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Financial management scope role

of financial management in business
time value of money risk and
return risk diversification

FINANCIAL MANAGEMENT:Financial Management means planning,

organizing, directing and controlling the
financial activities such as procurement
and utilization of funds of the
enterprise. It means applying general
management principles to financial
resources of the enterprise.

Objectives of Financial Management

The financial management is generally concerned with
procurement, allocation and control of financial resources of a
concern. The objectives can be-To ensure regular and adequate
supply of funds to the concern.
To ensure adequate returns to the shareholders which will depend
upon the earning capacity, market price of the share, expectations of
the shareholders.
To ensure optimum funds utilization. Once the funds are procured,
they should be utilized in maximum possible way at least cost.
To ensure safety on investment, i.e, funds should be invested in safe
ventures so that adequate rate of return can be achieved.
To plan a sound capital structure-There should be sound and fair
composition of capital so that a balance is maintained between debt
and equity capital.

Functions of Financial Management

Estimation of capital requirements
Choice of sources of funds
Investment of funds
Disposal of surplus
Management of cash
Financial controls

Estimation of capital requirements:

A finance manager has to make estimation with regards to capital
requirements of the company. This will depend upon expected costs and profits
and future programmes and policies of a concern. Estimations have to be made
in an adequate manner which increases earning capacity of enterprise.
Determination of capital composition:
Once the estimation have been made, the capital structure have to be
decided. This involves short- term and long- term debt equity analysis. This will
depend upon the proportion of equity capital a company is possessing and
additional funds which have to be raised from outside parties.
Choice of sources of funds:
For additional funds to be procured, a company has many choices like* Issue of shares and debentures
* Loans to be taken from banks and financial institutions
* Public deposits to be drawn like in form of bonds.
Choice of factor will depend on relative merits and demerits of each source and
period of financing.

Investment of funds:
The finance manager has to decide to allocate funds into profitable
ventures so that there is safety on investment and regular returns is possible.
Disposal of surplus:
The net profits decision have to be made by the finance manager. This can
be done in two ways:
* Dividend declaration - It includes identifying the rate of dividends and other
benefits like bonus.
* Retained profits - The volume has to be decided which will depend upon
expansional, innovational, diversification plans of the company.
Management of cash:
Finance manager has to make decisions with regards to cash
management. Cash is required for many purposes like payment of wages and
salaries, payment of electricity and water bills, payment to creditors, meeting
current liabilities, maintainance of enough stock, purchase of raw materials, etc.
Financial controls:
The finance manager has not only to plan, procure and utilize the funds
but he also has to exercise control over finances. This can be done through many
techniques like ratio analysis, financial forecasting, cost and profit control, etc.

FINANCIAL PLANNING:Financial Planning is the process of estimating the capital required

and determining its competition. It is the process of framing financial policies
in relation to procurement, investment and administration of funds of an
enterprise.

Objectives of Financial Planning

Financial Planning has got many objectives to look forward to:
Determining capital requirements- This will depend upon factors like cost of current and
fixed assets, promotional expenses and long- range planning. Capital requirements have
to be looked with both aspects: short- term and long- term requirements.
Determining capital structure- The capital structure is the composition of capital, i.e.,
the relative kind and proportion of capital required in the business. This includes
decisions of debt- equity ratio- both short-term and long- term.
Framing financial policies with regards to cash control, lending, borrowings, etc.
A finance manager ensures that the scarce financial resources are maximally utilized in
the best possible manner at least cost in order to get maximum returns on investment.

Importance of Financial Planning

Financial Planning is process of framing objectives, policies, procedures,
programmes and budgets regarding the financial activities of a concern. This
ensures effective and adequate financial and investment policies. The importance
can be outlined asAdequate funds have to be ensured.Financial Planning helps in ensuring a
reasonable balance between outflow and inflow of funds so that stability is
maintained.
Financial Planning ensures that the suppliers of funds are easily investing in
companies which exercise financial planning.
Financial Planning helps in making growth and expansion programmes which
helps in long-run survival of the company.
Financial Planning reduces uncertainties with regards to changing market trends
which can be faced easily through enough funds.
Financial Planning helps in reducing the uncertainties which can be a hindrance
to growth of the company. This helps in ensuring stability an d profitability in
concern.

