------------------------------------------
In ordinary language it implies the proportion of debt and equity in the total
capital of a company.
According to Gerstenberg Capital Structure refers to the 'the make up of a firm's
capitalisation'. In other words, it represents the mix of different sources of long
term funds in the capitalisation of the company.
-------------------------------------------------------------------------------
5.3 DIFFERENCE BETWEEN CAPITAL STRUCTURE AND FINANCIAL
STRUCTURE
--------------------------------------------------------------------------
Financial Structure is the entire left hand side of the company' balance sheet
i.e., ownership securities, creditorship securities and current liabilities. Whereas
capital structure refers to sources of all long-term funds like ownership securities
like equity capital and preference capital and creditorship securities like
debentures, bonds and long term loans.

--------------------------------------------------------------------------
6.4 OPTIMUM CAPITAL STRUCTURE
--------------------------------------------------------------------------
The optimum capital structure is obtained when the market value per equity
share is the maximum. It may be defined as that relationship of debt and equity
securities which maximizes the value of a company's share in the stock exchange.
Or 'at optimum capital structure, the value of an equity shares is the maximum
while the average cost of capital is the minimum.

35

---------------------------------------------------------------------------
6.5 FEATURES OF APPROPRIATE CAPITAL STRUCTURE
-------------------------------------------------------------------------

An appropriate capital structure will posses the following features.

1. Profitability. The most profitable capital structure of a company is one that
tends to minimize cost of financing and maximise earning per equity share.
Hence these companies naturally are profitable.
2. Solvency. The pattern of capital structure should be devised in such a way
that the company does not run into the risk of becoming insolvent. Excess use
of debt threatens the solvency of the company.
3. Flexibility. The capital structure should be in such a way that it should have a
provision of easily switching over to requirements of changing conditions by
easy swap and also there should be availability of funds for profitable activities.
4. Conservatism. The capital structure should be conservative so that the debt
content in the total capital structure does not exceed the limit which the
company can bear.
5. Control. The capital structure should be so devised that it involves minimum
risk of loss of control of the company.
--------------------------------------------------------------------------
6.5 FACTORS DETERMINING CAPITAL STRUCTURE
--------------------------------------------------------------------------
Great caution is required at the time of determining the initial capital
structure of a company since it will have long-term implications. Hence the finance
manager should be careful but it can be changes subsequently as per the
requirements. This capital structure decision is a continuous one and has to be
taken whenever a firm needs additional finances.

36

The following are the factors which determines the capital structure of a
company.
1. Trading on equity or Financial Leverage. The use of long-term fixed
interest bearing debt and preference share capital along with equity share
capital is called financial leverage or trading on equity. Making profit to
shareholders by using the other funds like debentures, preference capital
is called trading on equity. In other words if the rate of return on the total
capital employed is more than the rate of interest on debentures or rate
of dividend on preference shares.
2. Retaining control. The capital structure of a company is also affected by
the extent to which the promoters or existing management of the
company desire to maintain control over the affairs of the company. if the
existing management want maintain the same control over the company
for further funds they will issue only debentures and preference capital
instead of issuing equity shares.
3. Nature of enterprise. The nature of enterprise will determine the capital
structure of the organisation. If the company is a public utility
organisation or a monopoly organisation in that product then it can earn
stable profit. Hence it goes for debentures or bonds since they will have
adequate profits to meet recurring costs.
4. Legal requirements. The promoters of a company must comply with the
legal requirements of the organisation. For example the banking
companies has to raise funds only through equity share capital as per the
Banking Regulations Act.
5. Purpose of financing. The purpose of financing is another factor which
determines the capital structure of the organisation. The purpose of
financing is for productive purposes like purchase of machinery , payment
of old debts borrowed at high interest are financed through debentures

37

and bonds. If the purpose of financing is for non productive purposes like
welfare activities etc then it is raised through equity capital.
6. Period of finance. The capital structure of a company depends on the
period of finance. For example the funds required for the business is 5 to
10 years it is raised through debentures, redeemable preference shares
and bonds. Whereas if funds are raised for permanently then it is raised
through equity shares or preference shares.
7. Government policy. Government policy is an important factor in planning
the company's capital structure. The controller of capital Issues and
Government of India can interfere and dictate the capital structure of the
organisation.
8. Market sentiments of investors. The market sentiments of the investors
will determine the capital structure of the organisation. If company's
investors expect absolute safety attitude in their investment pattern then
the companies will go for raising the finance required through debentures.
If the investors want to make high profits through speculation then the
companies raise its capital by issuing equity shares.

