cf-iNTRO

Nature And Scope of Financial Management
 Financial management is such a managerial process which is
concerned with the planning and control of financial
resources.
 In the initial years of its development, financial management
was concerned only with collection of funds for business.
 According to modern viewpoint, not only collection of funds
but also their proper utilization are the basic functions of
financial management.
 As all the business activities like marketing, purchase,
production etc include the creation and utilization of funds,
financial manger must be clear about his duties and
responsibilities in relation to these activities.
1Dr Ajay K Patel

Meaning of Financial Management
“Financial Management is the operational
activity of a business that is responsible for
obtaining and effectively utilizing the funds
necessary for efficient business operations.”,
J.L. Massie.
2Dr Ajay K Patel

Approaches to Financial Management
1. Traditional Approach :
Under this approach, financial management was
used to procure and administer funds for the
corporation.
Procurement of finance needs knowledge of followings:
i. Institutional sources of finance.
ii. Issue of financial instruments to collect necessary
funds from the capital market.
iii. Legal and accounting relationship between the
business and source of finance.
3Dr Ajay K Patel

Limitations of Traditional Concept
1. One sided Approach
2. More Emphasis on the Financial Problems of
Corporations
3. More importance to periodic (Long Term effect)
Event
4. More Emphasis on Long term funds
4Dr Ajay K Patel

Modern Approach to Finance Function
According to this approach, financial management considers the
broader and analytical viewpoint.
financial management is concerned with both acquisition of
funds and their effective and optimum utilisation.
This viewpoint not only considers the sporadic events but also
the long term and short-term financial problems.
Three core decisions are taken under financial management :-
i. Investment Decision
ii. Financing Decision
iii. Dividend Decision
5Dr Ajay K Patel

Characteristics of Modern Approach
1. More Emphasis on Financial Decision
2. Financial Management as an Important
Component of Business Management
3. Continuous Function
4. Broader View
5. Measure of Performance
7Dr Ajay K Patel

Objectives of Financial Management
(i) Profit Maximisation Approach
(ii) Wealth Maximisation Approach
(i) Profit Maximisation Approach :- According to this
approach, a firm should undertake all those activities which
add to its profits and eliminates all others which reduce its
profits.
Criticism
(i) Ambiguity
(ii) Time Value of Money
(iii) Risk Factor
8Dr Ajay K Patel

Wealth Maximisation Approach :- According to this approach,
financial management should take such decisions which
increase net present value of the firm.
W = A1 + A2 + …………. + An - IO
(1+k) (1+k)
2
(1+k)
n
W = Net Present Value
A1 + A2 + …………. + An = Stream of expected cash
benefits from a course of action over a period of time.
K = Appropriate discount rate to measure risk and timing
IO = Initial outlay to acquire that asset or pursue the course of
action.
If W is positive, the decision should be taken. On the other hand
if W is negative, the decision should not be taken.
9Dr Ajay K Patel

Importance of Financial Management
(1) Significant part of Business Management
(2) Liquidity and Profitability
(3) Value of firm
(4) Centralised Nature
(5) Benefits to shareholders Benefits to Investors
(6) Other Benefits
10Dr Ajay K Patel

Time Value of Money
11Dr Ajay K Patel

Time Value of Money
• An individual preference for possession of a given
amount of cash now, rather than the same amount at
some future time, is called time value of money.
• There are three reasons for time preference for money.
– Uncertainty
– Preference of consumption
– Investment
The Time value of money is generally expressed by Interest rate.
This interest rate is something which an investor require on its
investment. Hence, it is also known as Required rate of return
OR Opportunity cost
12Dr Ajay K Patel

Time Value of Money
• How does interest rate help an individual or form
in making investment decision?
• Mr. Sharma is offered Rs.1,150 by Mr. Mehta one
year from now in exchange of Rs.1000 which he
should give it today, should he accept it, if the
local bank is offering 10% p.a. interest rate on
deposits?
– Exersice: Compare the interest amount with
excess amount offered by Mr. Mehta.
13Dr Ajay K Patel

Future value Or Compound Value
• The interest that is paid on the principal amount as well
as any interest earned, but not withdrawn, during the
earlier years is called compound interest.
• A compound value is the Future value of a cash flow/s
when applying the concept of compound interest.
• Future/ Compound value = Principal (1+ i)^n.
– Where, i = interest,
n = No. of years of compounding.
14Dr Ajay K Patel

• Suppose that Rs.1000 are placed in the saving account of a
bank at 5% interest rate. It will grow to Rs.1050 at the end of
one year, Since FV = 1000(1+0.05)= 1050.
• At the end of two year, the amount will grow to Rs. 1,102.05,
since FV = 1000(1+0.05)^2= 1102.05. Similarly, at the end of
three year the amount will grow to 1157.60,.i.e
1000(1+0.05)^3.
• So, Interest Earned 1st year is Rs.50, whereas Interest Earned
2nd year is Rs.52.05, and 3rd year Rs.55.55.
• It is clear that due to compounding effect every year the
interest earned is more than earlier year.
15Dr Ajay K Patel

• Exercise: If you deposit Rs.55,650 in a bank which is paying 10% as interest
on a ten year deposit, how much would the deposit grow at the end of ten
years?
• Solution;
To calculate the Future value of the deposited amount at the end of ten
year, we can use the following formula:
FV = P (1+ i)^n
where, P = Rs.55,650
I = 10%= 0.10
n = 10
Therefore, FV = 55650 (1+0.1)^10
= 55650 (2.594) = 1,44,356.1
Hence, the deposit of Rs.55,650 in a bank which is paying 10% as interest
on ten year deposit, will grow to Rs.1,44,356.10.
16Dr Ajay K Patel

Present Value or Discounting
 The process of determining the current value of
future cash flow/s is called Present value or
Discounting.
 The interest rate used for determining present value
is called discount rate.
 Present value gives us the answer of how much
amount would investor give up now to get an
amount in future year.
 How to calculate Present value?
◦ Ans- By reversing the formula used to calculate
Future value.
◦ We get, PV = FV/(1+i)^n
17Dr Ajay K Patel

Annuity
 Annuity is the fixed amount of cash flow after a fixed
interval of time periods.
 Example: The equal installments paid on House
Loan, Car Loan, receivable of pension amount, etc..
 Calculation of Future value and Present value of
Annuity can be illustrated with an example below.
 Suppose a firm deposits Rs.5000 at the end of each
year for 4 years at 6% p.a. How much would this
annuity accumulate at the end of 4th year.
18Dr Ajay K Patel

FV of Annuity
Year 1 2 3 4
Amount
deposited
5000 5000 5000 5000
FV at the end
of 4th year
5000
(1.06)^3
=5955.08
5000
(1.06)^2 =
5,618
5000
(1.06)^1 =
5,300
5,000
Total FV of
Annuity
21873.08
19Dr Ajay K Patel

PV of Annuity
Year 1 2 3 4
Amount
deposited
5000 5000 5000 5000
PV 5000/
(1.06)^=
4716.98
5000/
(1.06)^2
=
4449.98
5000/
(1.06)^3
=
4198.09
5,000/
(1.06)^4=
3960.47
Total PV
of Annuity
17,325.52
20Dr Ajay K Patel

FV of Annuity
• So the FV of annuity can be calculated as FVa
= An(1+i)^t + An(1+i)^t-1 + ….+ An
Where,
– FVa = Future value of Annuity
– An= Annuity
– i=interest
– t=n-1, n=future year.
• Also, the formula above can be expressed as,
FVa = An[{(1+i)^n – 1}/i]
21Dr Ajay K Patel

PV of Annuity
 So the PV of Annuity can be calculated as PVa =
An/(1+i) + An/(1+i)^2 + ….
…..+ An/ (1+i)^n
Where,
 PVa = Present value of Annuity
 An= Annuity
 i=interest
 n=future year.
 Also, the formula above can be expressed as, PVa
= An[{1- (1+i)^(-n)}/i]
22Dr Ajay K Patel

Perpetuity
• When an annuity occurs for indefinite time
periods than it is called perpetuity.
• Perpetuity nature in an annuity is generally
seen in certain welfare funds created by
Private or Government firms as a part of their
CSR.
• The formula to calculate the value of
perpetuity is, Pr = An/i.
23Dr Ajay K Patel

