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that save money. These decisions are related to asset composition of firm and can be bifurcated into capital budgeting decisions and working capital management.
A) CAPITAL BUDGETING : Related to allocation of funds to different long term assets and affects the profit either directly or indirectly. Such decisions are irreversible in nature and affects the capacity and strength to compete. Capital Budgeting decisions involve three steps: Estimation of cost and benefit of a proposal Estimation of required rate of return Evaluation of different proposals in order to select one
TRADITIONAL OR NON DISCOUNTING: A) Payback period B) Accounting rate of return TIME ADJUSTED OR DISCOUNTED CASH FLOW A) Net present value B) Profitability Index C) Discounted Payback D) Internal Rate of return
B)WORKING CAPITAL MANAGEMENT: Deals with management of current assets of the firm. They do not contribute directly to the earnings yet their existence is important for the proper ,efficient and optimum utilization of fixed assets. Finance manager is required to decide the levels of individual current assets. Also the finance manager must monitor the assets to ensure that desired level is being maintained
The term working capital may be used in two ways A) Gross Working Capital B) Net Working Capital TYPES OF WORKING CAPITAL NEEDS A) Permanent Working Capital B) Temporary Working Capital
2) FINANCING DECISIONS: Deals with financing pattern of the firm. As firms make
decisions concerning where to invest resources , they also have to decide how they should raise resources MAIN SOURCES OF FINANCING: Shareholders Fund: includes equity share capital, preference share capital and accumulated profit Borrowed Fund: includes debentures, bonds and loans from financial institutions A finance manager is has to evaluate various combinations of debt and equity to adopt one which is optimal for the firm. Tools available for a finance manager for this purpose are a) Leverage Analysis b) Capital Structure Models
LEVERAGE ANALYSIS
Leverage = % change in dependent variable %change in independent variable OPERATING LEVERAGE: Operating leverage =% change in EBIT % change in Sales Revenue
Degree of Operating Leverage=Contribution EBIT FINANCIAL LEVERAGE: Financial Leverage= % change in EPS %change in EBIT
Degree of financial leverage = EBIT PBT COMBINED LEVERAGE: Combined leverage= % change in EPS % change in sales DCL= DOL*DFL
CAPITAL STRUCTURE Capital structure also known by the term financial leverage or financing mix. Overall cost of capital depends(WACC) upon specific cost of capital of individual sources of finance and the proportion of different sources in the capital structure. A firm can change its WACC by changing the financing mix and can thus effect the value of firm. Establishing relationship between financial leverage, cost of capital and value of firm is a controversial matter in financial management.
ASSUMPTIONS Capital requirement of the firm are given and remain constant Cost of debt is less than cost of equity Cost of debt and cost of equity remain constant and increase in financial leverage does not affect the risk perception of the investors. Increasing use of financial leverage enable a firm to reduce its cost of capital by taking Advantage of cheaper source of finance( debt) and as a result the value of firm Increases. Opposite happens when there is decreasing financial leverage.
NET OPERATING INCOME APPROACH: CAPITAL STRUCTURE DO NOT MATTER ASSUMPTIONS Overall cost of capital is constant and depends upon the business risk which is also assumed to be constant. Cost of debt is taken as constant Use of more debt in capital structure increase the risk of shareholders and as a result the cost of equity increases which completely offsets the benefits of employing cheaper debt There is no tax This approach states that financing mix is irrelevant in determining the value of the firm. The increasing use of financial leverage changes the risk perception of shareholders as a result of which cost of equity increases offsetting the benefits of cheaper debt. WACC remains unaffected.NOI considers WACC to be constant which signifies that there is no optimal capital structure rather every capital structure is as good as any other.
As per traditional approach, a firm can be benefited from a moderate level of leverage when the advantages of using debt outweigh the disadvantages of increasing cost of equity. The overall cost of capital is a function of the financial leverage. The value of firm can be effected therefore by the judicious use of debt and equity in the capital structure
WALTER S MODEL:
ASSUMPTIONS All investment proposal to be financed through retained earnings only and no external finance is available to firm. Business risk complexion remains same even after fresh investment decisions are taken. Firm has infinite life. This model states that dividend decision depends on investment decision. A firm should or should not pay dividend depends on whether the firm has reinvestment opportunity or not. DIVIDEND POLICY TO BE FOLLOWED: If r> cost of capital, the payout ratio should be zero If r< cost of capital, the payout ratio should be 100% If r = cost of capital, dividend is irrelevant and the dividend policy is not expected to affect the market value of share.
GORDON S MODEL:
ASSUMPTIONS All investment proposal to be financed through retained earnings only and no external finance is available to firm. Business risk complexion remains same even after fresh investment decisions are taken. Firm has infinite life. Growth rate is the product of retention ratio and rate of return i.e. g= br Cost of capital is more than growth rate. Gordon argues that there is a preference for current dividend and there is a direct relationship between dividend policy and market value of share. Investors are basically risk averse and consider capital gain as risky propositions.