----------------------------------------------------------------
UNIT 7 CAPITAL STRUCTURE THEORIES
---------------------------------------------------------------

Objectives
• To give an idea of basic capital structure theories and to select optimum capital
structure.
• To highlight the essential features for a sound capital mix

Unit outline

38

7.1 Capital Structure Theories:

• Net Incomes (NI) Approach,

• Net Operating Income (NOI) Approach,

• Modigilani - Miller (MM) Approach, and

• Traditional Approach.

7.2 Capital Structure Management or Planning the Capital Structure

7.3 Essential features of a sound capital mix

------------------------------------------------------------------------------
7.1 CAPITAL STRUCTURE THEORIES
---------------------------------------------------------------------------------------------

To achieve the basic goal of optimum capital structure in the organisation
the finance manager must have the basic knowledge of capital structure theories.
There are extreme opinions on the optimum capital structure, hence it calls for
various theories in this. They are:
• Net Incomes (NI) Approach,
• Net Operating Income (NOI) Approach,
• Modigilani - Miller (MM) Approach, and
• Traditional Approach.
These theories are based on the following general assumption. They are:
(a) The firm employs only two types of capital-debt and equity.
(b) The firm pays 100% of its earnings as dividend. Thus there are no retained
earnings.
(c)The firm's total assets given are assumed to be constant in investment
decisions.
(d) The operating earnings are not expected to grow.
(e) The business risk remains constant and is independent of capital structure
and financial risks.

39

(f) The firm has a continuous life.

1. Net Incomes (NI) Approach
Durand has suggested this approach. According to this approach, capital
structure decision is relevant to the valuation of the firm because the change in
capital structure decision causes a corresponding change in the overall cost of
capital as well as the total value of the firm. According to this approach a higher
debt content in the capital structure (high financial leverage) will result in
decline in the overall or weighted average cost of the capital and increase in the
value of equity shares of the company.

This approach is based on the following three assumptions.
(i) There are no corporate taxes.
(ii) The cost of debt is less than cost of equity or equity capitalisation rate.
(iii) The debt content does not change the risk perception of the investors.

On the basis of Net Income approach the value of the firm is calculated as:
V=S+B
Where,
V= Value of Firm.
S= Market value of Equity.
B= market value of Debt.

Market value of equity = NI/ke, where, NI = Earnigs availabe for equity
shareholders; ke = cost of equity or equity capitalisation rate
Overall cost of capital (Ko) = EBIT/V
2. Net Operating Income (NOI) Approach
This approach has also been suggested by Durand. According to this approach
the market value of the firm is not affected by the change in capital structure.

40

Because the market value of the firm is ascertained by capitalising the net
operating income at the overall cost of capital (k), which is considered to be
constant.
Assumptions of this approach are:
a) The overall cost of capital remains constant for all degrees of debt-equity
mix.
b) The market capitalises the value of the firm as a whole hence, the split
between debt and equity is not relevant.
c) The use of debt having low cost increases the risk of equity shareholders,
this results in increase in equity capitalisation rate.
d) There are no corporate taxes.

According to this approach, the Value of the firm is calculated with the help
of the following formula.

EBIT (1-Tax rate)
Value of Firm (V) = --------
Ko
Ko = Overall cost of capital

Value of equity = V - B

According to NOI Approach, the total value of the firm remains constant
irrespective of the debt-equity mix or the degree of leverage.
Overall cost of capital (Ko) = Ke (S/V) + Kd (B/V)
Whereas Kd= Cost of debt or {Interest rate (1-Tax rate)} eg. 10%(1-0.35)
B = Market value of Debt
V = Value of firm
S=V-B
EBIT-1
Ke = ------- X 100
V-B

41

3. Modigiliani - Miller Approach
This approach is similar to the NOI approach. It also states that the value of
the firm is independent of its capital structure. Nevertheless, there is a basic
difference the two is that the NOI approach is purely definitional or conceptual. It
does not provide operational justification for irrelevance of the capital structure in
the valuation of the firm.