Multi-Period compounding
• In practice cash flows occur more than once a
year.
• The interest rate specified on loan or deposit
is on annual basis, i.e., the nominal interest
rate. But if compounding is done more than
once in a year, the actualized interest is higher
than Nominal interest rate and it is called
Effective Interest Rate.
• EIR = [1 + i/m]^n*m - 1
24Dr Ajay K Patel

Multi-Period compounding
• FVa = An[{(1+i/m)^n*m – 1}/(i/m)]
• PVa = An[{1- (1+i)^(-n*m)}/(i/m)]
Illustration: The Future/compound value of
Rs.1000, interest rate being 12% p.a. if
compounded; (i) annually, (ii)semi-annually,
(iii)quarterly, (iv)monthly and (v)continuously for
2 years?
• (i) FV = 1000 (1+ 0.12)^2 =…?
• (ii) FV = 1000(1+ …)^.. = ?
25Dr Ajay K Patel

Continuous compounding
• Some bank deposits or loan can have
continuous compounding or called daily
compounding.
• (V)Fn = PV * e^(i*n)
• Where e= 2.7183
• FV = 1000 e^ 0.12*2 = 1000* 1.2713 = 12,713.
26Dr Ajay K Patel

Loan Amortization
End of year Payment Interest Principal repayment Outstanding balance
0 10,000
1 3951 900 3051 6,949
2 3951 625 3,326 3623
3 3951 326 3,625* 0
Total 11,853 1,851 10,002
Suppose you have borrowed a 3-year loan of Rs.10,000 at 9% from
Your employer requires three equal-of-year repayments, then the annual
Installment will be:
10,000 = A x PVFA (3yrs,0.09%)
A = 10,000/2.531 = 3,951.
Loan Amortization Schedule
We have to pay Rs.3,951 end of each year. The interest is calculated on the outstanding balance
of preceding year at 9% p.a. The loan is completely paid off at the end of the 3rd year.
From the schedule, the total interest paid for 3 yrs on Rs.10,000 loan is Rs.1851
27Dr Ajay K Patel

Summary
Time value of money its three reasons
Uncertainty, Preference of consumption and
Investment.
– Future value of single and multiple cash flows
– Present value of single and multiple cash flows.
– Annuity
– Perpetuity
28Dr Ajay K Patel

Why cost of capital is important?
• The return earned on assets depends on the risk of
those assets. The return to an investor is the same as
the cost to the company.
• Our cost of capital provides us with an indication of
how the market views the risk of our assets.
• Knowing cost of capital can also help us determine
our required return for capital budgeting projects.
• The required return is the same as the appropriate
discount rate and is based on the risk of the cash
flows.
29Dr Ajay K Patel

Cost of equity
• The cost of equity is the return required by
equity investors given the risk of the cash
flows from the firm.
• There are two main methods for determining
the cost of equity:
1. Dividend growth model
2. SML or CAPM
30Dr Ajay K Patel

Dividend growth model
• The dividend growth model formula and
rearrange to solve for RE
gR
D
P
E 
 1
0
g
P
D
RE 
0
1
31Dr Ajay K Patel

Dividend growth model—Example
• Your company is expected to pay a dividend of Rs.4.40 per
share next year. (D1)
• Dividends have grown at a steady rate of 5.1% per year and
the market expects that to continue. (g)
• The current stock price is Rs.50. (P0)
• What is the cost of equity?
139.051.
50
40.4
RE 
32Dr Ajay K Patel

Estimating the dividend growth rate—
Example
• One method for estimating the growth rate is to use the
historical average.
Year Dividend % change
2003 1.23
2004 1.30
2005 1.36
2006 1.43
2007 1.50
(1.30 – 1.23) / 1.23 = 5.7%
(1.36 – 1.30) / 1.30 = 4.6%
(1.43 – 1.36) / 1.36 = 5.1%
(1.50 – 1.43) / 1.43 = 4.9%
Average = (5.7 + 4.6 + 5.1 + 4.9) / 4 = 5.1%
33Dr Ajay K Patel

Advantages and disadvantages of dividend
growth model method
• Advantage—easy to understand and use
• Disadvantages
– Only applicable to companies currently paying
dividends
– Not applicable if dividends aren’t growing at a
reasonably constant rate
– Extremely sensitive to the estimated growth rate
– Does not explicitly consider risk
34Dr Ajay K Patel

The SML method
• Compute cost of equity using the SML
– Risk-free rate, Rf
– Market risk premium, E(RM) – Rf
– Systematic risk of asset, 
))(( fMEfE RRERR  
35Dr Ajay K Patel

SML approach—Example
• Company’s equity beta = 1.2
• Current risk-free rate = 7%
• Expected market risk premium = 6%
• What is the cost of equity capital?
%2.14)6(2.17RE 
36Dr Ajay K Patel

Advantages and disadvantages of SML
method
• Advantages
– Explicitly adjusts for systematic risk
– Applicable to all companies, as long as beta is available
• Disadvantages
– Must estimate the expected market risk premium, which
does vary over time
– Must estimate beta, which also varies over time
– Relies on the past to predict the future, which is not always
reliable
37Dr Ajay K Patel

Cost of equity
• Data:
– Beta = 1.2
– Market risk premium = 8%
– Current risk-free rate = 6%
– Analysts’ estimates of growth = 8% per year
– Last dividend = Rs.2
– Current stock price = Rs.30
– Using SML: RE = 6% + 1.2(8%) = 15.6%
– Using DGM: RE = [2(1.08) / 30] + .08
= 15.2%
38Dr Ajay K Patel

Cost of debt
• The cost of debt = the required return on a
company’s debt.
• We usually focus on the cost of long-term debt or
bonds.
• Method 1 = Compute the yield to maturity on
existing debt.
• Method 2 = Use estimates of current rates based
on the bond rating expected on new debt.
• Note: The cost of debt is NOT the coupon rate.
39Dr Ajay K Patel

Cost of debt
• Suppose we have a bond issue currently
outstanding that has 25 years left to maturity.
The coupon rate is 9% and coupons are paid
semiannually. The bond is currently selling for
$908.72 per $1000 bond. What is the cost of
debt?
– 50 [N]; PMT = 45 [PMT]; 1000 [FV]; 908.75[+/-
][PV] ; [CPT] [I/Y] = 5%; YTM = 5(2) = 10%
40Dr Ajay K Patel

Cost of preference shares
• Reminders
– Preference shares generally pay a constant
dividend every period.
– Dividends are expected to be paid every period
forever.
• Preference share valuation is an annuity, so
we take the annuity formula, rearrange and
solve for RP.
• RP = D/P0
41Dr Ajay K Patel

Cost of preference shares— Example
• Your company has preference shares that have
an annual dividend of Rs.3. If the current price
is Rs.25, what is the cost of a preference
share?
• RP = 3 / 25 = 0.12 = 12%
42Dr Ajay K Patel

Weighted average cost of capital
• Use the individual costs of capital to compute
a weighted ‘average’ cost of capital for the
firm.
• This ‘average’ = the required return on the
firm’s assets, based on the market’s
perception of the risk of those assets.
• The weights are determined by how much of
each type of financing is used.
• Weights = percentages of the firm that will be
financed by each component.
43Dr Ajay K Patel

Capital structure weights
• Notation
– E = market value of equity = number of
outstanding shares times price per share
– D = market value of debt = number outstanding
bonds times bond price
– V = market value of the firm = D + E
• Weights
– wE = E/V = percentage financed with equity
– wD = D/V = percentage financed with debt
12-44Dr Ajay K Patel

Capital structure weights—Example
• Suppose you have a market value of equity
equal to Rs.500 million and a market value of
debt equal to Rs.475 million.
– What are the capital structure weights?
• V = 500 million + 475 million = 975 million
• wE = E/D = 500 / 975 = 0.5128 = 51.28%
• wD = D/V = 475 / 975 = 0.4872 = 48.72%
12-45Dr Ajay K Patel

