Professional Documents
Culture Documents
Traditional approach
Traditionally, finance itself in any organization aimed to achieve optimal use
of the limited financial resources. The scope of finance is mostly confined to
the procurement of funds by business houses to address financial needs.
Earlier, finance as a function remained focused on funding activities and
involved extensive decision making around financial instruments,
investment houses and practices. This period (the mid-1950s) is referred to
as corporation finance. Under this approach, finance as a function
emphasizes more on managerial aspects of business and stretches the
responsibilities of a finance manager to include all decision-making
associated with the efficient use of resources.
A modern day finance manager should possess a balanced blend of
management skills, financial expertise, administrative ability, technological
knowledge, communication skills and decision-making skills.
Modern Approach
Under this approach, finance as a function emphasizes more on managerial
aspects of business and stretches the responsibilities of a finance manager to
include all decision-making associated with the efficient use of resources.
A modern day finance manager should possess a balanced blend of
management skills, financial expertise, administrative ability, technological
knowledge, communication skills and decision-making skills.
2. Consideration Of Risk
Wealth maximization objective also considers the risks associated to the streams of
future cash flows. The risk is taken care of by using appropriate required rate of
return to discount the future streams of cash flows. Higher the risk, higher will be
the required rate of return and vice versa.
4. Residual Owners
Shareholders are residual claimants in earnings and assets of the company.
Therefore, if shareholders wealth is maximized, then all others with prior claim
than shareholders could be satisfied.
Core Concepts
Working capital is the capital of a business which is used in its day-to-day trading operations,
calculated as the current assets minus the current liabilities.
Working capital is a measure of both a company's efficiency and its short-term financial health.
Working capital is calculated as:
The working capital ratio (Current Assets/Current Liabilities) indicates whether a company has
enough short term assets to cover its short term debt. Anything below 1 indicates negative W/C
(working capital). While anything over 2 means that the company is not investing excess assets.
Most believe that a ratio between 1.2 and 2.0 is sufficient. Also known as "net working capital".
2. Nature of Business:
The type of business, firm is involved in, is the next consideration
while deciding the working capital. In case of trading concern or
retail shop the requirement of working capital is less because length
of operating cycle is small.
The wholesalers as compared to retail shop require more working
capital as they have to maintain large stock and generally sell goods
on credit which increases the length of operating cycle. The
manufacturing company requires huge amount of working capital
because they have to convert raw material into finished goods, sell
on credit, maintain the inventory of raw material as well as finished
goods.
3. Scale of Operation:
The firms operating at large scale need to maintain more inventory,
debtors, etc. So they generally require large working capital whereas
firms operating at small scale require less working capital.
5. Seasonal Factors:
The working capital requirement is constant for the companies which are
selling goods throughout the season whereas the companies which are selling
seasonal goods require huge amount during season as more demand, more
stock has to be maintained and fast supply is needed whereas during off
season or slack season demand is very low so less working capital is needed.
7. Credit Allowed:
Credit policy refers to average period for collection of sale proceeds. It
depends on number of factors such as creditworthiness, of clients, industry
norms etc. If company is following liberal credit policy then it will require
more working capital whereas if company is following strict or short term
credit policy, then it can manage with less working capital also.
8. Credit Avail:
Another factor related to credit policy is how much and for how long period
company is getting credit from its suppliers. If suppliers of raw materials are
giving long term credit then company can manage with less amount of
working capital whereas if suppliers are giving only short period credit then
company will require more working capital to make payments to creditors.
9. Operating Efficiency:
The firm having high degree of operating efficiency requires less amount of
working capital as compared to firm having low degree of efficiency which
requires more working capital.
12. Inflation:
If there is increase or rise in price then the price of raw materials and cost of
labour will rise, it will result in an increase in working capital requirement.
2. “Management of cash flows plays a very important role in cash management”. Discuss
Cash flow is of vital importance to the health of a business. One saying is: “revenue is vanity,
cash flow is sanity, but cash is king”. What this means is that whilst it may look better to have
large inflows of revenue from sales, the most important focus for a business is cash flow.
Many businesses may continue to trade in the short- to medium-term even if they are making a
loss. This is possible if they can, for example, delay paying creditors and/or have enough money
to pay variable costs. However, no business can survive long without enough cash to meet its
immediate needs.
Cash comes into the business (cash inflows), mostly through sales of goods or services and flows
out (cash outflows) to pay for costs such as raw materials, transport, labour, and power. The
difference between the two is called the net cash flow. This is either positive or negative. A
positive cash flow occurs when a business receives more money than it is spending. This enables
it to pay its bills on time.
A negative cash flow means the business is receiving less cash than it is spending. It may struggle
to pay immediate bills and need to borrow money to cover the shortfall. The distinction between
cash flow and profit is shown in the example. In accounting, negative figures are shown in
brackets.