Assumptions of MM Theory
The MM theory is based on the following assumptions:
1) Perfect capital markets exist where individuals and companies can borrow
unlimited amounts at the same rate of interest.
2) There are no taxes or transaction costs.
3) The firm's investment schedule and cash flows are assumed constant and
perpetual.
4) Firms exist with the same business or systematic risk at different levels
of gearing.
5) The stock markets are perfectly competitive.
6) Investors are rational and expect other investors to behave rationally.

a) MM Theory: No taxation.
b) MM Theory with Corporate Tax

4. Traditional Approach or weighted average cost of capital (WACC)
The traditional approach or intermediate approach is a mid-way between the two
approaches. It partly contains features of both the approaches as given below:
a) The traditional approach is similar to NI Approach to the extent that it accepts
that the capital structure or leverage of the firm affects the cost of capital and

42

its valuation. However, it does not subscribe to the NI approach that the value
of the firm will necessarily increase with all degree of leverages.
b) It subscribes to the NOI approach that beyond a certain degree of leverage, the
overall cost of capital increases resulting in decrease in the total value of the
firm. However, it differs from NOI approach in the sense that the overall cost of
capital will not remain constant for all degree of leverage.
According to Traditional approach the firm through judicious use of debt-
equity mix can increase its total value and thereby reduce its overall cost of
capital. This is because debt is relatively cheaper source of funds as compared to
raising money through shares because of tax advantage. However, beyond a point
raising of funds through debt may become a financial risk and would result in a
higher equity capitalisation rate.
Traditionally, optimal capital structure is assumed at a point where weighted
average cost of capital (WACC) is minimum. For a project evaluation, this WACC is
considered as the minimum rate of return required from project to pay-off the
expected return of the investors and as such WACC or Composite cost of capital is
generally referred to as the required rate of return.
It is calculated as follows:

WACC = (Cost of Equity X % Equity) + (Cost of debt X % debt)

---------------------------------------------------------------
7.2 PLANNING THE CAPITAL STRUCTURE
-------------------------------------------------------------
Determining the capital mix and also the estimation of capital requirements
for current and future need of a firm are very important for a firm. Equity capital
and debt are the two principle sources of finance of a business. But it should be in
what proportion? How much of financial leverage a firm should employ? Are the
two important questions comes before finance manager. The relationship between
financial leverage and cost of capital will answer this question.

43

The capital structure planning, which aims at the maximisation of profits and
the wealth of the shareholders, ensures the maximum value of a firm or the
minimum cost of capital. It is very difficult for a finance manager to determine the
proper mix of debt and equity for his firm. The financial manager must try to reach
as near as possible of the optimum point of debt and equity mix.

----------------------------------------------------------------

7.3 ESSENTIAL FEATURES OF A SOUND CAPITAL MIX

----------------------------------------------------------------
The following are the essential features of a sound capital mix.

1. Maximum possible use of leverage.

2. The capital structure should be flexible.

3. The use of debt should be within the capacity of a firm.

4. It should involve minimum possible risk of loss of control.

5. It must avoid undue restrictions in agreement of debt.
---------------------------------------------------------------
UNIT 8 PROBLEMS ON COST STRUCTURE THEORIES
--------------------------------------------------------

Objective
• To familiarise about various cost structure theories for practical applications

Unit outline

8.1 Problems on Cost Structure Theories

44

---------------------------------------------------------------------------
8.1 PROBLEMS ON COST STRUCTURE THEORIES
-----------------------------------------------------------------------------------------------

1. Companies P and Q are identical in all respects including risk factors except for
debt / equity, P having issued 10% debentures of Rs, 9 lakhs while Q has
issued only equity. Bothe the companies earn 20% before interest and taxes on
their total assets of Rs. 15 lakhs.
Assuming tax rate of 50% and capitalisation rate of 15% for an all-equity
company, compute the value of companies P and Q using (a) net income approach
and (b) net operating income approach.
Particulars P Q
EBIT (@ 20% on Rs. 15 lakhs) 3,00,000 3,00,000
Less : Interest 90,000 -
------------ -------------
EBT 2,10,000 3,00,000
Less : Tax @ 50% 1.05,000 1,50,000
------------ ------------
Earnings after Tax (EAT) 1,05,000 1,50,000