FINANCE DECISIONS

Investment Decision
One of the most important finance functions is to intelligently allocate capital to
long term assets. This activity is also known as capital budgeting. It is important to
allocate capital in those long term assets so as to get maximum yield in future.
Following are the two aspects of investment decision
a.Evaluation of new investment in terms of profitability
b.Comparison of cut off rate against new investment and prevailing investment.

Financial Decision
Financial decision is yet another important function which a financial manger
must perform. It is important to make wise decisions about when, where and how
should a business acquire funds. Funds can be acquired through many ways and
channels. Broadly speaking a correct ratio of an equity and debt has to be maintained.
This mix of equity capital and debt is known as a firms capital structure. A firm tends to
benefit most when the market value of a companys share maximizes this not only is a
sign of growth for the firm but also maximizes shareholders wealth.

Dividend Decision
Earning profit or a positive return is a common aim of all the businesses.
But the key function a financial manger performs in case of profitability is to decide
whether to distribute all the profits to the shareholder or retain all the profits or
distribute part of the profits to the shareholder and retain the other half in the
business. Its the financial managers responsibility to decide a optimum dividend
policy which maximizes the market value of the firm. Hence an optimum dividend
payout ratio is calculated. It is a common practice to pay regular dividends in case of
profitability Another way is to issue bonus shares to existing shareholders.

Liquidity Decision
It is very important to maintain a liquidity position of a firm to avoid
insolvency. Firms profitability, liquidity and risk all are associated with the
investment in current assets. In order to maintain a tradeoff between profitability
and liquidity it is important to invest sufficient funds in current assets. But since
current assets do not earn anything for business therefore a proper calculation must
be done before investing in current assets. Current assets should properly be valued
and disposed of from time to time once they become non profitable. Currents assets
must be used in times of liquidity problems and times of insolvency.

FINANCIAL MANAGER
Financial activities of a firm is one of the most
important and complex activities of a firm. Therefore in
order to take care of these activities a financial manager
performs all the requisite financial activities.
A financial manger is a person who takes care of all
the important financial functions of an organization. The
person in charge must ensure that the funds are utilized in
the most efficient manner. His actions directly affect the
Profitability, growth and goodwill of the firm.

main functions of a Financial Manager:

Raising of Funds
In order to meet the obligation of the business it is important to have enough cash
and liquidity. A firm can raise funds by the way of equity and debt. It is the responsibility of a
financial manager to decide the ratio between debt and equity. It is important to maintain a
good balance between equity and debt.

Allocation of Funds
Once the funds are raised through different channels the next important function is to
allocate the funds. The funds should be allocated in such a manner that they are optimally used.
In order to allocate funds in the best possible manner the following point must be considered
These financial decisions directly and indirectly influence other managerial activities. Hence
formation of a good asset mix and proper allocation of funds is one of the most important activity

Profit Planning
Profit earning is one of the prime functions of any business organization. Profit earning
is important for survival and sustenance of any organization. Profit planning refers to proper
usage of the profit generated by the firm. Profit arises due to many factors such as pricing,
industry competition, state of the economy, mechanism of demand and supply, cost and output.

FINANCIAL GOALS
PROFIT MAXIMIZATION
WEALTH MAXIMIZATION

PROFIT MAXIMIZATION
Profit is the remuneration paid to the entrepreneur after

deduction of all expenses. Maximization of profit can be defined

as maximizing the income of the firm and minimizing the
expenditure.
The main responsibility of a firm is to carry out business by

manufacturing goods and services and selling them in the open

market.
A firm can only make profit if it produces a good or delivers a
service at a lower cost than what is prevailing in the market. The
margin between these two prices would only increase if the firm
strives to produce these goods more efficiently and at a lower
price without compromising on the quality.
Define profit, time value of money, uncertainty of returns.

