FINANCIAL MANAGEMENT UNIT 1

FINANCE:
AN INTRODUCTION
For: II Semester MBA, Pondicherry University

Mohammed Umair| M.Com,

PGDBA, NET
Department of
Kristu Jayanti
Commerce
&Department
St. Josephs
Management
of

College Evening College

 SYLLABUS
UNIT I

Financial Management Financial goals - Profit vs. Wealth

Maximization; Finance Functions Investment, Financing and Dividend
Decisions Cost of Capital Significance of Cost of Capital
Calculation of Cost of Debt Cost of Preference Capital Cost of
Equity Capital (CAPM Model and Gordons Model) and Cost of Retained
Earnings Combined Cost of Capital (weighted/Overall).
 For a comprehensive understanding of the subject you
can buy my book by clicking the link:
https://sapnaonline.com/shop/Author/mohammed-u
mair
What is finance?

FINANCE IS THE SCIENCE AND ART OF MANAGING MONEY AND OTHER ASSETS.

Thus the study of finance can be classified into

following
Publicways:-
Finance: Public finance deals with role of the government
in managing financial requirements of the economy.
Personal Finance: Personal finance deals with monetary
decisions and activities of an individual or a family unit that
includes routine income and expenses planning.
Corporate Finance: Corporate finance also called as financial
management or Business finance focuses is concerned with
planning, raising, investing and monitoring of finance in order to
achieve the financial objectives of the company.
What is finance
Function?
Finance function refers to action performed by a
finance department that involves acquiring and
utilizing funds of a business.
AIMS OF FINANCE FUNCTION
The following are the aims of finance
function:
Acquiring Sufficient and Suitable Funds: The primary aim
of finance function is to assess the needs of the enterprise,
properly, and procure funds, in time.

Proper Utilization of Funds: Raising funds is important, more

than that is its proper utilization. If proper utilization of funds
were not made, there would be no revenue generation.

Increasing Profitability: Profitability is necessary for every

organization. The planning and control functions of finance aim
at increasing profitability of the firm.
Maximizing Firms Value: The ultimate aim of finance function
is maximising the value of the firm, which is reflected in wealth
maximisation of shareholders.
 SCOPE OF FINANCIAL MANAGEMENT

The scope of financial decisions revolves around four important

decisions. In all the following financial areas of decision-making,
the role of finance manager is vital.

1. Financing Decision:
All organizations irrespective of type of business must raise funds to buy the assets necessary
to support operations. Thus financing decisions involves addressing two questions:
How much capital should be raised to fund the firm's operations (both existing & proposed)
What is the best mix of financing these investment proposals?

2. Investment Decision:
This decision in financial management is concerned with allocation of funds
raised from various sources into acquisition assets or investment in a project.
Further, Investment decision not only involves allocating capital to long term
assets but also involves decisions of utilizing surplus funds in the business,
any idle cash earns no further interest and therefore not productive.
 SCOPE OF FINANCIAL MANAGEMENT

The scope of financial decisions revolves around four important

decisions. In all the following financial areas of decision-making,
the role of finance manager is vital.

3. Dividend Decision:
Share holders are the owners and require returns, and how much money
to be paid to them is a crucial decision. Thus payment of dividend is
decision involves deciding whether profits earned by the business should
be retained rather than distributed to shareholders in the form of
dividends.

. Working Capital Decisions:

Working capital primarily deals with currents assets and current
liabilities, in fact it is calculated as the current assets minus the current
liabilities. One of the key objectives of working capital management is to
ensure liquidity position of a firm to avoid insolvency.
ORGANIZATION OF THE FINANCE FUNCTION

In the context of financial management organisation structure

of finance indicates established pattern of relationships
among individuals and positions in a finance department of a
business enterprise.
ORGANIZATION OF THE FINANCE FUNCTION
The board of directors is the top governing body, and the chairperson of the
board is generally the highest-ranking individual. The CEO comes next, but
note that the chairperson of the board often serves as the CEO as well. The
CFO, who is generally a senior vice president and the third ranking officer, is
in charge all the financial activities of the organisation.

a The Finance ManagerRole, Functions and Duties

Forecasting and Planning:

Executing financing and investment decisions:
Coordination and control:
Management of financial resources:
Maximize profits & Minimise cost:
Dealing with financial markets:
 FINANCIAL PLANNING
Financial Planning is the process of ascertaining an
organisations financial needs for the future and
identifying how to achieve them.