Taxes and the WACC—
Classical tax system
• We are concerned with after-tax cash flows,
so we need to consider the effect of taxes on
the various costs of capital.
• Interest expense reduces our tax liability.
– This reduction in taxes reduces our cost of debt.
– After-tax cost of debt = RD(1-TC).
• Dividends are not tax deductible, so there is
no tax impact on the cost of equity.
46Dr Ajay K Patel

WACC
WACC = (E/V) x RE + (P/V) x RP + (D/V) x RD x (1- TC)
Where:
(E/V) = % of common equity in capital structure
(P/V) = % of preferred stock in capital structure
(D/V) = % of debt in capital structure
RE = firm’s cost of equity
RP = firm’s cost of preferred stock
RD = firm’s cost of debt
TC = firm’s corporate tax rate
47Dr Ajay K Patel

WACC I—
Extended example
• Equity information
– 50 million shares
– Rs.80 per share
– Beta = 1.15
– Market risk
premium = 9%
– Risk-free rate = 5%
• Debt information
– Rs.1 billion in
outstanding debt (face
value)
– Current quote = 110
– Coupon rate = 9%,
semiannual coupons
– 15 years to maturity
• Tax rate = 40%
48Dr Ajay K Patel

WACC II—Extended example
• What is the cost of equity?
– RE = 5 + 1.15(9) = 15.35%
• What is the cost of debt?
– N = 30; PV = -1100; PMT = 45; FV = 1000; CPT I/Y =
3.9268
– RD = 3.927(2) = 7.854%
• What is the after-tax cost of debt?
– RD(1-TC) = 7.854(1-.4) = 4.712%
49Dr Ajay K Patel

WACC III—Extended example
• What are the capital structure weights?
– E = 50 million (80) = 4 billion
– D = 1 billion (1.10) = 1.1 billion
– V = 4 + 1.1 = 5.1 billion
– wE = E/V = 4 / 5.1 = .7843
– wD = D/V = 1.1 / 5.1 = .2157
• What is the WACC?
– WACC = .7843(15.35%) + .2157(4.712%) = 13.06%
50Dr Ajay K Patel

Investment Decision
51Dr Ajay K Patel

Definition
Investment is the employment of funds on assets to earn
income or capital appreciation.
In economic terms, investment is defined as the net addition
made to the capital stock of the country.
In financial terms, investment is defined as allocating money
to assets with a view to gain profit over a period of time.
Investments in economic and financial terms are inter-
related, where an individual's savings flow into the capital
market as financial investment, which are further used as
economic investment.
52Dr Ajay K Patel

Investment decision
To answer for a perfect investment, it
is very much required to answer that:
Where to invest?
When to invest?
How much to invest?
How to invest?
What is the purpose of investment?
53Dr Ajay K Patel

Types of Investment Decision
• Purpose based
– Expansion and Diversification
– Replacement and Modernization
• Dependence based
– Mutually exclusive investments
– Independent investments
– Contingent/Dependent investments
54Dr Ajay K Patel

Investment Evaluation
• Process
1. Estimation of Cash Flows
2. Estimation of required rate of return
3. Application of decision rule for making the
choice.
55Dr Ajay K Patel

Investment Evaluation
Decision Rules are referred as Capital
budgeting techniques, or investment criteria;
◦ It should consider all cash flows to determine true
profit.
◦ It should provide objective ways to identify Good
and Bad projects.
◦ It should help to priorities projects.
◦ It should help to select among mutually exclusive
projects.
56Dr Ajay K Patel

Capital Budgeting
“Capital budgeting is long-term planning for
making and financing proposed capital
outlays.” --- Charles T. Horngren
“Capital budgeting involves planning of
expenditures for assets returns which will be
realized in future periods.” --- Milton h.
Spencer
57Dr Ajay K Patel

Capital budgeting techniques
Capital
Budgeting
techniques
Traditional
Urgency
method
Pay-Back
method
ARR
Discounted
CFs
NPV
IRR
PI
MIRR
59Dr Ajay K Patel

The payback period (PbP)
• The CIMA defines payback as 'the time it takes the cash inflows from a
capital investment project to equal the cash outflows, usually expressed in
years'.
• When deciding between two or more competing projects, the usual
decision is to accept the one with the shortest payback.
• Example 1:
Years : 0 1 2 3 4 5
Project A: 1,000,000 250,000 250,000 250,000 250,000 250,000
For a project with equal annual receipts:
= 4 years
60Dr Ajay K Patel

Example 2:
Years 0 1 2 3 4
Project B - 10,000 5,000 2,500 4,000 1,000
Payback period lies between year 2 and year 3.
Sum of money recovered by the end of the second year
= 7,500, i.e. (5,000 + 2,500)
Sum of money to be recovered by end of 3rd year
= 10,000 - 7,500 = 2,500
= 2.625 years
61Dr Ajay K Patel

• Disadvantages of the payback method:
– It ignores the timing of cash flows within the payback period, the cash
flows after the end of payback period and therefore the total project
return.
– It is unable to distinguish between projects with the same payback
period.
– It may lead to excessive investment in short-term projects.
• Advantages of the payback method:
– Payback can be important: long payback means capital tied up and
high investment risk. The method also has the advantage that it
involves a quick, simple calculation and an easily understood concept.
62Dr Ajay K Patel

The accounting rate of return - (ARR)
• ARR is also known as ROI .
• It is the ratio of average Net operating
after-tax profit divided by average
investment.
• Average investment is half of the original
investment
ARR = - - - - - - - - -
Average EAT
Average
Investment
63Dr Ajay K Patel

NPV
• It the economic method of evaluating the investment proposals.
• It is a DCF technique that recognizes the time value of money.
• It postulates that CFs arising at different time periods differ in value and
are comparable only when their equivalents-present values-are found out.
 
.
10
t
t
n
t r
CF
NPV

 
- Investment
64Dr Ajay K Patel

NPV?
10 8060
0 1 2 3
10%
Project L:
-100.00
9.09
49.59
60.11
118.79 = TPVL NPVS = 18.79.
65Dr Ajay K Patel

Rationale for the NPV Method
NPV= PV inflows - Cost
= Net gain in wealth.
Accept project if NPV > 0.
Choose between mutually
exclusive projects on basis of
higher NPV. Adds most value.
66Dr Ajay K Patel

IRR
• It is another DCF method, which takes account of magnitude and timing
of CFs.
• It is the rate that equates the investment outlay with the present value
of CFs.
0 1 2 3
CF0 CF1 CF2 CF3
Cost Inflows
IRR is the discount rate that forces PV inflows =
cost. This is the same as forcing NPV = 0.
67Dr Ajay K Patel

IRR
 t
n
t
t
CF
IRR



0 1
0.
IRR: Enter NPV = 0, solve for IRR.
 
.
10
NPV
r
CF
t
t
n
t



NPV: Enter r, solve for NPV.
68Dr Ajay K Patel

Rationale for the IRR Method
If IRR > WACC, then the project’s rate of
return is greater than its cost-- some return is
left over to boost stockholders’ returns.
Example: WACC = 10%, IRR = 15%.
Profitable.
69Dr Ajay K Patel

Profitability Index
• It the ratio of the present value of cash inflows, to the
initial cash outflow/ present value of investment. This
formula is also called Benefit-cost ratio.
PI = PV of cash Inflows
Initial cash outflow
Decision criterion
Accept project if PI >1, Investment will increase
shareholder wealth.
Reject project if PI <1, Investment will decrease
shareholder wealth.
Indifferent if PI = 1.
70Dr Ajay K Patel

• The initial cash outflow of project is Rs. 100,000
and it can generate cash inflow of 40,000, 30,000,
50,000 and 20,000 in year 1 through 4. assume a
10 percent rate of discount.
• The PV of cash inflow at 10 percent discount rate
is:
PV = 40000 (PVIF,1, 0.10) + 30000 (PVIF,2,0.10) + 50000(PVIF,3,0.10) +
20000(PVIF,4,0.10)
= 40000(0.909) + 30000 (0.826) + 50000(0.751) + 20000(0.68)
= 112,350
PI = 112,350/100000 = 1.1235
71Dr Ajay K Patel

Capital Rationing
• Capital rationing technique is used when
company has limited fund for investing in
profitable investment proposals.
• Capital rationing exists when investor is interested
to invest his limited fund in most
profitable investment proposal.
72Dr Ajay K Patel