WEALTH MAXIMIZATION
A process that increases the current net value of business or shareholder
capital gains, with the objective of bringing in the highest possible return.
The wealth maximization strategy generally
involves making sound financial investment decisions which take
into consideration any risk factors that would compromise or outweigh the
anticipated. benefits.
Wealth maximization is a financial management technique that
concentrates its focus on increasing the net worth of a company or firm. This
approach says, more traditional method of management that seeks out increased
profits above all other pursuits. Those who pursue this technique also seek out
profits, but they concern themselves with cash flow, earnings per share of
shareholders, and the social value of any financial initiatives as well

TIME VALUE OF MONEY

The time value of money is the principle that a certain
currency amount of money today has a different buying
power value than the same currency amount of money in the
future. The value of money at a future point of time would
take account of interest earned or inflation accrued over a
given period of time.

SIGNIFICANCE OF TIME VALUE OF MONEY

This concept is so important in understanding financial
management.

We must take this time value of money into consideration

when we are making financial decisions.

It can be used to compare investment alternatives and to

solve problems involving loans, mortgages, leases, savings,
and annuities.

There are mainly three ways for accounting

for the time value of money:
* Simple interest
* Compounding
* Discounting

Compounding:The ability of an asset to generate earnings, which are then

reinvested in order to generate their own earnings. In other
words, compounding refers to generating earnings from previous
earnings.
Also known as "compound interest".
The process of earning interest on a loan or other fixed-income
instrument where the interest can itself earn interest. That is,
interest previously calculated is included in the calculation of
future interest.
Compound interest is interest paid on an investment during the
first period is added to the principal; then, during the second
period, interest is earned on the new sum

Simple Interest
Interest is earned only on principal.
Example: Compute simple interest on $100
invested at 6% per year for 3 years.

1st year interest is $6.00

2nd year interest is $6.00

3rd year interest is $6.00

Total interest earned: $18.00

DISCOUNTING
The process of determining the present value of
a payment or a stream of payments that is to be
received in the future. Given the time value of
money, a dollar is worth more today than it
would be worth tomorrow given its capacity to
earn interest. Discounting is the method used to
figure out how much these future payments are
worth today.

RISK
Risk means the chance of loss.
The chance that an investments
actual return will be different than
expected. Risk includes the
possibility of losing some or all of
the original investment.

Sources of risk
The essence of risk in an
investment is the variation in its
returns.
The variation in risk is caused by a
number of factors.
These factors may be internal or
external.
continues.

 External factors means the factors

which are beyond the control of
business.
Internal factors means the factors
which can be controlled by the
organization.
The risk caused by external factors
is called systematic risk.
The risk caused by internal factors
is called unsystematic risk.

REASONS :economic changes

political changes
technological changes
stock price
social changes

TYPES OF SYSTEMATIC RISK

A. INTEREST RATE RISKS
B. MARKET RISK
C. PURCHASING POWER RISK

INTEREST RATE RISK

This type of risk is affect to debt securities like
debentures or bonds.
Debt securities have normally a coupon rate of
interest and it is equal to the interest rate
prevailing in the market when these securities
are issued.
Some times, the interest rate prevailing in the
economy will be changed , but the coupon rate
will not be changed.
These variations in bond prices caused due to
the variations in interest rates is known as
interest rate risk.

MARKET RISK
Market risk of shares may move upward or
downward.
General rise in price is called bullish trend and fall
in price is called bearish trend.
These changes may reflect in the sensitive index of
BSE or nifty.
The stock market is seen to be volatile. This
volatility leads to variations in the returns of
investors in shares. These variations in return caused
by the volatility of the stock market is referred to as
the market risk.

PURCHASING POWER RISK

Inflation results in reducing
purchasing power o f money.
thus inflation causes a variation in
thee purchasing power of the returns
from an investment.
This is known as purchasing power
risk.

Inflation may be caused by two

reasons:Sometimes demand is increasing
but supply cannot be increased, price
of the goods increases.
Rise in cost of production leads to
increase in price of product.

UNSYSTEMATIC RISK.

Risk caused due to some

factors which are controlled
by the organization is called
unsystematic risk.

REASONS :Scarcity of raw materials

Labour stike
Inefficiency of management
Financial pattern
Operating environment
Work overloading

TYPES OF UNSYSTEMATIC
RISK
A. BUSINESS RISK
B. FINANCIAL RISK

BUSINESS RISK
Every company operates within a
particular operating environment.
The operating cost may be fixed cost
or variable cost. Too much fixed cost
adversely affects the working of
company. It leads to total decline of
revenue.