(a) Valuation of company under Net Income Approach
Calculation of value of Equity
Value of Equity (capitalised @ 15%)
P = (1,05,000 x 100 / 15) = 7,00,000
Q = (1,50,000 x 100 / 15) =10,00,000
Value of Debt
P = 9,00,000, Q = 0
Value of Company = S + D
P = 7,00,000 + 9,00,000 = 16,00,000
Q = 10,00,000 + 0 = 10,00,000
(b) Valuation of companies under Net Operating Income Approach
EBIT (1 - T)
V= --------
K

45

Value of equity (S) = V - B
Company P
EBIT (1 - T)
V (value of equity) = --------
K

3,00,000 (1 - 0.50)
V= ---------------------- = 10,00,000
0.15
Value of Debt = (9,00,000 x 1 - 0.5) = 4,50,000
Value of Equity (S) = V - B
= 10,00,000 - 4,50,000 = 5,50,000
Add value of Debt = 9,00,000
------------------
Value of company 14,50,000
-----------------
Company Q
EBIT (1 - T)
V= --------
K

3,00,000 (1 - 0.50)
V = ---------------------- = 10,00,000
0.15
Value of Equity (S) = V - B
= 10,00,000
Value of Debt = -
----------------
Value of company 10,00,000
---------------

2. The following information is available regarding the two firms A and B which are
identical in all respects except the degree of leverage. Firm A has 6% debt of
Rs 6 lakhs while firm B has no debt. Both the firms are earning an EBT of Rs
2,40,000 each. The equity capitalization rte is 10% and the corporate tax is
60%. Compute the value of the two firms on MM Model.
Solution
Value of unlevered firm B

46

Vu = EBT (1 - T) / ke
= 2,40,000 (1-0.6) / 10%
= 96,000 / 0.10
= 9,60,000
Value of levered firm A
Vi = Vu + Bt
= 9,60,000 + 6,00,000 (0.6)
= 9,60,000 + 3,60,000
= Rs. 13,20,000

3. The values for two firms X and Y in accordance with the traditional theory are
given below:

X Y
Expected operating income Rs. 50,000 Rs. 50,000
Total cost of debt 0 10,000
Net Income 50,000 40,000
Cost of equity (ke) 0.10 0.11
Market value of shares (s) 5,00,000 3,60,000
Market value of debt 0 2,00,000
Total value of the firm 5,00,000 5,60,000
Average cost of capital (ke) 0.10 (0.09)
Debt equity ratio 0 0.556

Compute the values for firms X and Y as per the MM theses. Assume that
(i) Corporate income taxes do not exist, and

47

(ii) The equilibrium value of ke is 12.5%
Solution:

COMPUTATION OF THE VALUES OF FIRMS
Company X Company Y
Rs. Rs.
Expected net operating income ¯x 50,000 50,000
Less: cost of debt (D) 0 10,000
------------ ----------
Net income for equity 50,000 40,000
---------- ---------
Equilibrium cost of capital (ko) 0.125 0.125

Total value of company (V)= ¯x / ko 4,00,000 4,00,000
Market value of debt (B) - 2,00,000
Market value of equity (V - B) 4,00,000 2,00,000
Cost of equity (ke) = ¯x - D/ s 12.5% 20%

4. In considering the most desirable capital structure of a company, the following
estimates of the cost of Debt and Equity capital (after Tax) have been made at
various levels of Debt-Equity Mix:

Debt as % of total Cost of Debt Cost of Equity
capital employed (%) (%)
0 5.0 12.0
10 5.0 12.0
20 5.0 12.5
30 5.5 13.0
40 6.0 14.0
50 6.5 16.0
60 7.0 20.0

48

Calculate the optimal Debt-Equity Mix for the company by calculating composite
cost of capital.