An Example:(Firm’s Cost of Capital = 12%)
Independent projects ranked according to their IRRs:
Project Project Size→ IRR
E $20,000 → 21.0%
B 25,000 → 19.0
G 25,000 → 18.0
H 10,000 → 17.5
D 25,000 → 16.5
A 15,000 → 14.0
F 15,000 → 11.0
C 30,000 → 10.0
No Capital Rationing - Only projects F and C would be rejected. The firm’s
capital budget would be 120,000.
Existence of Capital Rationing - Suppose the capital budget is constrained
to be 80,000.
Using the IRR criterion, only projects E, B, G, and H, would be accepted,
even though projects D and A's IRR is higher than our cost of
capital but we can not include because of our capital budget is limited up
to 80000.
73Dr Ajay K Patel

Comparing techniques
• There are questions we need to ask when evaluating an
investment and the answer will determine which technique is
one to use for that investment:
1. Are the projects mutually exclusive or independent?
2. Are the projects subjected to capital rationing?
3. Are the projects of same risk?
4. Are the projects of the same scale of investment?
• Decision rules;
1. If the projects are independent and not subject to capital rationing, we can use
any one of the discounted cash flow method.
2. Of the projects are mutually exclusive, have same investment outlay, same
risk, we must use only NPV or MIRR as to determine the wealth to maximize.
3. If projects are mutually exclusive and are of different risks or are of different
scales, NPV preferred over MIRR.
74Dr Ajay K Patel

Capital budgeting in practice
• There is an increased use of more sophisticated capital
budgeting techniques;
– Most FM use more than one technique to evaluate the same
projects, with a discounted CF technique (NPV, IRR, PI) used as a
primary method and pay pack period used as a secondary
method; and
– The most commonly used is the IRR.
– IRR is popular bcoz it is measure of return and therefore easy to
understand.
– The popularity of IRR method is troublesome since it may lead to
decisions about projects that are not in best interest of owners in
certain circumstances. However, NPV method is becoming more
widely accepted and, replace IRR as popular method.
75Dr Ajay K Patel

Comparing techniques
• Consider tow projects, Project Big and Project Small, each
have a cost of capital of 5% with CFs;
• Applying DCF methods to each projects,
If Big and Small are mutually exclusive projects which project
should firm prefer.
Years 0 1 2 3
Big -1,000,000 400,000 400,000 400,000
Small -10 4 4 5
Methods NPV PI IRR MIRR
Big 89299 1.089 9.701 8.037
Small 1.757 1.176 13.78 10.82
76Dr Ajay K Patel

PROJECT RISK ANALYSIS
77Dr Ajay K Patel

Techniques for Risk
Analysis
Analysis of Stand-
Alone Risk
Analysis of
Contextual Risk
Sensitivity
Analysis
Break-even
Analysis
Simulation
Analysis
Scenario
Analysis
Corporate
Risk Analysis
Market Risk
Analysis
Hillier
Model
Decision tree
Analysis
78Dr Ajay K Patel

Sources and Perspective of Risk
Sources of Risk
• Project-specific risk
• Competitive risk
• Industry-specific risk
• Market risk
• International risk
Perspectives on Risk
• Standalone risk
• Firm risk
• Market risk
79Dr Ajay K Patel

Measures of Risk
Risk refers to variability. It is a complex and multi-faceted phenomenon.
A variety of measures have been used to capture different facets of risk.
The more important ones are:
• Range
• Standard deviation
• Coefficient of variation
• Semi - variance
80Dr Ajay K Patel

Sensitivity Analysis
Cash Flow forecast
(‘000)
YEAR 0 YEARS 1 - 10
1. INVESTMENT (20,000)
2. SALES 18,000
3. VARIABLE COSTS (66* 2/3 % OF SALES) 12,000
4. FIXED COSTS 1,000
5. DEPRECIATION 2,000
6. PRE-TAX PROFIT 3,000
7. TAXES 1,000
8. PROFIT AFTER TAXES 2,000
9. CASH FLOW FROM OPERATION 4,000
10. NET CASH FLOW (20,000) 4,000
NPV = financial modelling.xls = 2,600,000
81Dr Ajay K Patel

RANGE NPV
KEY VARIABLE PESSIMISTIC EXPECTED OPTIMISTIC PESSIMISTIC EXPECTED OPTIMISTIC
INVESTMENT 25000 20000 15000
(RS. IN MILLION)
SALES 13500 18000 22500
(RS. IN MILLION)
VARIABLE COSTS 70 66.67 64
(as a % of sales)
FIXED COSTS 1250 1000 750
(RS. IN MILLION)
Sensitivity of NPV to Variations in the Value of Key Variables
82Dr Ajay K Patel

Evaluation
Advantages:
• It shows how robust or vulnerable a project is to changes in
values of the underlying variables.
• It indicates where further work may be done.
• It communicative the concerns that project evaluators
normally have.
Limitations:
• It does not provide information about the chances of change.
• In real life, many variable change at same time.
• It is subjective interpretation.
83Dr Ajay K Patel

Break-Even Analysis
• Accounting Break –Even Analysis
Fixed Costs + Depreciation 1 + 2
= = Rs. 9 million
Contribution margin ratio 0.333
Cash flow forecast for Naveen’s flour mill project
(‘000)
Year 0 Year 1 - 10
1. Investment (20,000)
2. Sales 18,000
3. Variable costs (66 2/3% of sales) 12,000
4. Fixed costs 1,000
5. Depreciation 2,000
6. Pre-tax profit 3,000
7. Taxes 1,000
8. Profit after taxes 2,000
9. Cash flow from operation 4,000
10. Net cash flow (20,000) 4,000
84Dr Ajay K Patel

Financial Break-even Analysis
At what level of sales will the project have a zero NPV?
The annual cash flow of the project depends on sales as follows:
1. Variable costs : 66.67 percent of sales
2. Contribution : 33.33 percent of sales
3. Fixed costs : Rs. 1 million
4. Depreciation : Rs. 2 million
5. Pre-tax profit : (.333 x Sales) – Rs. 3 million
6. Tax (at 33.3%) : .333 (.333 Sales – Rs. 3 million)
7. Profit after tax : .667 (.333 x Sales – Rs. 3 million)
8. Cash flow (4+7) : Rs. 2 million + .667 (.333 x Sales – Rs. 3 million)
= 0.222 Sales
85Dr Ajay K Patel

Contd…
Since the cash flow lasts for 10 years, its present value at a discount rate of 12 percent
is:
PV (cash flows) = 0.222 Sales x PVIFA (10 years, 12%)
= 0.222 Sales x 5.650
= 1.254 Sales
The project breaks even when the present value of cash flows equals initial
investment. Hence, the financial break-even occurs when
PV (cash flows) = Investment
1.254 Sales = Rs. 20 million
Sales = Rs. 15.95 million
Thus, the sales for the flour mill must be Rs. 15.94 million per year for the investment
to have a zero NPV.
Note: It is significantly highly than Rs. 9 million which represents the accounting
break-even sales.
86Dr Ajay K Patel

Decision Tree Analysis
 Decision tree analysis is a tool for analysing situations where sequential
decision making in face of risk is involved.
 The key steps in decision tree analysis are:
1. Identifying the problem and alternatives
2. Delineating the decision tree
3. Specifying probabilities and monetary outcomes
4. Evaluating various decision alternatives
87Dr Ajay K Patel

Specification of Probabilities and Monetary Value
of Outcomes
Once the decision tree is outlined, the following data have to be gathered :
 Probabilities associated with each of the possible outcomes at various
chance forks, and
 Monetary value of each combination of decision alternative and chance
outcome.
The probabilities of various outcomes may sometimes be defined objectively.
For example, the probability of a good monsoon may be based on objective,
historical data.
However, the possible outcomes encountered in real life are such that objective
probabilities for them cannot be obtained.
How can you, for example, define objectively the probability that a new product
like an electric moped will be successful in the market? In such cases,
probabilities have to be necessarily defined subjectively.
88Dr Ajay K Patel