Types of Financial Plans

After the company starts, the finance manager does the financial
planning. The types of financial plans are depicted and briefly
explained below.
Short-term financial plan is prepared for maximum one year.
This plan looks after the working capital needs of the company.
Medium-term financial plan is prepared for a period of one to
five years. This plan looks after replacement and maintenance of
assets, research and development, etc.
Long-term financial plan is prepared for a period of more than
five years. It looks after the long-term financial objectives of the
company, its capital structure, expansion activities, etc.
Need, Benefits, Significance and Objectives of financial planning

What is the need of financial planning? Increase financial efficiency

What are the benefits of financial Reduce finance-related risks
planning? Coordination with other departments
What is significance of financial planning? Gives right direction
What are the objectives of financial Helps to achieve objectives of financial
planning? management
Keeps good control of financial activities

Principles and Characteristics of Sound Financial Planning

Principles Description
Simplicity financial plan should be easily understandable to all the stake holders
Objectivity provide clarity and direction for strategic planning
Flexibility easily changed or modified, adjusted when there is a change
Liquidity an asset can be converted to cash, financial plan should ensure availability
Economy cost of borrowing funds should always be kept in mind
Provision for Provision of funds should be made for meeting the contingencies
contingencies
Optimum use efficiently, effective use of funds

STEPS IN FINANCIAL PLANNING OR FINANCIAL PLANNING PROCESS

NEED AND IMPORTANCE OF
FINANCIAL MANAGEMENT

1. ESTIMATING THE CAPITAL REQUIREMENTS OF THE CONCERN

2. DETERMINING THE CAPITAL STRUCTURE OF THE ENTERPRISE
3. FINALIZING THE CHOICE AS TO THE SOURCES OF FINANCE
4. DECIDING THE PATTERN OF INVESTMENT OF FUNDS
5. DISTRIBUTION OF SURPLUS JUDICIOUSLY
6. EFFICIENT MANAGEMENT OF CASH
OBJECTIVES OF FINANCIAL MANAGEMENT

A. PROFIT MAXIMIZATION
B. WEALTH MAXIMIZATION

Profit maximization is the process of identifying the most efficient manner

of obtaining the highest rate of return from its production model.
The following arguments are advanced in favor of profit maximization as the
objective of business:

Barometer of Performance: Profitability is a barometer for measuring efficiency and

economic prosperity of a business enterprise.
Survival in different business conditions: Economic and business conditions do not
remain same at all times. There may be adverse business conditions like recession,
depression, severe competition etc. A business will be able to survive under unfavorable
situation, only if it has some past earnings to rely upon.
Expansion and Diversification: Profits are the main sources of finance for the growth
and expansion of a business. So, a business should aim at maximization of profits for
enabling its growth and development.
Attract Investors: Profits are the main sources returned to investors or shareholders as
a percentage of their capital contribution.
Maximize stakeholders return: Growth and development of a business has a number
of requirements and not only the money.
To fulfill social desire: Profitability is essential for fulfilling social goals also. A firm
by pursuing the objective of profit maximization also maximizes socio-economic welfare
 OBJECTIVES OF FINANCIAL MANAGEMENT

A. PROFIT MAXIMIZATION
B. WEALTH MAXIMIZATION

However, profit maximization objective has been criticized on

many grounds. They are:

Not a clear term: The term profit is vague and it cannot be precisely defined. It means different
things for different people. Should we consider short-term profits or long-term profits? Does it mean
total profits or earnings per share?
Does not Considers Risk: It does not take into consideration the risk of the prospective earnings
stream. Some projects are more risky than other.
Leads to corrupt practices: A firm pursuing the objective of profit maximization starts exploiting
workers and the consumers. Hence, it is immoral and leads to a number of corrupt practices.
Attracts competition: Supernormal profit attracts entry of new firms because knowledge is
everywhere and also the main aim of any producers is to make profit.
Induces Government intervention: Firms may fear that the existence of supernormal profits
would attract government intervention into the market and thereby restrict the firms activities.
Leads to employee unrest: The concept of larger profit making would result in employers and
business owners not only focusing their attention on making a financial profit at all cost which
inevitably leads to workforce exploitation
OBJECTIVES OF FINANCIAL MANAGEMENT

A. PROFIT MAXIMIZATION
B. WEALTH MAXIMIZATION

Wealth maximization emphasis on stockholders wealth, the individual

stockholder can use this wealth to maximize his individual utility.
The following arguments are advanced in favor of Wealth maximization as the
objective of business:

There is a rationale in applying wealth maximizing policy as an

operating financial management policy. It serves the interests of
suppliers of loaned capital, employees, management and society.
Besides shareholders, there are short-term and long-term
suppliers of funds who have financial interests in the concern.
Short-term lenders are primarily interested in liquidity position so
that they get their payments in time. The long-term lenders get a
fixed rate of interest from the earnings and also have a priority
over shareholders in return of their funds.
Wealth maximization objective not only serves shareholders
interests by increasing the value of holdings but ensures security
to lenders also. The economic interest of society is served if
 OBJECTIVES OF FINANCIAL MANAGEMENT

A. PROFIT MAXIMIZATION
B. WEALTH MAXIMIZATION
Cons or Demerits: The wealth maximization objective has also
been criticized by certain financial theorists mainly on following
accounts;

It is a prescriptive idea. The objective is not descriptive of what the

firms actually do.
The objective of wealth maximization is not necessarily socially
desirable.
There is some controversy as to whether the objective is to maximize
the stockholders wealth or the wealth of the firm which includes other
financial claimholders such as debenture holders, preferred
stockholders, etc.,
The objective of wealth maximization may also face difficulties when
ownership and management are separated as is the case in most
of the large corporate form of organizations.
 CONCEPT OF FINANCING DECISIONS
The financing decisions are concerned with deciding capital
structure and procuring funds.

Scope or process of Financing Decisions

Enterprises often need to raise capital for
commencing new business, expanding
business and sustaining business. Business
in most of the cases is an outcome of ideas
of people and the moment idea is conceived
the need of funds arises.
As the business grows there is inevitably the
requirement of funds to finance the
expansion, further day to day running of the
business also needs funds.
A solid financial base is essential for starting
up a new business. The right financing
package will carry the business enterprise
through any temporary difficulties yet still
allow business to make the most of growth
opportunities when they arise. The financial
needs of a business will vary according to
the type and size of the business.
SOURCES OF FUNDS

*Short term loans are discussed in Last unit-Working capital

 FINANCIAL MANAGEMENT
-INTERNAL SOURCES OF FUNDS
The after-tax profit earned and retained by a
Retained Earnings business which is an important and
inexpensive source of finance, for example,
the retained earnings of the business. A large
part of finance is funded from profit.

When a business can not raise finance from

Sales of Assets banks or other sources, it may be forced to sell
some assets, such as company cars, land
property; or even subsidiary or associated
company to solve its urgent financial problems
(this activity is called divestment).

PhotoDisc
 -EXTERNAL LONG-TERM SOURCES OF FUNDS

Share capital:
The most important source of funds for a limited
company. It is often considered as permanent capital as it
is not repaid by the business, but the shareholder can
have a share in the profit, called dividend.