Liquidity
Businesses aim to provide greater financial returns than the level of interest earned by simply
placing the cash in a bank. They can also hold too much cash. Cash does not earn anything so
holding too much cash could mean potential losses of earnings. The cash situation is referred to
as the liquidity position of the business. The closer an asset is to cash, the more 'liquid' it is. A
deposit account at a bank or stock that can easily be sold are liquid. Assets such as buildings are
the least liquid. Liquid assets are those that are most easily turned into cash.
Cash flow is always important, but especially when it is not easy to obtain credit. When the
economy is in recession, financial service providers are reluctant to lend money. Borrowing also
becomes more expensive as interest rates are raised to partially offset the risk of borrowers not
paying back loans.
Controlling cash is essential and management accountants deal with a range of cash
issues:
ensuring that sufficient cash is available for investment by not tying up cash
in stock unnecessarily
putting procedures in place for chasing up outstanding debts
controlling different levels of cash outflows in relation to the size of the
business.
For example, a car repair garage buys parts and tyres whilst a hairdresser buys shampoos,
equipment and pays for power. In each case, if the business has cash problems it may be slow
to pay its bills to suppliers. This creates further cash problems which spread throughout the
economy. If small suppliers are not paid they may go out of business. This in turn may affect
businesses further up the ladder.
Core Concepts
Capital Structure–Meaning & Concept, capital structure theories, factors affecting capital
structure decisions, EBIT-EPS analysis
The capital structure is how a firm finances its overall operations and growth by using
different sources of funds. Debt comes in the form of bond issues or long-term notes
payable, while equity is classified as common stock, preferred stock or retained
earnings. Short-term debt such as working capital requirements is also considered to be
part of the capital structure.
The expected cash flow must match with the obligation of making payments
because if company fails to make fixed payment it may face insolvency.
Before including the debt in capital structure company must analyse properly
the liquidity of its working capital.
High ICR means companies can have more of borrowed fund securities
whereas lower ICR means less borrowed fund securities.
If DSCR is high then company can have more debt in capital structure as
high DSCR indicates ability of company to repay its debt but if DSCR is less
then company must avoid debt and depend upon equity capital only.
4. Return on Investment:
Return on investment is another crucial factor which helps in deciding the
capital structure. If return on investment is more than rate of interest then
company must prefer debt in its capital structure whereas if return on
investment is less than rate of interest to be paid on debt, then company
should avoid debt and rely on equity capital. This point is explained earlier
also in financial gearing by giving examples.
5. Cost of Debt:
If firm can arrange borrowed fund at low rate of interest then it will prefer
more of debt as compared to equity.
6. Tax Rate:
High tax rate makes debt cheaper as interest paid to debt security holders is
subtracted from income before calculating tax whereas companies have to
pay tax on dividend paid to shareholders. So high end tax rate means prefer
debt whereas at low tax rate we can prefer equity in capital structure.
7. Cost of Equity:
Another factor which helps in deciding capital structure is cost of equity.
Owners or equity shareholders expect a return on their investment i.e.,
earning per share. As far as debt is increasing earnings per share (EPS), then
we can include it in capital structure but when EPS starts decreasing with
inclusion of debt then we must depend upon equity share capital only.
8. Floatation Costs:
Floatation cost is the cost involved in the issue of shares or debentures. These
costs include the cost of advertisement, underwriting statutory fees etc. It is a
major consideration for small companies but even large companies cannot
ignore this factor because along with cost there are many legal formalities to
be completed before entering into capital market. Issue of shares, debentures
requires more formalities as well as more floatation cost. Whereas there is
less cost involved in raising capital by loans or advances.
9. Risk Consideration:
Financial risk refers to a position when a company is unable to meet its fixed
financial charges such as interest, preference dividend, payment to creditors
etc. Apart from financial risk business has some operating risk also. It
depends upon operating cost; higher operating cost means higher business
risk. The total risk depends upon both financial as well as business risk.
If firm’s business risk is low then it can raise more capital by issue of debt
securities whereas at the time of high business risk it should depend upon
equity.
10. Flexibility:
Excess of debt may restrict the firm’s capacity to borrow further. To maintain
flexibility it must maintain some borrowing power to take care of unforeseen
circumstances.
11. Control:
The equity shareholders are considered as the owners of the company and
they have complete control over the company. They take all the important
decisions for managing the company. The debenture holders have no say in
the management and preference shareholders have limited right to vote in the
annual general meeting. So the total control of the company lies in the hands
of equity shareholders.
During depression period in the market business is slow and investors also
hesitate to take risk so at this time it is advisable to issue borrowed fund
securities as these are less risky and ensure fixed
repayment and regular payment of interest but if there is Boom period,
business is flourishing and investors also take risk and prefer to invest in
equity shares to earn more in the form of dividend.