Evaluation of Alternatives
Once the decision tree is delineated and data about probabilities and monetary values
gathered, decision alternatives may be evaluated as follows :
1. Start at the right-hand end of the tree and calculate the expected monetary value at
various chance points that come first as we proceed leftward.
2. Given the expected monetary values of chance points in step 1, evaluate the
alternatives at the final stage decision points in terms of their expected monetary
values.
3. At each of the final stage decision points, select the alternative which has the highest
expected monetary value and truncate the other alternatives. Each decision point is
assigned a value equal to the expected monetary value of the alternative selected at
that decision point.
4. Proceed backward (leftward) in the same manner, calculating the expected monetary
value at chance points, selecting the decision alternative which has the highest
expected monetary value at various decision points, truncating inferior decision
alternatives, and assigning values to decision points, till the first decision point is
reached.
89Dr Ajay K Patel

Spectrum case
The scientists at Spectrum have come up with an electric moped. The
firm is ready for pilot production and test marketing.
This will cost Rs.20 mn and take 6 months. Management believes that
there is a 70 % chance that the pilot production and test marketing will
be successful.
In case of success, Spectrum can build a plant costing Rs.150 mn.
The plant will generate an annual cash inflow of Rs.30 mn for 20 years
if the demand is high or an annual cash inflow of Rs.20 m if the
demand is moderate.
High demand has a probability of 0.6; Moderate demand has a
probability of 0.4.
To analyze such situations where sequential decision making is
involved decision tree analysis is helpful. 90Dr Ajay K Patel

D1
c1
D2
c2
D3
D11: Carry out pilot
production and
market test
-Rs 150
million
D12:Do nothing
C12 : Failure
Probability : 0.3
Probability
: 0.7
C11 : Success
D21:Invest
-Rs 20
million
Probability
: 0.6
C21 : High
demand Annual
cash flow
30 mn
Annual
cash flow
20 mn
C22 : Moderate
demand
Probability
: 0.4
D22: Stop
D31: Stop
Spectrum Case
91Dr Ajay K Patel

Spectrum Case
The alternatives in the decision tree shown are evaluated as follows:
1. Start at the right-hand end of the tree and calculate the EMV at chance
point C2 that comes first as we proceed leftward.
EMV(C2) = 0.6 [30xPVIFA (20, 12%)] + 0.4 [20 x PVIFA (20,
12%)]
= Rs.194.2 million
2. Evaluate the EMV of the decision alternatives at D2 the last stage
decision point.
Alternative EMV
D21 (Invest Rs.150 million) (194-150) = Rs.44.2 million
D22 (Stop) 0
3. Select D21 and trim D22 as EMV(D21) > EMV(D22).
4. Calculate the EMV at chance point C1 that comes next as we roll
backwards.
EMV (C1) = 0.7 [44.2] + 0.3 [0] = Rs.30.9 million
92Dr Ajay K Patel

5. Evaluate the EMV of the decision alternatives at D1 the first
stage decision point :
Alternative EMV
D11 (Carry out pilot production and
market test at a cost of Rs.20 million) Rs.10.9 million
D12 (Do nothing) 0
Based on the above evaluation, the optimal decision strategy is as
follows :
Choose D11 (carry out pilot production and market test) at the
decision point D1 and wait for the outcome at the chance
point C1.
If the outcome at C1 is C11 (success), invest Rs.150 million; if the
outcome at C1 is C12 (failure) stop.
93Dr Ajay K Patel

FINANCING DECISION
94Dr Ajay K Patel

Leverage Analysis
95Dr Ajay K Patel

‘Leverage’ is the action of a lever or the
mechanical advantage gained by an instrument;
it also means ‘effectiveness’ or ‘power’.
The dictionary meaning of the term ‘leverage’
refers to an increased means of accomplishing
some purpose.
In finance, the term leverage refers to amplify or
increase profit.
Meaning
96Dr Ajay K Patel

• It is used to describe the firm’s ability to use fixed costs or
funds to magnify the return to its shareholders.
• When the volume of sales changes, leverage helps in
magnifying such influence. It may, therefore, be defined
as relative change in profit due to change in sales.
• A high degree of leverage implies that there will be a large
change in profit due to relative small change in sales or
vice versa.
Meaning
97Dr Ajay K Patel

Types of Fixed Costs
There are two main types of fixed costs in the study
of leverages:
Operating cost – These costs are associated with the
operations of business, such as rent for the building,
salaries of staff, etc. This is responsible for operating
leverage and represent business/investment risk.
Financial cost– These are associated with the fixed
financial charges due to availing of finance (i.e. in form
of interest on debt capital). This is responsible for
financial leverage and represents business’ financial
risk.
98Dr Ajay K Patel

Types of Risk
There are two main types of risk that a company faces:
Business risk – It is the variability in a firm’s EBIT. This
type of risk is a function of the firm’s regulatory
environment, labor relations, competitive position, etc.
Note that business risk is, to a large degree, outside of
the control of managers.
Financial risk – It is the variability of the firm’s EBT(or
earnings per share). This type of risk is a direct result
of management decisions regarding the relative
amounts of debt and equity in the capital structure
99Dr Ajay K Patel

Types of Leverage
• Operating Leverage
• Financial Leverage
• Combined Leverage
100Dr Ajay K Patel

Degree of Operating Leverage (DOL)
• The degree of operating leverage is directly
proportional to a firm’s level of business risk.
• Operating leverage refers to a changes in sales
into changes in EBIT.
• Operating leverage results from the presence
of fixed costs in the firm’s cost structure
101Dr Ajay K Patel

Calculating DOL
The degree of operating leverage can be
calculated as:
DOL
EBIT
Sales

%
%


• This approach is intuitive, but it requires two income
statements to calculate.
• When we have to calculate DOL for single income
statement:
EBIT
VCSales
DOL


EBIT
VCSales
DOL


102Dr Ajay K Patel

Sales
2000
Less: Variable costs 800
------
Contribution
1200
Less: Fixed costs 500
------
Profits 700
If the sales of this firm is increased by 25%, the income
statement will stand revised as follows:
Sales 2500 (increase of 25%)
Less: Variable costs 1000 (increase of 25%)
------
Contribution 1500 (increase of 25%)
Less: Fixed costs 500 (No change)
--------
Profits 1000
---------
A hypothetical income statement for a firm is as follows:
103Dr Ajay K Patel

Degree of Financial Leverage (DFL)
The degree of financial leverage is a measure of
the % changes in EBT that result from changes
in EBIT, it is calculated as:
DFL
EBT
EBIT

%
%


• This approach is intuitive, but it requires two income statements to
calculate.
• When we have to calculate DOL with one income statement:
DFL
EBIT
EBT

104Dr Ajay K Patel

Degree of Combined Leverage (DCL)
The degree of combined leverage is a measure of
the total leverage (both operating and
financial leverage) that a company is using:
DCL
EBT
Sales
EBIT
Sales
EBT
EBIT
DOL DFL    
%
%
%
%
%
%






• It is important to note that DCL is the product (not the sum)
of both DOL and DFL
105Dr Ajay K Patel

Trading on Equity
Trading on equity is that state of business when the
firm uses debt capital along with equity share capital
in its capital structure.
Generally in practical terms the term is technically used
when the firm uses more of debt than equity.
Therefore, it is also used to indicate the state of
financial leverage.
106Dr Ajay K Patel

CAPITAL STRUCTURE
 Capitalisation
 Total amount of capital
 Capital structure
 Composition of long term finance viz.
 Financial structure
 Composition of long and short both kinds of finance
107Dr Ajay K Patel

CAPITAL STRUCTURE
 Capital Structure is the proportion of debt, preference and
equity capitals in the total financing of the firm’s assets.
 The firm has to decide proper financing mix/capital
structure that results in maximizing the wealth of the
equity shareholders. Such a capital structure is called as
the optimum capital structure.
 At the optimum capital structure, the weighted average
cost of capital would be the minimum.
108Dr Ajay K Patel

FACTORS DETERMINING THE
CAPITAL STRUCTURE
 Financial leverage/Trading on equity
 Growth and stability of sales
 Cost of capital
 Risk
 Cash flow ability to service debts
 Nature and size of firms
 Requirements of investors
109Dr Ajay K Patel

 Capital market conditions
 Assets structure
 Purpose of financing
 Terms of finance
 Costs of floatation
 Corporate tax rate
 Legal requirements
110Dr Ajay K Patel