Types of shares are:

1. Ordinary shares: The most common types of shares,
and the most riskiest shares since no guaranteed
dividend. Dividend depends on how much profit is
made by the firm. But all ordinary shareholders have
voting rights.
2. Preference shares: The share owners receive a fixed
rate of return. They carry less risk because
shareholders are entitled to the dividend before the
ordinary shares. But they are not strictly owners of the
company.
 EXTERNAL LONG-TERM SOURCES OF FUNDS

Any money which is borrowed for a

Loan capital
long period of time by a business is
called loan
capital
There are four major types of loan capital: Debentures, Mortgage, Loan
specialists funds, Government assistance.

Types of loan capital:

1. Debentures: The holder of a debenture is a creditor of the company,
not an owner. Holders are paid with an agreed fixed rate of return, but
having no voting rights. The amount of money borrowed must be
repaid by the expiry date.
2. Mortgage: These are long-term bank loans (usually over one year
period) from banks or other financial institutions. The borrowers land
or property must be used as a security on such as a loan.
3. Loan specialists funds: These are venture capitalists or specialists
who provide funds for small businesses, especially for high tech
investment projects in their start-up stage. There are also individuals
who invest in such businesses, which are often called business
angels.
4. Government assistance: To encourage small businesses and high
employment, governments may be involved in providing finance for
businesses. In the USA, there is an organization which is called the
Small Business Administration (SBA). SBA provides guarantees for
small businesses loans and they even offer some loans themselves.
 Debt and Equity Capital: Two Basic Sources of
Funds
 Comparison of Debt and Equity Capital
 CONCEPT OF CAPITALIZATION, CAPITAL
STRUCTURE AND FINANCIAL STRUCTURE
Point of
Capitalization Capital Structure Financial Structure
Difference
Financial structure refers to
It is the sum of a
Capital structure of a the balance between all of the
corporation's long
company refers to company's liabilities and its
term financing
Meaning types of long term equities. Financial structure
included in the
financing included in thus concerns the entire
capital.
the capital. "Liability side of the balance

sheet.
Financial structure on the
Debt, common stock,
Debt, common other hands also includes
Componen preferred stock,
stock, preferred short term debt and accounts
ts retained earnings
stock payable.
and reserves.

Quantitative
aspect: as it Qualitative aspects: It represents financial
Perspectiv
represents as it represents obligations a company owes
e
quantum of funds source of funding to outside parties
used
CS=FS-CL
terminants of Capital Structure or Factors influencing capital requirements
The capital structure of a company is a particular
combination of debt, equity and other sources of finance
that it uses to fund its long-term asset.

Factors affecting capital structure

Internal Factors External Factors
Nature of Business Corporate taxes
Size of a Firm Degree of competition
Stability in Earnings Economic condition
Growth stage Cost of capital
Asset structure Government policies
Control factor Floatation cost
Risk apatite of management Cost of capital
apital Structure Planning or Approaches to select capital Structure
Planning of capital structure involves deciding the way in which assets of the company
are to be financed. The common sources of capital structure constitutes mix of long-term
sources of funds, such as debentures, long-term debt, preference share capital and
equity share capital including reserves and surpluses. Due considerations in capital
structure planning should be given to formulate appropriate capital structure, the
following are key approaches for selecting appropriate capital structure

1. Cost and Risk Approach: In this

approach of capital structure planning a
firm primarily considers cost and risk as a
basis of planning capital structure. For
business cost is the amount payable for
the capital it obtains from various
sources.
2. EBITEPS Approach:

In simple words, EBITEPS Approach

emphasis on maximizing the earning of
equity share holders. In order to maximize
earning of equity share holders a firm must
use debt capital in such as way that that it
results increased earnings per share.
CapitalCost of capital is also called as cut-off rate, target rate, hurdle rate and
Structure Planning Cost and Risk Approach
required rate of return.
When the firms are using different sources of finance, the finance manager
must take
careful decision with regard to the cost of capital; because it is closely
associated with the
value of the firm and the earning capacity of the firm.