2. What are capital structure theories? Explain various capital structure theories with the
help of diagram.
In financial management, capital structure theory refers to a systematic approach to financing
business activities through a combination of equities and liabilities. Competing capital structure
theories explore the relationship between debt financing, equity financing and the market value of
the firm.
When cost of capital is lowest and the value of the firm is greatest, we
call it the optimum capital structure for the firm and, at this point, the
market price per share is maximised.
(iii) The use of debt does not change the risk perception of the
investors since the degree of leverage is increased to that extent.
The value of the firm (V) will also be the maximum at this point.
They are:
(i) The overall capitalisation rate of the firm Kw is constant for all
degree of leverages;
(ii) Net operating income is capitalised at an overall capitalisation rate
in order to have the total market value of the firm.
S–V–T
Ke = EBIT – I/S
The NOI Approach can be illustrated with the help of the
following diagram:
In other words, after attaining the optimum level, any additional debt
taken will offset the use of cheaper debt capital since the average cost
of capital will increase along with a corresponding increase in the
average cost of debt capital.
It is found from the above that the average cost curve is U-shaped.
That is, at this stage the cost of capital would be minimum which is
expressed by the letter ‘A’ in the graph. If we draw a perpendicular to
the X-axis, the same will indicate the optimum capital structure for the
firm.
Thus, the traditional position implies that the cost of capital is not
independent of the capital structure of the firm and that there is an
optimal capital structure. At that optimal structure, the marginal real
cost of debt (explicit and implicit) is the same as the marginal real cost
of equity in equilibrium.
For degree of leverage before that point, the marginal real cost of debt
is less than that of equity beyond that point the marginal real cost of
debt exceeds that of equity.
Core Concepts
Dividend Policy– Meaning & Concepts, types of dividend policy, types of dividends,
theories of dividend policy decisions.
Dividend policy is the set of guidelines a company uses to decide how much of its earnings it will
pay out to shareholders. Some evidence suggests that investors are not concerned with a
company's dividend policy since they can sell a portion of their portfolio of equities if they want
cash. This evidence is called the "dividend irrelevance theory," and it essentially indicates that an
issuance of dividends should have little to no impact on stock price. That being said, many
companies do pay dividends, so let's look at how they do it.
1.) Regular dividend policy: in this type of dividend policy the investors get dividend at usual
rate. Here the investors are generally retired persons or weaker section of the society who want
to get regular income. This type of dividend payment can be maintained only if the company has
regular earning.
Merits of Regular dividend policy:
2. Discuss in brief various dividend policy theories with their assumptions and limitations.
1. Walter’s model:
Professor James E. Walterargues that the choice of dividend policies almost
always affects the value of the enterprise. His model shows clearly the
importance of the relationship between the firm’s internal rate of return (r)
and its cost of capital (k) in determining the dividend policy that will
maximise the wealth of shareholders.
The above equation clearly reveals that the market price per share is the
sum of the present value of two sources of income:
i) The present value of an infinite stream of constant dividends, (D/K) and
[r (E-D)/K/K]
Criticism:
Walter’s model is quite useful to show the effects of dividend policy on an all
equity firm under different assumptions about the rate of return. However, the
simplified nature of the model can lead to conclusions which are net true in
general, though true for Walter’s model.
The criticisms on the model are as follows:
1. Walter’s model of share valuation mixes dividend policy with investment
policy of the firm. The model assumes that the investment opportunities of
the firm are financed by retained earnings only and no external financing debt
or equity is used for the purpose when such a situation exists either the firm’s
investment or its dividend policy or both will be sub-optimum. The wealth of
the owners will maximise only when this optimum investment in made.
2. Gordon’s Model:
One very popular model explicitly relating the market value of the firm to
dividend policy is developed by Myron Gordon.
Assumptions:
Gordon’s model is based on the following assumptions.
7. The retention ratio (b), once decided upon, is constant. Thus, the growth
rate (g) = br is constant forever.
The above equation explicitly shows the relationship of current earnings (E,),
dividend policy, (b), internal profitability (r) and the all-equity firm’s cost of
capital (k), in the determination of the value of the share (P0).
3. Modigliani and Miller’s hypothesis:
According to Modigliani and Miller (M-M), dividend policy of a firm is
irrelevant as it does not affect the wealth of the shareholders. They argue that
the value of the firm depends on the firm’s earnings which result from its
investment policy.
Thus, when investment decision of the firm is given, dividend decision the
split of earnings between dividends and retained earnings is of no
significance in determining the value of the firm. M – M’s hypothesis of
irrelevance is based on the following assumptions.
4. Risk of uncertainty does not exist. That is, investors are able to forecast
future prices and dividends with certainty and one discount rate is appropriate
for all securities and all time periods. Thus, r = K = Kt for all t.