CAPITAL STRUCTURE THEORIES
There are 4 basic Capital Structure theories.
Relevance of capital structure
1. Net Income Approach
2. Traditional Approach
Irrelevance of capital structure
1. Net Operating Income Approach
2. Modigliani-Miller (MM) Approach and
111Dr Ajay K Patel

COMMON ASSUMPTIONS
 Replacement of one form of capital to another.
 Firm value is consistent with shareholders wealth.
 Capital structure is optimum when total cost of capital is
minimum.
 Earning of the firm remains constant.
112Dr Ajay K Patel

NET INCOME (NI) APPROACH
 According to, Net Income theory was introduced by David
Durand., capital structure decision has an impact on valuation
of the firm.
 A change in the financial leverage will lead to a corresponding
change in the overall cost of capital as well as the total value of
the firm.
 According to NI approach, if the financial leverage increases,
the cost of capital declines and the value of the firm and market
price of the equity shares increases.
 Similarly, if the financial leverage decreases, the cost of capital
increases and value of the firm and market price of the equity
shares decreases.
113Dr Ajay K Patel

ASSUMPTIONS OF NI APPROACH:
 There are no taxes
 The cost of debt is less than the cost of equity.
 The use of debt does not change the risk perception of
the investors
Leverage
ko/ke/K
d
Kd
ke
ko
114Dr Ajay K Patel

AS PER NI APPROACH
 V = E + D
 E = (EBIT-Interest) / Ke
 Ko = Ke *E/(E+D) + Kd* D/(E+D)
115Dr Ajay K Patel

TRADITIONALAPPROACH
 This Traditional theory was advocated by financial experts
Ezta Solomon and Fred Weston.
 According to this theory a right combination of debt and
equity will always lead to market value enhancement of
the firm.
 This approach accepts that equity shareholders perceive
financial risk and expect premiums for the risks
undertaken.
 It also states that after a level of debt in the capital
structure, the cost of equity capital increases.
116Dr Ajay K Patel

ko/ke/Kd(%)
Leverage
ke
ko
Kd
Optimum capital structure
Stage I
Stage 3
Stage 2
Stage I: Kd remain constant, Ke increases at no or slow rate,
and Ko decreases.
Stage II: Beyond a certain level of increase in debt,
leverage will have negative impact on Ko.
At this point, Ko is minimum for maximum value of firm.
Stage III: Ke, Kd increases leading to increase Ko.
117Dr Ajay K Patel

NET OPERATING INCOME APPROACH
 Net Operating Income Approach was also suggested by David
Durand.
 This approach suggests that the capital structure decision of a
firm is irrelevant and that any change in the leverage or debt
will not result in a change in the total value of the firm as well
as the market price of its shares.
 This approach also says that the overall cost of capital is
independent of the degree of leverage.
118Dr Ajay K Patel

FEATURES OF NOI APPROACH:
 At all degrees of leverage (debt), the overall capitalization rate
would remain constant.
 For a given level of Earnings before Interest and Taxes
(EBIT),
Value of a firm =EBIT/Overall capitalization rate
 The value of equity of a firm can be determined by
subtracting the value of debt from the total value of the firm.
 This can be denoted as follows:
Value of Equity = Value of firm - Value of debt
119Dr Ajay K Patel

 Cost of equity increases with every increase in debt and the
weighted average cost of capital (WACC) remains constant.
 When the debt content in the capital structure increases, it
increases the risk of the firm as well as its shareholders.
 Hence, to compensate for higher risk involved in investing in
highly levered company, equity holders naturally expect higher
returns which in turn increases the cost of equity capital.
120Dr Ajay K Patel

Kd
ko/ke/Kd(%)
ko
ke
Leverage
121Dr Ajay K Patel

AS PER NOI APPROACH
 V = EBIT / Ko
 E = V – D
 Ke = (EBIT – Interest) / E
122Dr Ajay K Patel

MODIGLIANI MILLAR APPROACH
 Modigliani Millar approach, popularly known as the MM
approach is extension to NOI approach.
 The MM approach favors NOI approach and agrees with the
fact that cost of capital is independent of the degree of
leverage and at any mix of debt-equity proportions, the value
of firm remains same.
 The value of firm is dependent on earnings and risk of its
assets.
 It provides operational or behavioral justification for constant
cost of capital at any degree of leverage.
123Dr Ajay K Patel

ASSUMPTIONS OF MM APPROACH
 Capital markets are perfect.
 All investors have the same expectation of the company's net
operating income for the purpose of evaluating the value of the
firm.
 Within similar operating environments, the business risk is
equal among all firms.
 100% dividend payout ratio.
 An assumption of "no taxes" was there earlier, which has been
removed.
124Dr Ajay K Patel

BASIC PROPOSITIONS OF MM
APPROACH (WITHOUT TAXES):
 Proposition I: At any degree of leverage, the firm's cost of capital (Ko)
and value of the firm (V) remains constant. Although levered firm can
have higher value than unlevered firm in short run, but in long run due
to presence of arbitrage process, both the firms will be at equal market
value.
 Proposition II: With the increase in leverage, cost of equity rises
exactly to offset the advantage of reduced cost by debt, keeping the
value of the firm constant.
 Ke = Ko – (Ko -Kd) D/E
 The minimum cut-off rate for the purpose of capital investments in all
the cases will be WACC and will be completely unaffected by the type
of security issued to finance the investment.
125Dr Ajay K Patel

 Proposition I:
Levered Co. Un-Levered Co.
EBIT 10,00,000 10,00,000
- Interest 3,00,000 0
Net Profit 7,00,000 10,00,000
Ke 20% 20%
Value of Equity 35,00,000 50,00,000
Value of Debt 30,00,000
Total Value 65,00,000 50,00,000
WACC 15.38% 20%
126Dr Ajay K Patel

Proposition I: As Lev firm value is higher than Un-lev . Hence there will be
arbitrage by investors.
 An investor owner of 10% equity in Levered firm will have ownership right of
Rs.350,000. Further he will get Rs.70,000 as annual return. But, in Unlevered
firm 10% equity will get 100,000 as annual return. So to avail profit he sells
shares for Rs.350,000 and decides to buy 10% of Un-levered firm for
Rs.500,000.
 He decides to borrows additional Rs.300,000 at 10% as loan. So, the total profit
that he will get from all-equity firm will be 10% of profit i.e.100,000.
 The remaining amount 150,000 is left over with the investor. So the net income
the investor will earn = 100,000 – 30,000= 70,000.
 Although the amount of earning remains same but the investor has converted the
corporate leverage to home made leverage. This opportunity will attract more
investors to all-equity firm. Hence share price of all equity firm will increase
and create equilibrium in long run.
127Dr Ajay K Patel

APPROACH (WITH TAXES):
 The value of the levered firm would be greater than
unlevered firm by the value of tax shield of debt.
 Increase in debt, the cost of equity will rise though at
lower rate than what it would in the absence of taxes .
 The WACC declines for the levered firm despite increase
in cost of equity.
 V of unlevered firm = EBIT (1-t)/Ko
 V of levered firm = EBIT (1-t)/Ko + PV of Interest
Tax Shield
128Dr Ajay K Patel

Kd after-tax
Kd before-tax
Ko after tax
Ko before-tax
Ke before tax
129Dr Ajay K Patel

ARBITRAGE PROCESS
 Arbitrage is the process of purchasing a security in a market
where the price is low and selling it in a market where the
price is higher.
 This results in restoration of equilibrium in the market price
of a security asset.
 This process is a balancing operation which implies that a
security offering same return cannot sell at different prices.
130Dr Ajay K Patel

CONCLUSION OF MM
 The value of the firm will be higher than unlevered firm by
present value of amount of taxes saved.
 The Ke will increase at lower rate with the increase in debt
in presence of taxes.
 Due to the continuous reduction in cost of capital with
increase in leverage, it will be beneficial for the firm to
keep borrowing. And value of firm will be maximum at
100% debt.
131Dr Ajay K Patel