FINANCIAL RISK
Financial risk is a function of financial leverage. It
means the use of debt in the capital structure.
The presence of debt in the capital structure
creates fixed payment to be made whether the
company makes profit or loss. This fixed interest
payment creates more variability in the EPS
available to equity shareholders. The variability
in EPS due to the presence of debt in the capital
structure of a company is called financial risk.

RISK AND RETURN

Risk is the chance that an investment's actual return will be different than
expected. Technically, this is measured in statistics by standard deviation. Risk
means you have the possibility of losing some, or even all, of our original
investment.
Low levels of uncertainty (low risk) are associated with low potential returns. High
levels of uncertainty (high risk) are associated with high potential returns.
The risk/return tradeoff is the balance between the desire for the lowest possible
risk and the highest possible return. This is demonstrated graphically in the chart
below. A higher standard deviation means a higher risk and higher possible return.

DIVERSIFICATION OF RISK
Diversification is a risk-management technique that mixes a wide variety of
investments within a portfolio in order to minimize the impact that any one security will
have on the overall performance of the portfolio.
Diversification essentially lowers the risk of your of portfolio. There are three main
practices that can help to ensure the best diversification:
Spread portfolio among multiple investment vehicles such as cash, stocks, bonds,
mutual funds, and perhaps even some real estate
Vary the risk in your securities. If you are investing in equity funds, then consider large
cap as well as small cap funds. And if you are investing in debt, you could consider both
long term and short term debt. It would be wise to pick investments with varied risk
levels; this will ensure that large losses are offset by other areas
Vary your securities by industry. This will minimize the impact of specific risks of certain
industries
Diversification is the most important component in helping you reach your long-range
financial goals while minimizing your risk. At the same time, diversification is not an
ironclad guarantee against loss. No matter how much diversification you employ,
investing involves taking on some sort of risk.

Long term investment decision capital

budgeting different techniques
traditional and modern methods of
capital budgeting capital rationing
risk analysis in capital rationing an
overview of cost of capital

Investment Decision
The investment decision of a firm is generally
known as capital budgeting or capital
expenditure decisions.
It defines the investment of current funds
most efficiently in long-term assets as an
anticipation of expected flow of benefits over
a series of years.

Importance of Investment Decision

Growth
Risk
Funding
Irreversibility
Complexity

Types Of Investment Decision

Expansion and Diversification

Replacement and Modernization
Mutually Exclusive Investment
Independent Investment
Contingent Investment

Capital Budgeting
Capital budgeting is the process of making
investment decisions in capital expenditure.
It involves planning and control of capital
expenditure.
It is the process of deciding whether or not to
commit the recourse to a particular long term
project whose benefit are to be realized over a
long period of time.

Characteristics / needs/
importance of capital budgeting
Exchange of current funds for the
benefit to be achieved in future.
Future benefits.
Invested in long term non- flexible
activities.
Investment of huge funds.
Difficulties in investment decisions.

Factors Influencing Capital Budgeting

Availability of funds
Structure of capital
Taxation Policy
Government Policy
Lending Policies of Financial Institutions
Immediate need of the Project
Earnings
Capital Return
Economic Value of the Project
Working Capital
Accounting Practice

Capital budgeting process

STAGES IN CAPITAL BUDGETING

1.
2.
3.
4.
5.
6.

Identification Stage determine which types of capital

investments are necessary to accomplish organizational
objectives and strategies
Search Stage Explore alternative capital investments
that will achieve organization objectives
Information-Acquisition Stage consider the expected
costs and benefits of alternative capital investments
Selection Stage choose projects for implementation
Financing Stage obtain project financing
Implementation and Control Stage get projects under
way and monitor their performance

Kinds of capital budgeting

1. Accept reject decision:It relates to independent projects which do not compete with one
another. This decisions are mainly based on minimum return on
investment.
2.Mutually exclusive project decision:It relates to the decisions about depend projects. In such a way
acceptance of one project causes rejection of another.
3.Capital rationing decision:Here the total capital should be allocated to several profitable
projects according to their nature. Simply limited capital should
be rationed to several projects.