Under M – M assumptions, r will be equal to the discount rate and identical
for all shares. As a result, the price of each share must adjust so that the rate
of return, which is composed of the rate of dividends and capital gains, on
every share will be equal to the discount rate and be identical for all shares.
Thus, the rate of return for a share held for one year may be calculated
as follows:
Where P^ is the market or purchase price per share at time 0, P, is the market
price per share at time 1 and D is dividend per share at time 1. As
hypothesised by M – M, r should be equal for all shares. If it is not so, the
low-return yielding shares will be sold by investors who will purchase the
high-return yielding shares.
This process will tend to reduce the price of the low-return shares and to
increase the prices of the high-return shares. This switching will continue
until the differentials in rates of return are eliminated. This discount rate will
also be equal for all firms under the M-M assumption since there are no risk
differences.
From the above M-M fundamental principle we can derive their valuation
model as follows:
If the firm sells m number of new shares at time 1 at a price of P^, the value
of the firm at time 0 will be
Criticism:
Because of the unrealistic nature of the assumption, M-M’s hypothesis lacks
practical relevance in the real world situation. Thus, it is being criticised on
the following grounds.
2. M-M argue that the internal and external financing are equivalent. This
cannot be true if the costs of floating new issues exist.
4. Even under the condition of certainty it is not correct to assume that the
discount rate (k) should be same whether firm uses the external or internal
financing.
If investors have desire to diversify their port folios, the discount rate for
external and internal financing will be different.
Cost of Capital–Meaning & concept, Computation of cost for different source of capital,
weighted average cost of capital
Ans : Cost of capital refers to the opportunity cost of making a specific investment. It is the rate of
return that could have been earned by putting the same money into a different investment with equal
risk. Thus, the cost of capital is the rate of return required to persuade the investor to make a given
investment.
Calculate the market share of firm equity by multiplying the total number of share
into price per share. This figure indicates by the E in the formula
Calculate the market value –not the book value- of the company debt by the
number of bonds by the price per bond. This figure indicates by ‘D’.
2. Write note on :
Cost of debt capital
The primary cost of capital is the cost the firm has to pay to raise the debts from
the outside world. For example the Interest rate paid on loans is considered to be
the cost of debt capital as interest has to be paid for the raising the loan. Dividend
is another cost of the debt capital.
Cost of Debt can be calculate before tax and after tax both
Before tax
Cost of debt = coupons rate of bonds
After tax
Cost of debt = coupons rate of bonds (1-tax)
In case of adjustments
Kp = D/NP
D= annual preference dividend
NP = Par value pref. shares – discount – floation cost
Or
NP = Par value Preference share + premium
D + (m.v – n.p)/n
½ (m.v + n.p)
Where
n is the number of years
m.v is maturity value
Cost of retained earnings (ks) is the return stockholders require on the company's common stock.
There are three methods one can use to derive the cost of retained earnings:
a) Capital-asset-pricing-model (CAPM) approach
b) Bond-yield-plus-premium approach
c) Discounted cash flow approach
a) CAPM Approach
To calculate the cost of capital using the CAPM approach, you must first estimate the risk-free rate (rf),
which is typically the U.S. Treasury bond rate or the 30-day Treasury-bill rate as well as the expected rate
of return on the market (rm).
The next step is to estimate the company's beta (bi), which is an estimate of the stock's risk.
Inputting these assumptions into the CAPM equation, you can then calculate the cost of retained
earnings.
Formula 11.3
b) Bond-Yield-Plus-Premium Approach
This is a simple, ad hoc approach to estimating the cost of retained earnings. Simply take the
interest rate of the firm's long-term debt and add a risk premium (typically three to five
percentage points):
Formula 11.4
c) Discounted Cash Flow ApproachAlso known as the "dividend yield plus growth approach".
Using the dividend-growth model, you can rearrange the terms as follows to determine ks.
Formula 11.5
ks = D1 + g;
P0
where:
D1 = next year's dividend
g = firm's constant growth rate
P0 = price
Typically, you must also estimate g, which can be calculated as follows:
Formula 11.6
The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all
its security holders to finance its assets. The WACC is commonly referred to as the firm’s cost of capital.
Importantly, it is dictated by the external market and not by management. The WACC represents the minimum
return that a company must earn on an existing asset base to satisfy its creditors, owners, and other providers
of capital, or they will invest elsewhere.[1]
Companies raise money from a number of sources: common stock, preferred stock, straight debt, convertible
debt, exchangeable debt, warrants, options, pension liabilities, executive stock options, governmental
subsidies, and so on. Different securities, which represent different sources of finance, are expected to generate
different returns. The WACC is calculated taking into account the relative weights of each component of
the capital structure. The more complex the company's capital structure, the more laborious it is to calculate
the WACC.