Solution:
Calculation of Optimal Debt-Equity Mix
Debt as % of Cost of Cost of WACC
total capital Debt Equity
employed (%) (%)
0 5.0 12.0 (5 x 0 ) + (12 x 1.00) = 12.00
10 5.0 12.0 (5 x 0.10) + (12 x 0.90) = 11.30
20 5.0 12.5 (5 x 0.20 ) + (12 x 0.80) = 11.00
30 5.5 13.0 (5.5 x 0.30 ) + (13 x 0.70) = 10.75
40 6.0 14.0 (6 x 0.40 ) + (14 x 0.60) = 10.80
50 6.5 16.0 (6.5 x 0.50 ) + (16 x 0.50) = 11.25
60 7.0 20.0 (7 x 0.60 ) + (20 x 0.40) = 12.20

At optimum debt-equity mix 30: 70, the WACC is at minimum level of 10.75%.

-------------------------------------------------------
UNIT 9 COST OF CAPITAL
-----------------------------------------------------
Objectives
• To familiarise about the cost of capital
• To incorporate the importance of cost of capital in business financial decisions.

Unit outline
9.1 Meaning

9.2 Significance or Importance of Cost of Capital

9.3 COMPUTATION OF COST OF CAPITAL

49

A. Computation of specific cost of capital

---------------------------------------------------------------
9.1 MEANING OF COST OF CAPITAL
--------------------------------------------------------------
The main goal of business firm is to maximise the wealth of shareholders in
the long-run, the management should only invest in projects which give a return in
excess of cost of funds invested in the projects of the business. The term cost of
capital refers to the minimum rate of return a firm must earn on its investments so
that the market value of the company' equity shares does not fall. This is intended
to achieve the objective of wealth maximisation. This is possible when the firm
earns a return on the projects financed by equity shareholders' funds at a rate
which is at least equal to the rate of return expected by them.
The cost of capital is the rate of return the company has to pay to various
suppliers of funds in the company.
According to Solomon Ezra, "Cost of capital is the minimum required rate of
earnings or the cut-off rate of capital expenditures."
Hampton, John J. defines cost of capital as 'the rate of return the firm
requires from investment in order to increase the value of the firm in the market
place".
Thus, we can say that cost of capital is that minimum rate of return which a
firm, must and, is expected to earn on its investments so as to maintain the
market value of its shares.

-------------------------------------------------------------------------------
9.2 SIGNIFICANCE OR IMPORTANCE OF COST OF CAPITAL
---------------------------------------------------------------------------

The determination of cost of capital of a firm is important to the
management to take some financial decisions like:

50

a) Capital Budgeting decisions. In capital budgeting decisions, the cost of capital is
often used as a discount rate on the basis of which the firm's future cash flows
are discounted to find out their present values.
b) Capital structure decisions. The cost of capital is an important consideration in
capital structure decisions. The finance manager must raise capital from
different sources in a way that it optimises the risk and cost factors.
c) Basis for evaluating the financial performance. The actual profitability of the
project is compared to the projected overall cost of capital and the actual cost
of capital of funds raised to finance the project. if the actual profitability of the
project is more than the projected and the actual cost of capital, the
performance may be said to be satisfactory.
d) Basis for taking other financial decisions. The cost of capital is also used in
making other financial decisions such as dividend policy, capitalisation of
profits, making the right issue and working capital.

------------------------------------------------------------------------
9.3 COMPUTATION OF COST OF CAPITAL
--------------------------------------------------------------------------

B. Computation of specific cost of capital
Computation of specific cost of various sources of finance viz., debt, preference
share capital, equity share capital and retained earnings is discussed as below:
1. Cost of Debt (Kd). The cost of debt is the rate of interest payable on debt.
The interest paid on debts will have tax benefits i.e., tax is paid on the profits
after allowing debenture interest.
a) Cost of Irredeemable Debentures:
I (1 - t)
Kd = ----------
NP
Where,
I = Annual interest
T = Companies tax rate

51

NP = Net proceeds of loans or debentures
In case of debt is raised at premium or discount, we should consider P as the
amount of net proceeds received from the issue and not the face value of
securities. The formula is
I
Kd = ----------
NP
In case of underwriting commission (UC) paid if any is deducted from NP (UC is
always calculated at par value. Maximum permissible limit is 2.5%).
2. Cost of Preference shares

a) Irredeemable Preference shares
Kp = PD / NP
b) Redeemable Preference shares
PD + RV-NP
---------
n
Kp = -------------------------
RV + NP
-----------
2
Where PD is preference dividend

Dividend paid on preference shares is an appropriation of profit and hence is does

not get tax benefit.