Capital Budgeting Methods/ evaluation of

investment proposals
A. Traditional methods:1. Payback Period
2. Accounting method
B. Time adjusted methods:1. Net Present Value (NPV)
2. Internal Rate of Return (IRR)
3. Accrual Accounting Rate of Return (AARR)
4. Profitability index method

Cash outflow
Money paid out by an organization as a result of
its operating activities, investment activities,
and financing activities.

The cash outflow of a business is constituted of its

expenses--its bills, and other costs.

Cash inflow
The cash inflow of a company is simply the total
money earned by that company.
The cash inflow can include interest or money made
on investments, sales, or any other operating activity
that can result in a monetary profit.
Cash inflow minus cash outflow will yield the takehome profit of a business.

Payback Method
This method is based on the principal that every
capital expenditure pays itself back within a
certain period out of the additional earnings
generated from the capital assets.
It measures the period of time for the original
cost of a project to be recovered from the
additional earnings of the project.
Under this method various investment proposals
are ranked according to the length of their pay
back period in such a manner that the investment
with a shorter payback period is preferred to the
one which has longer pay back period.
It is also known as pay out period/ pay off period.

PBP=

Cash out flow

annual cash inflow

Net Present Value Method

It s the modern method of evaluating
investment proposal method take into
consideration the time value of money and
attempts to calculate the return on
investment by introducing the factor of time
element.
It recognizes the fact that a rupee earned
today is worth more than the same rupee
earned tomorrow.

Evaluation of NPV method

Time value recognizes time value of money
a rupee received today is worth ore than a
rupee received tomorrow.
True profitability
Value additivity NPV(A+B)=NPV(A)+NPV(B)
Shareholders value

Limitations of NPV method

Estimating cash flow it is difficult to obtain
the estimates of cash flows due to uncertainty.
Measuring discount rate it is difficult to
precisely measure the discount rate.

Discounted Cash Flows

Discounted Cash Flow (DCF) Methods
measure all expected future cash inflows and
outflows of a project as if they occurred at a
single point in time
The key feature of DCF methods is the time
value of money (interest), meaning that a
dollar received today is worth more than a
dollar received in the future

Discounted Cash Flows (continued)

DCF methods use the Required Rate of Return (RRR),
which is the minimum acceptable annual rate of return
on an investment.
RRR is the return that an organization could expect to
receive elsewhere for an investment of comparable risk
RRR is also called the discount rate, hurdle rate, cost of
capital or opportunity cost of capital

Three-Step NPV Method

1. Draw a sketch of the relevant cash inflows and
outflows
2. Convert the inflows and outflows into present
value figures using tables or a calculator
3. Sum the present value figures to determine the
NPV. Positive or zero NPV signals acceptance,
negative NPV signals rejection

NPV Method Illustrated

Internal Rate of Return (IRR) Method

The IRR Method calculates the discount rate at
which the present value of expected cash
inflows from a project equals the present
value of its expected cash outflows.

IRR Method

Analysts use a calculator or computer program to

provide the IRR
Trial and Error Approach:

Use a discount rate and calculate the projects NPV. Goal: find
the discount rate for which NPV = 0
1.
2.
3.

If the calculated NPV is greater than zero, use a higher discount

rate
If the calculated NPV is less than zero, use a lower discount rate
Continue until NPV = 0

Comparison NPV and IRR Methods

IRR is widely used
NPV can be used with varying RRR
NPV of projects may be combined for
evaluation purposes, IRR cannot
Both may be used with sensitivity analysis
(what-if analysis)

Relevant Cash Flows in

DCF Analysis

Relevant cash flows are the differences in

expected future cash flows as a result of
making an investment
Categories of Cash Flows:
1. Net Initial Investment
2. After-tax cash flow from operations
3. After-tax cash flow from terminal disposal of an
asset and recovery of working capital

Net Initial Investment

1.
2.
3.

Three Components:
Initial Machine Investment
Initial Working Capital Investment
After-tax Cash Flow from Current Disposal of
Old Machine

Cash Flow from Operations

Two Components:
1. Inflows (after-tax) from producing and selling
additional goods or services, or from savings
in operating costs. Excludes depreciation,
handled below:
2. Income tax cash savings from annual
depreciation deductions

Accounting Rate Of Return

It is also known as Return On Investment(ROI)
It uses accounting information as revealed by
financial statements, to measure the
profitability of an investment.