Meaning of Cost of Capital

Cost of capital is the required rate of return on its investments which belongs to
equity, debt and retained earnings. If a firm fails to earn return at the expected
rate, the market value of the shares will fall and it will result in the reduction of
overall wealth of the shareholders.

According to the definition of John J. Hampton Cost of

capital is the rate of return the firm required from
investment in order to increase the value of the firm in
the market place.

According to the definition of Solomon Ezra, Cost of capital is

the minimum required rate of earnings or the cut-off rate of
capital expenditure.
Capital Structure Planning Cost and Risk Approach

COMPUTATION OF COST OF CAPITAL

Computation of cost of capital is a very important part of the financial
management to
decide the capital structure of the business concern.

Measurement of Cost of Capital

It refers to the cost of each specific sources of finance like:
Cost of equity
Cost of debt
Cost of preference share
Cost of retained earnings
Measurement of Cost of Capital Cost of
The cost of equity is
equity In other words:
the return a firm Cost of equity refers to a shareholder's required
rate of return on an equity investment. It is the
theoretically pays to its rate of return that could have been earned by
equity investors. putting the same money into a different
investment with equal risk.
Cost of equity can be calculated from the following approach (Dividend
Growth Model)

+ Growth Rate of dividend

+
g

According to this method, the

Where, return required by the investor is
Ke = Cost of equity capital equal to the current dividend yield
D = Dividend per equity share on the common stock plus an
g = Growth in expected dividend expected growth rate for dividend
Np = Net proceeds of an equity share payments. It is also known as
Gordon model.
 Illustration 1: calculation of cost of equity
A Ltd intends to issue new equity shares. Its present equity shares are
being sold in the market at Rs. 125 a share. The companys past record
show its dividend growing at 7%. The company pays a dividend of Rs,
15 per share. You are required to calculate Cost of funds raised by
issue of equity shares.

Given:
D = Dividend per equity share Rs. 15
g = 7%
Np = Net proceeds of an equity share Market Price Rs. 125 a share
Ke = Cost of equity capital ?

Solution:
+ g + Growth Rate of dividend

+ 7%

+ 0.07

0.19 or 19%
 A company2:
Illustration plans to issue of
calculation 10000 new
cost of shares of Rs. 100 each at a par. The
equity
floatation costs are expected to be 4% of the share price. The company pays a
dividend of Rs. 12 per share initially and growth in dividends is expected to be
5%.
(a) Compute the cost of new issue of equity shares. (b) If the current market
price of an equity share is Rs. 120. Calculate the cost of existing equity share
capital
(B) If the current market price of an
ompute the cost of new issue of equity shares.
Given:
equity share is Rs. 120. Calculate
D = Dividend per equity share Rs. 12 the cost of existing equity share
g = 4% capital
Given:
Np = Net proceeds of an equity share (Issue
D = Dividend per equity share Rs. 12
price of Share Flotation Cost = (100-4= Rs. 96)
Ke = Cost of equity capital ? g = 4%

Solution:
+ g Np = Net proceeds of an equity share Market Price

Rs. 120 a share

Ke = Cost of equity capital ?

+ 5% + g
Solution:

+ 0.05 + 5% + 0.05

0.175 or 17.5% 0.15 or 15%

otation cost is the cost of issuing new shares in the market.

Illustration
The current 3: market
calculation of cost
price of equity
of the shares of Apple Ltd. is Rs. 95. The
floatation costs are
Rs. 5 per share, dividend paid amounts to Rs. 4.50 and is expected to
grow at a rate of 7%. You are required to calculate the cost of equity
share capital.

Given:
D = Dividend per equity share Rs. 4.50
g = 7%
Np = Net proceeds of an equity share Market Price Rs. 95 a share
Ke = Cost of equity capital ?