Any premium or discount on issue of shares is to be adjusted with net proceeds.

Underwriting paid if any is also deducted from the net proceeds (Max. permissible

limit 5% calculated on par value)

Note: there is no difference in calculation of Kp whether to be calculated before

tax or after tax because it doesn't get tax benefit.

3. Cost of Equity

52

Cost of equity is assumed to be nil because of the following reasons:

a) There is no fixed rate of dividend paid to equity shareholders.

b) There is no legal binding for declaring dividends to equity shareholders.

The following are the approaches to cost of equity:

a) Dividend price approach (DP approach)
The rate of dividend expected by the equity shareholders is considered as
cost of equity.
b) Earning price approach
Ke = Dividend / Market Price x 100

c) DP + Growth approach
Ke = Dividend / Market Price x 100 + Growth Rate
d) Realised Yield approach (past)
Note:
Dividend
MP = ---------
Ke - GR
There is no tax effect and always it is irredeemable.
4. Weighted Average Cost of Capital (WACC)

It refers to overall cost of capital after taking into consideration the weights

of each source of capital.

Weights can be of two types:

a) Weights assumed on face value (book price)

b) Weights assumed on market price.

----------------------------------------------------------------
UNIT 10 PROBLEMS ON COST OF CAPITAL

53

----------------------------------------------------------------

Objective

• To study the costs of various sources of capital for better selection of source on

the basis of cost of capital.

Chapter outline

10.1 Problems on cost of capital

---------------------------------------------------------------
10.1 PROBLEMS ON COST OF CAPITAL
-------------------------------------------------------------

I Cost of Debt

Problems
1. A company issues Rs. 10,00,000 16% debentures of Rs. 100 each. The
company is in 35% tax rate. You are required to calculate the cost of debt after
tax if debentures are issued at
(i) Par
(ii) 10% Discount
(iii) 10% Premium
(iv) If brokerage is paid at 2% what will be the cost of debenture if issued at
par.
(v) Calculate Kd before tax for (iv) above.

Solution

I (1 - t) 1,60,000 (1 -0.35)

54

(i) Kd (at Par) = ---------- = --------------------- = 10.4%
NP 10,00,000

1,60,000 (1 - 0.35)
(ii)Kd (at Discount) = ---------------------- = 11.56%
9,00,0000
1,60,0000 (1 - 0.35)
(iii) Kd (at Premium) = ----------------------- = 9.45%
11,00,000
1,60,0000 (1 - 0.35)
(iv) Kd (Brokerage at 2%) = -------------------------= 10.61%
10,00,000 - 20,000

I 1,60,000
(v) Kd (before tax) = ------ = ---------------------= 16.33%
NP 10,00,000 - 20,000

b) Cost of Redeemable debentures
Formula
I (1 - t) + (RV - NP)
------------
n
Kd = ----------------------------------- X 100
(RV + NP)
------------
2
Where,
RV = Redemption value
n = number of years

2. A 7 year Rs 100 debenture is available at a net cost of Rs 95. The coupon rate
is 15% and the bond will be redeemed at a premium of 6% on maturity. The
firm's tax rate is 40%. Calculate the cost of debenture.
Solution
I (1 - t) + (RV - NP)
------------
n
Kd = ----------------------------------- X 100

55

(RV + NP)
------------
2

15 (1 - 0.4) + (106 - 95)
------------
7
Kd = ------------------------------- X 100 = 10.52%
(106 + 95)
-------------
2

3. A 10% Rs. 1,000 par bond of 10 years sold at Rs. 950 and underwriting
commission 5%. Calculate cost of debt. a) Before tax , and b) After tax
Solution

Calculation of Net proceeds:

Par value Rs 1,000
(-) Discount 50
-----------
950
(-) Underwriting commission
on 1,000 at 5% 50
----------
Net proceeds 900

a) Before tax
I + (RV - NP)
------------
n
Kd = ----------------------------------- X 100
(RV + NP)
------------
2

100 + (1000 - 900)
------------
10
Kd = ------------------------- X 100 = 11.58%
(1000 + 900)

56

-------------
2

b) After tax

I (1 - t) + (RV - NP)
------------
n
Kd = ----------------------- X 100
(RV + NP)
------------
2

100 (1 - 0.35) + (1000 - 900)
------------
10
Kd = ------------------------------- X 100 = 7.9%
(1000+ 900)
-------------
2

4. ABC Ltd., issues 2 sets of debentures. One at discount at 10% and the other at
a premium of 15% respectively.
Series 1: 12%, 1,000 debentures of Rs 100 each.
Series 2 : 7 ½ % 1000 debentures of Rs 10 each.
Series 2 was redeemed after a period of 8 years at a premium of 15%.
Underwriting commission is paid on both the series as per the maximum limits
specified under company's act. Calculate Kd after tax and before tax for both the
series.