Capital Rationing
It is defined as a situation wherein a firm is not
allowed to acquire essential funds to invest in
investment projects with positive NPV due to
some external, or self-imposed reasons.
The management has not simply to determine
the profitable investment opportunities, but it
has to decide to obtain that combination of the
profitable project which yield highest NPV within
the available funds.

Types of capital rationing

External capital rationing
Occurs usually due to the imperfection of capital market.
There are two kinds of reasons for capital rationing external and internal.
When a business is unable to borrow funds from outside
sources, it is an external reason for capital rationing. A firm
may be unable to borrow funds because of internal financial
shortages, substandard operating performance, unfavorable
credit conditions or when it introduces a new, untested
product. Banks are particularly reluctant to lend to small
businesses and individuals with a less-than-satisfactory
performance.

Internal capital rationing

Occurs due to the self-imposed restrictions by the
management.
In a privately-owned company, management may want to
limit growth of business to have a stronger hold on the
business. In larger companies, upper management may
specify spending limits for each department, following a
comprehensive corporate strategy. Internal reasons also
include human resource constraints, in which the company
may not have adequate middle management personnel to
cover expansion.

Cost of capital
Cost of capital is the minimum amount of
return expected by the investor.
It is the weighted average cost of various
sources of finance used by the firm.
A decision to invest in a particular project
depends upon the cost of capital of the
project.
The capital used by the firm is in the form
of debt, equity shares, preference shares
and retained earnings.

Computation of cost of capital

A . Computation of cost of specific source of
finance
B . Computation of weighted average cost of
capital.

Computation of cost of specific

source of finance
Computation of each specific sources
like DEBT, PREFERENCE SHARE
CAPITAL, EQUITY SHARE CAPITAL and
RETAINED EARNINGS.

Meaning and importance Theories of

capital structure Net income Net
operating income MM approach

Capital structure
Capital structure of a company refers to the
composition of its capitalization and it includes
all long term capital sources i.e., loans,
reserves, shares and bonds.
the Capital structure of business can be
measured by the ratio of various kinds of
permanent loan and equity capital to total
capital.

Factors affecting capital structure

INTERNAL
Financial leverage
Risk
Growth and stability
Retaining control
Cost of capital
Cash flows
Flexibility
Purpose of finance
Asset structure

EXTERNAL
Size of the company
Nature of the industry
Investors
Cost of inflation
Legal requirements
Period of finance
Level of interest rate
Level of business activity
Availability of funds
Taxation policy
Level of stock prices
Conditions of the capital market

Optimal capital structure

The OCM can be defined as that capital structure or combination of debt and equity
that leads to the maximum value of the firm
OCM maximises the value of the company and hence the wealth of its owners and
minimise the companys cost of capital.
the following consideration should be kept in mind while maximising the value of the
firm in achieving the goal of the optimal capital structure:
1. If ROI is higher the fixed cost of funds, the company should prefer to raise the
funds having a fixed cost, such as, debentures, Loans and PSC. It will increase EPS
and MV of the firm.
2. If debt is used as a source of finance, the firm saves a considerable amount in
payment of tax as interest is allowed as a deductible expense in computation of
tax.
3. It should also avoid undue financial risk attached with the use of increased debt
financing
4. The Capital structure should be flexible.

Point of indifference / Range of earnings

The earnings per share, equivalent point or point of indifference
refers to that EBIT, level at which EPS remains the same
irrespective of Different alternatives of Debt-Equity mix. At this
level of EBIT, the rate of return on capital employed is equal to
the cost of debt and this is also known as the break-even level
of EBIT for alternative financial plans
Capital Gearing
CG means the ratio between the various types of securities in the
capital structure of the company. A company is said to e highgear when it has proportionately higher/larger issue of Debt
and PS for raising the LT resources. Whereas low-gear stands for
a proportionately large issue of equity shares.

Leverage
Leverage-an Increased means of accomplishing some
purpose
In financial management, it is the firms ability to use fixed
cost assets or funds to increase the returns to its owners;
Financial leverage- the use of long term fixed income
bearing debt and preference share capital along with the
equity share capital is called financial leverage or trading
on equity
A Firm is known to have a favourable leverage if its earnings
are more than what debt would cost. On the contrary, if
it does not earn as much as the debt costs then it will be
known as an unfavourable leverage.