LIMITATIONS OF MM HYPOTHESIS:
 Arbitrage process cannot be smooth due the institutional
restrictions.
 Arbitrage process would also be affected by the transaction
costs.
 The corporate leverage and personal leverage are not perfect
substitutes.
 The risk perception of corporate and personal leverage may
be different.
 Corporate taxes do exist. However, the assumption of "no
taxes" has been removed later.
132Dr Ajay K Patel

Dividend policy
 The objective of firm’s dividend policy should be to
maximize a shareholder’s return so that the value of
firm is maximized.
 The importance aspect of dividend policy is to
determine the amount of earning to be distributed
(Payout Ratio) to shareholders and amount to be
retained (Retention Ratio) in the firm.
 Shareholders return consists of two components .i.e.,
Dividends and Capital Gains.
 A dividend policy has influence on both the
components.
134Dr Ajay K Patel

Dividend policy
 On relationship between dividend policy and value of
the firm, different theories can be grouped under :
(a) theories that consider dividend decision to
irrelevant,
(b) theories that consider dividend decision are
relevant to the value of the firm.
135Dr Ajay K Patel

School of Thoughts
 Dividend Relevance
 Walter’s model
 Gordon’s model, Bird-in Hand Argument.
 Dividend irrelevance
 Residual theory of dividend.
 Miller-Modigliani hypothesis
136Dr Ajay K Patel

Walter’s Model
 Professor James E Walter argues that “choice of dividend
policies almost always affect the value of the firm”.
 Assumptions;
1. Internal financing
2. Constant return and cost of capital
3. 100 percent payout or retention
4. Constant EPS and DIV
5. Infinite time
137Dr Ajay K Patel

Walter’s Model
 Walter’s formula of determine market rice per share is given as;
P = DIV + (EPS-DIV)r/k
Where;
P is price of share, EPS is earning per share, DIV is dividend, r is rate
of return, k is firm’s cost of capital.
Situations;
Growth firm: Internal rate more than opportunity cost of capital.
( r > k)
Normal firm: Internal rate equal to opportunity cost of capital.
( r = k)
Declining firm: Internal rate less than to opportunity cost of capital.
( r < k)
K
138Dr Ajay K Patel

Dividend Policy and Value of share
Payout
Ratio
Growth firm( r > k) Normal firm( r =k) Decline firm( r < k)
r= 0.15, k=0.10, EPS=10 r= 0.10, k=0.10, EPS=10 r= 0.08, k=0.10, EPS=10
0% 150 100 80
40% 130 100 88
80% 110 100 96
100% 100 100 100
Optimum payout ratio
for growth firm is O
NO unique Optimum
payout ratio for normal
firm
Optimum payout ratio
for decline firm is 100
139Dr Ajay K Patel

Thus , dividend policy of the firm
depends on the availability of the
opportunity and relationship between
internal rate of return and cost of
capital.
Thus;
•Retain all earning when r>k
•Distribute all earning when
r<k
•Dividend policy has no impact
when r=k
Thus Walter’s model is a financing
decision and payment of dividend is a
Passive residual.
140Dr Ajay K Patel

Gordon’s Model
 Myron Gordon develops on model explicitly relating the market value
of the firm to dividend policy.
 According to Gordon model, the market value of a share is equal to the
present value of an infinite streams of dividend s received by
shareholders. Thus,
Po = ∑DIV (1+g)t/( 1+ ke)t = E(1-b)/Ke-g
Assumptions:
All equity firm Perpetual earnings
No external financing g=br
Constant return Constant retention
Constant cost of capital Cost of capital greater than growth
rate.
141Dr Ajay K Patel

Gordon’s Model
D/P ratio r=15% r=10% r=8%
0% 0 0 0
40% 400 100 77
80% 114.3 100 95
100% 100 100 100
For growth firm
r>ke, the market
price decreases
when the payout
ratio is increased.
For growth firm
r=ke, the market
price doesn’t
change.
For a firm having
r<Ke, the market
price increases
when the payout is
increased.
Market price for Combination of r and D/P ratio, If XYZ has EPS = 10, Ke = 10%.
Thus Gordon conclusion about the relationship between the dividend policy and
value of firm are similar to that of Walter’s model.
142Dr Ajay K Patel

Bird in hand argument
 It suggest that dividend policy is relevant as the investor
prefer current dividend against the future uncertain capital
gains.
 When investor are certain about their returns, they
discount their earning with lower rate and therefore
placing higher value for share of firm.
 So investor require a higher rate of return as retention rate
increases and this would adversely affect the share price.
143Dr Ajay K Patel

Irrelevance approach
 Underlying intuition for dividend irrelevance
 Firms that pay more dividend offer less price appreciation but
provide the same total return to shareholders.
 The investors are indifferent of receiving their returns in the
form current dividend or price increase in market.
 Assumptions:
 Investment and financing have already been made and that
these decisions will not be changed by dividend payments.
 The perfect capital market without any transaction cost and
floatation cost.
144Dr Ajay K Patel

Residual Theory
 Residual Theory argues that the amount of profits to be
distributed is a balancing figure and thus depends upon
investment of firm.
 Residual dividend policy is used by those companies,
which finance new projects through equity that is
internally generated.
 The dividend payments are made from profit that remains
after all project capital needs are met. This equity is also
known as residual equity.
145Dr Ajay K Patel

Residual Theory
 Under residual Theory, firm would treat the dividend
decision in three steps;
 Find the retained earnings needed for the capital expenditure.
 Pay out any leftover earnings (the residual) as dividends.
 This policy minimizes flotation and equity costs, hence minimizes
the WACC.
Dividends = Net Income – We X Total capital budget.
146Dr Ajay K Patel

Residual theory of dividend
Capital budget: Rs.800,000,
Target capital structure: 40% debt, 60% equity.
Forecasted net income: Rs.600,000.
How much out of Rs.600,000 should we pay out as dividends?
 Of the Rs.800,000 capital budget,
 0.6(800,000) = Rs.480,000 will be equity to keep at
target capital structure and
 0.4(800,000) = Rs.320,000 will be debt.
 With Rs.600,000 of net income,
Residual = Rs.600,000 – Rs.480,000 = Rs.120,000 will be paid as
dividends.
 Payout ratio = Rs.120,000/Rs.600,000 = 0.20 = 20%.
147Dr Ajay K Patel

M-M approach
 Under perfect market situation, dividend policy of a is irrelevant
to the value of the firm.
 He argues neither the firm paying dividend nor the
shareholders receiving the dividends will be adversely
affected by firms paying either too little or too much
dividend.
 MM have used arbitrage process to show that the division of
profits between dividends and retained earnings is irrelevant
from the point of view of shareholders .
 Given the investment opportunities, a firm will finance these by
earnings, but firm pays dividend, then will raise an equal amount
of share capital externally.
148Dr Ajay K Patel

M-M approach
 In order to test, MM started with following valuation model.
 Po = (D1 + P1)/(1 + Ke)
 If the firm, has n number of outstanding shares, then the value of company
will be; nPo = n(D1 + P1)/(1 + Ke)
 If firm finance its investment by new shares 'm' at price 'P1'. Then the value
of firm will be; nPo = (nD1 + nP1 +mP1 -mP1)/(1 + Ke)
 The new fund raised by firm 'mP1' is equal to total investment less retained
earning.; mP1 = I – (E – nD1). Hence put it in earlier equation we get;
 nPo = [nD1 + (n +m)P1 - {I – (E – nD1)}]/(1 + Ke) = [(n+m)P1 -I + E]/(1 + Ke)
 In above equation 'D' is not present, hence MM concluded that the value
of firm does not depend on dividend decision.
149Dr Ajay K Patel

M-M approach
 A firm having 1,00,000 shares outstanding and is planning to declare a
dividend of Rs.5 at the end of current year. The CMP of share is Rs.100. Ke
= 10%,. Analyse what will be the value of the share/firm if (a) payment of
dividend is made; (b)Payment of dividend is discarded.
 Use.. Po = (D1 + P1)/(1 + Ke)
 Extended case; Say the firm has total earning of Rs.10,00,000 during year 1,
and is planning investment of Rs.20,000,000. Analyse what will be the
value of the share/firm if (a) payment of dividend is made; (b)Payment of
dividend is discarded.
 Use... nPo = [(n+m)P1 -I + E]/(1 + Ke)
150Dr Ajay K Patel