Solution
Series 1:
I (1 -t) 12,000 (1 -0.35)
a) Kd = --------- = --------------------- x 100 = 8.91%
NP 87,500

57

Calculation of N P:
Par value 1,00,000
(-) Discount 10,000
----------
90,000
(-) Underwriting
Commission @ 2.5% 2,500
(1,00,000 x 2.5%) -----------
Rs. 87,500
-----------------

b) Kd = I/Np = 12,000 / 87,500 x 100
= 13.71%

Series 2:
Calculation of NP:

Par value 1,000
(+) Premium 150
------
1,150
(-) Underwriting
Commission 25
------
1,125

I (1 - t) + (RV - NP)
------------
n
a) Kd = ----------------------------------- X 100
(RV + NP)
------------
2

75 (1 - 0.35) + (1,150 - 1,125)
------------
8
Kd = ----------------------------------- X 100
(1,150 - 1,125)
------------
2
= 4.56 %

58

I + (RV - NP)
------------
n
b) Kd = ----------------------------------- X 100
(RV + NP)
------------
2

75 + (1,150 - 1,125)
------------
8
Kd = ----------------------------------- X 100 = 6.87 %

(1,150 - 1,125)
------------
2
-------------------------------------------------------------------------------
UNIT 11 PROBLEMS OF COST OF PREFERENCE SHARES
----------------------------------------------------------------

Unit Outline
Problems of Cost of Preference shares
a) Irredeemable Preference shares
Kp = PD / NP
b) Redeemable Preference shares
PD + RV-NP
---------
n
Kp = -------------------------
RV + NP
-----------
2

c) Problems on Cost of Equity
Approaches to the cost of equity:

59

Dividend price approach (DP approach)
Earning price approach
Ke = Dividend / Market Price x 100

e) DP + Growth approach
f) Realised Yield approach (past)
Note:
Dividend
MP = ---------
Ke - GR
There is no tax effect and always it is irredeemable.
1. Assuming that the firm's tax rate is 50% compute after tax cost and before tax
Cost of preference shares in the following cases:
a) 9 % Preference shares sold at par.
b) A Company issues 14% irredeemable preference shares, the face value of share
is Rs. 100 but the issue price is Rs 95. What is the cost of Preference shares?
What is the cost if the issue price is Rs 105?
c) A Company Preference shares sold at Rs 100 with a 10% dividend and
redemption Rs 112 if the company redeems within 5 years.
Solution:
a) Kp = PD / NP = 9 / 100 = 9%
b) i) Kp = PD / NP = 14 / 95 = 14.74%
ii) Kp = PD / NP = 14 / 105 = 13.33%

PD + RV-NP
---------
n

60

c) Kp = ------------------------- x 100
RV + NP
-----------
2
10 + 112- 100
---------------
5
Kp = ------------------------- x 100 = 11.7 %
112 + 100
-----------
2

Cost of equity shares (Ke)
A companies share is quoted in market at Rs 40 currently. A company pays a
dividend of Rs 2 per share and investors expects a growth rate of 10% compute
a) The Companies cost of equity capital.
b) If anticipated growth rate is 11% p.a. Calculate the indicated growth market
price per share.
c) If companies cost of capital is 16% and anticipated growth rate is 10% p.a.
Calculate the market price if dividend of Ts 2 per share is to be maintained.