Impact of financial leverage

When the d/f b/w the earnings from assets financed by
fixed cost funds and cost of these funds are distributed to
the equity stockholders, they will get additional earnings
without increasing their own investment. Consequently,
the EPS and the Rate of return on ESC will go up.
On the contrary, if the firm acquires fixed cost funds at a
higher cost than the earnings from those assets then the
EPS and return on equity capital will decrease.

Significance of financial leverage

Planning of capital structure
Profit planning
Limitations of FL/ trading on equity
Double-edged weapon
Beneficial only to companies having stability in
earnings
Increases risk and rate of interest
Restriction from financial instruments

Operating leverage
Operating leverage results from the presence of fixed costs
the help in magnifying net operating income fluctuations
flowing from small variations in revenue.
The changes in sales are related to changes in the revenue.
The fixed costs do not change with the changes in sales,
any increase in sales, FC remaining the same, will
magnify operating revenue
OL shows the ability of a firm to use fixed operating cost to
increase the effect of change in sales and the charges in
fixed operating income.

A measurement of the degree to which a firm or project incurs a

combination of fixed and variable costs.

1. A business that makes few sales, with each sale providing a very
high gross margin, is said to be highly leveraged. A business that
makes many sales, with each sale contributing a very slight margin, is
said to be less leveraged. As the volume of sales in a business
increases, each new sale contributes less to fixed costs and more to
profitability.

2. A business that has a higher proportion of fixed costs and a lower

proportion of variable costs is said to have used more operating
leverage. Those businesses with lower fixed costs and higher variable
costs are said to employ less operating leverage.

 The higher the degree of operating leverage,

the greater the potential danger from
forecasting risk. That is, if a relatively small
error is made in forecasting sales, it can be
magnified into large errors in cash flow
projections. The opposite is true for
businesses that are less leveraged. A business
that sells millions of products a year, with
each contributing slightly to paying for fixed
costs, is not as dependent on each individual
sale.

Combined leverage
The OL affects the income which is the result
of production. On the other hand, FL is the
result of financial decisions. The CL focuses
attention on the entire income of the concern
This leverage shows the relationship between
a change in sales and the corresponding
variation in taxable income.
Working capital leverage
This leverage measures the sensitivity of ROI of
changes in the level of current assets.

Capital Structure
Capital structure includes only long term debt
and total stockholder investment.
Capital Structure = Long Term Debt +
Preferred Stock + Net Worth
OR
Capital Structure = Total Assets Current
Liabilities.

EBIT EPS Approach

In this approach, it is analyzed that how
sensitive is EPS to the changes in EBIT under
different capital structure.

ROI ROE Approach

This approach analyses the relationship
between the ROI and ROE for different levels
of financial leverage.
ROI return on investment
ROE- return on equity

Theories of Capital Structure

Net Income Approach

Net Operating Income Approach
Traditional Approach.
Modigliani and Miller Approach [MM
Hypothesis]

Assumptions of Capital Structure

Theories
Firm uses only two sources of funds: perceptual riskless debt and
equity;
There are no corporate or income: or personal tax;
The dividend payout ratio is 100% [There are no retained earnings];
There is no change in the total assets.
There is no change in capital
The firms operating profits (EBIT) are not expected to grow;
The business risk is remained constant
The firm has perpetual life

Definitions used in Capital Structure

E = Total Market Value of Equity.

D = Total Market Value of Debt.
V = Total Market Value of the Firm.
I = Annual Interest payment.
NI = Net Income.
NOI = Net Operating Income.
Ee = Earning Available to Equity Shareholder.

 he 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 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. Companies raise money from a
number of sources: common equity, 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.

Net Income (NI) Approach

 Net Income theory was introduced by David

Durand. According to this approach, the
capital structure decision is relevant to the
valuation of the firm. This means that a
change in the financial leverage will
automatically 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 weighted average cost
of capital decreases and the value of the firm
and the market price of the equity shares
increases. Similarly, if the financial leverage
decreases, the weighted average cost of
capital increases and the value of the firm and
the market price of the equity shares
decreases.