Working Capital
151Dr Ajay K Patel

Working capital: Concept
• Working capital typically means the firm’s holding of current
or short-term assets such as cash, receivables, inventory and
marketable securities.
• Working Capital refers to that part of the firm’s capital, which
is required for financing short-term or current assets.
• These items are also referred to as circulating capital.
152Dr Ajay K Patel

Concept of working capital
 There are two possible interpretations of
working capital concept:
1. Balance sheet concept
2. Operating cycle concept
Balance sheet concept: There are two interpretations
of working capital under the balance sheet
concept.
a. Excess of current assets over current liabilities
b. Gross or total current assets.
Excess of current assets over current liabilities are called the net
working capital or net current assets.
153Dr Ajay K Patel

Operating cycle concept
• A company’s operating cycle typically consists of three
primary activities:
– Purchasing resources,
– Producing the product and
– Distributing (selling) the product.
These activities create funds flows that are both unsynchronized
and uncertain.
Unsynchronized because cash disbursements usually take place
before cash receipts.
Uncertain because future sales and costs cannot be forecasted
with complete accuracy.
154Dr Ajay K Patel

Operating cycle concept
• The firm has to maintain cash balance to pay the
bills as they come due.
• In addition, the company must invest in
inventories to fill customer orders promptly.
• And finally, the company invests in accounts
receivable to extend credit to customers.
• Operating cycle is equal to the length of
inventory and receivable conversion periods.
155Dr Ajay K Patel

Operating cycle of a typical company
Payable
Deferral period
Inventory conversion
period
Cash conversion
cycle
Operating
cycle
Pay for
Resources
purchases
Receive
CashPurchase
resources
Sell
Product
On credit
Receivable
Conversion period
156Dr Ajay K Patel

THE WORKING CAPITAL
CYCLE
(OPERATING CYCLE)
Accounts Payable
Cash
Raw
Materials
W I P
Finished
Goods
Value Addition
Accounts
Receivable
SALES
157Dr Ajay K Patel

If you Then ......
Collect receivables (debtors)
faster
You release cash from the
cycle
Collect receivables (debtors)
slower
Your receivables soak up
cash
Get better credit (in terms
of duration or amount) from
suppliers
You increase your cash
resources
Shift inventory (stocks)
faster
You free up cash
Move inventory (stocks)
slower
You consume more cash
158Dr Ajay K Patel

• Raw material storage peiod: = Average stock of raw material
Cost of raw material consumed/365
• WIP holding period: Average WIP inventory/ Cost of production/365
• Finished goods storage period: Average stock of finished goods/Cost of goods
sold/365
• Inventory conversion period: Avg. inventory/ Cost of sales/365
• Receivable conversion period:Accounts receivable/Annual credit sales/365
• Payables deferral period: Accounts payable/(Credit purchases)/365
Operating cycle: Inventory conversion period + receivable
conversion period.
Cash conversion cycle = operating cycle – payables deferral period.
159Dr Ajay K Patel

TYPES OF WORKING CAPITAL
WORKING CAPITAL
BASIS OF
CONCEPT
BASIS OF
TIME
Gross
Working
Capital
Net
Working
Capital
Permanent
/ Fixed
WC
Temporary
/ Variable
WC
Regular
WC
Reserve
WC
Special
WC
Seasonal
WC
160Dr Ajay K Patel

Working capital investment
• The size and nature of investment in current assets is a
function of different factors such as
– Type of products manufactured,
– Length of operating cycle,
– Sales level,
– Inventory policies,
– Unexpected demand and
– Unanticipated delays in obtaining new inventories,
– Credit policies and
– Current assets.
161Dr Ajay K Patel

Difference between permanent & temporary
working capital
Amount Variable Working Capital
of
Working
Capital
Permanent Working Capital
Time
162Dr Ajay K Patel

Variable Working Capital
Amount
of
Working
Capital
Permanent Working Capital
Time
163Dr Ajay K Patel

Concepts of Working capital
Financing
• Matching Approach
• Aggressive Approach
• Conservative Approach
164Dr Ajay K Patel

Matching approach to asset financing
Fixed Assets
Permanent Current Assets
Total Assets
Fluctuating Current Assets
Time
Rs
Short-term
Debt
Long-term
Debt +
Equity
Capital
165Dr Ajay K Patel

Conservative approach to asset financing
Fixed Assets
Total Assets
Time
Rs
Short-term
Debt
Long-term
Debt +
Equity
capital
166Dr Ajay K Patel

Aggressive approach to asset financing
Fixed Assets
Total Assets
Time
RS
Short-term
Debt
Long-term
Debt +
Equity
capital
167Dr Ajay K Patel

FACTORS DETERMINING WORKING CAPITAL
1. Nature of the Industry
2. Demand of Industry
3. Cash requirements
4. Nature of the Business
5. Manufacturing time
6. Volume of Sales
7. Terms of Purchase and Sales
8. Inventory Turnover
9. Business Turnover
10. Business Cycle
11. Current Assets requirements
12. Production Cycle
168Dr Ajay K Patel

Working capital estimation
169Dr Ajay K Patel

Satyam Ltd profit and loss A/c and balance sheet for the year
ended 31.12.15 are given below. You required to calculate the
working capital requirement under operating cycle method:
Opening stock
Raw material 10,000
WIP 30,000
Finished goods 5,000
Credit purchase 35,000
Manufacturing expn 15,000
Gross profit 55,000
150,000
Administration expn 15,000
Selling &distrbtn expn 10,000
Net profit 30,000
55,000
Credit sales 1,00,000
Closing stock
Raw material 11,000
WIP 30,500
150,000
Gross profit 55,000
.
55,000
170Dr Ajay K Patel

Liabilities
Equities (16,000@Rs.10) 160,000
Net Profit 30,000
Creditors 10,000
2,00,000
Assets
Fixed Assets 1,00,000
Debtors 30,500
Cash and Bank 19,500
Closing stock
Raw material 11,000
WIP 30,500
2,00,000
Opening debtors (excluding profit) and opening creditor were Rs.6,500 and
Rs.5,000 respectively
171Dr Ajay K Patel

Calculation of operating cycle
Raw material
Average raw material /Raw material consumed
per day
=10,500/34,000/365 =
Work in progress
Average WIP /Total cost of production per day
=30,250/48500/365 =
172Dr Ajay K Patel

Finished goods
Average stock/ Total cost of goods sold per day
=6750/45,000/365 =
Debtors
Average Debtors/ credit sales per day
=18,500/ 100,000/365 =
173Dr Ajay K Patel

Creditor
Average creditor/credit purchases per day
=7500/35,000/365
Net Operating Cycle is
Total days – Credit allowed by creditors
=
174Dr Ajay K Patel

Estimation of Net Working capital requirement for Exl
Ltd from the data given below
Cost of production (per unit) Amount(per unit )
Raw materials 100
Direct labour 40
Overheads 80
220
The following are the additional information:
Selling price per unit Rs.240
Level of activity 1,04,000 units p.a
Raw material in stock Average 4 weeks
Work In Progress (Assume 100% stage of completion of materials and 50 percent for
labor and overheads) Average 2 weeks
Finished goods in stock Average 4 weeks
Credit allowed by supplier Average 4 weeks
Credit allowed by debtors Average 8 weeks
Lag in payment of wages Average 1.50 weeks
Cash at bank is expected to Rs.25,000. Production is sustained during 52 weeks of year
175Dr Ajay K Patel

Statement of Working Capital Requirement
Particulars Amount
Raw materials 2,000 x 4 x 100 8,00,000
WIP
•Raw materials 2,000 x 2 x 100 4,00,000
•Wages (2,000 x 2 x 40)50% 80,000
•Overheads (2,000 x 2 x 80) 50% 1,60,000 6,40,000
Finished stock 2,000 x 4 x 220 17,60,000
Debtors 2,000 x 8 x 220 35,20,000
Cash 25,000
Total Current Assets 67,45,000
Creditors 2,000 x 4 x 100 8,00,000
Outstanding wages 2,000 x 4 x 1.5 1,20,000
Total current liabilities 9,20,000
Net working capital (TCA - TCL) 58,25,000
176Dr Ajay K Patel

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