Solution:
a) Ke = D/MP x 100 + GR
= 2 / 40 x 100 + 10%
= 15 %
b) MP = D /Ke% - GR%
= 2 / 15% - 11%
= 2 / 4% = Rs. 50.
c) MP = 2 / 16 - 10
= 2 / 6% = Rs. 33.33%

----------------------------------------------------------------

61

Unit 12 Problems on Weighted Average cost of Capital (WACC)
----------------------------------------------------------------

Unit outline

• Problems on Weighted Average cost of Capital (WACC)

1. Calculate WACC of A Ltd. From the following information:
Sources Capital Cost of capital
Debt 4,00,000 14%
Equity share 6,00,000 20%
Assume corporate tax rate as 35%.
Solution:
Method 1:
Sources Capital Weights Cost of capital WACC
Debt 4,00,000 0.4 0.091 0.0364
Equity 6,00,000 0.6 0.2 0.12
------------- ----------
10,00,000 0.1564
------------- ----------

WACC = 0.1564 x 100 = 15.64%

Method 2:

Sources Capital Cost of capital Total cost of capital

Debt 4,00,000 9.1% 36,400

62

Equity 6,00,000 20% 1,20,000
----------- ----------
10,00,000 1,56,000
------------- -------------

WACC = 1,56,400 / 10,00,000 x 100 = 15.64%

Working Notes:
Cost of capital: Debt = 14 x 0.65 (after tax) = 0.091 because it gets tax
benefit.

2. 'Z' Ltd, Y Ltd, and X Ltd., are in the same type of business and hence have
similar operating risks. However the capital str5ucture of each of them is different
and the following are the details.
Particulars X Ltd. Y Ltd. Z Ltd.

Equity share capital:
(Face value Rs. 10 / share 5,00,000 2,50,000 4,00,000
Market Value per share Rs. 12 20 15
Dividend per share 2.88 4 2.7
Debentures
(Face value Rs.100) 2,50,000 1,00,000
Market value
per debenture Rs 80 125
Interest rate 8% 10%

Assume that the current level of dividends are generally expected to
continue indefinitely and the income tax rate is at 50%. You are required to
compute the WACC of each of the company.
Solution:
Cost of equity:
Formula Ke = D / M x 100

63

X ltd, Y ltd, Z ltd,
2.88 /12 x 100 4 / 20 x 100 2.7 / 15 x 100
= 24% = 20% = 18%
Cost of Debt:
Formula
Kd = I (1 - T) / MP
X ltd, Y ltd, Z ltd,
8 (1 - 0.5) /80 10 (1 - 0.5) / 125 0%
= 5% = 4%
Sources Capital Cost of capital Total COC WACC
X: Debt 2,50,000 5% 12,500 1,32,500
---------- x 100
Equity 5,00,000 24% 1,20,000 7,50,000
----------- -------------
7,50,000 1,32,500 = 17.67%
----------- -------------

Y: Debt 1,00,000 4% 4,000 54,000
--------- x 100
Equity 2,50,000 20% 50,000 3,50,000
------------ ----------
3,50,000 54,000 = 15.43%
----------- ---------

Z: Debt --- 0% --- 72,000
-------- x 100
Equity 4,00,000 18% 72,000 4,00,000
---------- ---------
4,00,000 72,000 = 18%
---------- --------

On Face value:

X Ltd., Ke = 2.88 /10 x100 = 28.8 %
Y Ltd., Ke = 4 /10 x100 = 40%
Z ltd., Ke = 2.7/10 x100 =27%

64

X ltd., Kd = I (1 - t) / FV = 8 (1 -0.5) / 100 = 4%
Y Ltd., Kd = 10 (1- 0.05)/100 = 5%.

Sources Capital Cost of capital Total COC WACC
X: Debt 2,50,000 4% 10,000 1,54,000
---------- x 100
Equity 5,00,000 28.8% 1,44,000 7,50,000
----------- -------------
7,50,000 1,54,000 = 20.53%
----------- -------------

Y: Debt 1,00,000 5% 5,000 1,05,000
--------- x 100
Equity 2,50,000 40% 1,00,000 3,50,000
------------ ----------
3,50,000 1,05,000 = 30%
----------- ---------

Z: Debt --- 0% --- 1,08,000
-------- x 100
Equity 4,00,000 27% 1,08,000 4,00,000
---------- ---------
4,00,000 1,08,000 = 27%
---------- --------

-------------------------------------------------------------
Unit 13 Problems on Marginal cost of capital
-------------------------------------------------------------

Chapter Outline

• Problems on Marginal cost of capital

Marginal cost of capital

65

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