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

Net Income Approach

A change in the proportion in capital structure will lead
to a corresponding change in Ko and V.
Assumptions:
(i) There are no taxes;
(ii) Cost of debt is less than the cost of equity;
(iii) Use of debt in capital structure does not change the
perception of investors.
(iv) Cost of debt and cost of equity remains constant;

risk

Net Income Approach

Formula used for NI Approach

Net Income [NI] = EBIT Debenture Interest.
Value of the Firm [V] = Market Value of Equity
[E] + Market Value of Debt [D]
Market Value of Equity [E] = Net Income [NI] /
Cost of Equity [Ke]
Cost of Capital [Ko] = EBIT / V * 100

Net Operating Income Approach

There is no relation between capital structure and Ko and V.
Assumptions:
(i)

Overall Cast of Capital (Ko) remains unchanged for all degrees of

leverage.
(ii) The market capitalises the total value of the firm as a whole and no
importance is given for split of value of firm between debt and equity;
(iii) The market value of equity is residue [i.e., Total value of the firm minus market
value of debt)
(iv) The use of debt funds increases the received risk of equity investors, there by ke
increases
(v) The debt advantage is set off exactly by increase in cost of equity.
(vi) Cost of debt (Ki) remains constant
(vii) There are no corporate taxes.

Net Operating Income Approach

Formula used for NOI Approach

Value of the Firm [V] = EBIT / Ko
Market Value of Equity [E] = V D
Cost of Equity/ Equity Capitalization Rate [Ke]
= Ee / E or EBIT I / V - D

MM Hypothesis
This approach was developed by Prof. Franco
Modigliani and Mertan Miller.
According to this approach, total value of the
firm is independent of its capital structure.

Assumptions
a.
b.
c.
d.
e.
f.
g.

Information is available at free of cost

The same information is available for all investors
Securities are infinitely divisible
Investors are free to buy or sell securities
There is no transaction cost
There are no bankruptcy costs
Investors can borrow without restrictions as the same
terms on which a firm can borrow
h. Dividend payout ratio is 100 percent
i. EBIT is not affected by the use of debt

Propositions:
I. Ko and V are independent of capital structure
II. Ke = to capitalisation rate of the pure equity plus a
premium for financial risk.
Ke increases with the use of more debt. Increased Ke
off set exactly the use of a less expensive source of
funds (debt)
III.The cut of rate for investment purposes is completely
independent of the way in which an investment is
financed.

MM Approach [Proposition I]
arbitrage Progress:
Refers to an act of buying an asset or security in one market at lower
price and selling it is an other market at higher price.
Steps in working out Arbitrage Process:
Step 1: Investors Current Position: In this step there is a need to find
out the current investment and income (return).
Step 2: Calculation of Savings in Investment by moving from levered
firm to unlevered firm. Savings in investment is equals to total
funds [Funds raise by sale of shares plus funds raised by
personnel borrowing] minus same percentage of investment.
Here the income will be same which was earning in previous
firm.
Step 3: Calculation of Increased Income, by investing total funds
available.

Limitations of MM Approach
Investors cannot borrow on the same terms and
conditions of a firm
Personal leverage is not substitute for
corporate leverage
Existence of transaction cost
Institutional restriction on personal leverage
Asymmetric information
Existence of corporate tax

Traditional Approach
This approach was given by Soloman.
This approach is the midway between NI
Approach and NOI Approach.
Traditional approach says judicious use of debt
helps increase value of firm and reduce cost of
capital

Main Prepositions
1. The pretax cost of debt (Ki) remains more or less constant up to a certain
degree of leverage and /but rises thereafter of an increasing rate
2. The cost of equity capital (Ke) remains more or less constant rises slightly up
to a certain degree of leverage and rises sharper there after, due to increased
perceived risk.
3. The over all cost of capital (Ko), as a result of the behavior of pre-tax cost of
debt (Ki) and cost of equity (Ke) behavior the following manner: It
(a) Decreases up to a certain point level of degree of leverage [stage I increasing
firm value];
(b) Remains more or less unchanged for moderate increase in leverage
thereafter [stage II optimum value of firm], and

(c) Rises sharply beyond certain degree of leverage [stage III decline in firm
value].