Solution:
+ g + Growth Rate of dividend

+ 7%

+ 0.07
*Flotation cost applicable only when new
shares are issued to the public. Here
floatation cost to be neglected as the
0.1173 or 11.73% company is not issuing new shares.
 Measurement of Cost of Capital Cost of equity (CAPM
approach)
The capital asset pricing 1. This approach is based on the principle that risk and
return of an investment are positively correlated
model (CAPM) is used to more risky the investment, higher is the desired
calculate the required rate returns.
of return for any risky 2. This model emphasizes not only the risk differential
asset. between equity share and government bond but also
risk differential among various common stocks.

Cost of equity can be calculated from the following equation using

CAPM approach

Ke = Rf + b (RmRf)

Where,
Ke = Cost of equity capital
Rf = the rate of return for a risk-free security
b = beta of the stock
Rm = the Stock market's expected rate of return
 Measurement of Cost of Capital Cost of equity (CAPM
The Hypothetical Limited wishes to calculate its cost capital using
approach)
the CAPM approach. The following information is supplied to you.
The risk-free rate of return is 10%. The firms beta is 1.50 and the
return on market is equals to 12.5%. Compute Cost of equity
capital.

Solution

Ke = Rf + b (RmRf)
Given,
Ke = Cost of equity capital - ?
Rf = the rate of return for a risk-free security
-10%
b = beta of the stock 1.50
Rm = the Stock market's expected rate of return
Ke = 10 + 1.5 (12.5 Ke = 10 + 3.75
12.5% Ke = 13.75%
10)
The CAPM says that the expected return of a share is equals the rate on a
risk-free security plus a risk premium. If this expected return does not meet
or beat the required return, then the investment should not be undertaken.
 Measurement of Cost of Capital Cost of
Cost of debt generally
Debt The cost of debt can be calculated in either
refers to the effective before or after tax returns. However, the interest
expense being deductible, the after tax cost is
paid by a company on considered very often. Moreover, the cost of debt
its debts. is one part of capital structure of the company
and also includes the cost of equity.

Cost of debt can be calculated from the following equation

(1
Tax rate)

(1-t)

Where,
Kd = Cost of debt capital
I = Annual interest payable
Np = Net proceeds of debenture
t = Tax rate
 Illustration 1: calculation of cost of Debt
Kingfisher Limited has debt capital of Rs. 1,00,000 on which
15% interest is payable. Tax applicable is 35%. Your are
required to calculate cost of capital assuming debt is issued
at (a) Par value (b) 10% discount and (c) At a premium of
10%.
Given:
Given: (a) Par value Kd = ?
(b) Discount
Kd = ? I = On Rs. 1,00,000 at 15% Rs. 15,000 p.a
I = On Rs. 1,00,000 at 15% Rs. 15,000 p.a Np = Net proceeds of debenture (b) Rs. 1,00,000-
Np = Net proceeds of debenture (a) Par Rs. 1,00,000 10% Discount =Rs. 90,000.
t = 35% t = 35%

Solution: (1-t) Solution: (1-t)

(1 Tax rate)
(1 Tax rate)

(1-0.35)

(1-0.35)
0.15 (0.65) 0.167 (0.65)

0.0975 or 19.75% 0.1085 or 10.85%

Given:
Kd = ?
(1-0.35)
0.136 (0.65) (C) Premium
I = On Rs. 1,00,000 at 15% Rs. 15,000 p.a
Np = Net proceeds of debenture (b) Rs. 1,00,000+10% Discount =Rs.
1,10,000. 0.0884 or 8.84%
 Illustration 2: calculation of cost of Debt

From flowing information four different companies calculate cost of

debt of each company.

1. A Ltd. issues Rs. 10,00,000, 8% debentures at par. The tax rate

applicable to the company is 50%. Compute the cost of debt capital.

2. B Ltd. issues Rs. 1,00,000, 8% debentures at a premium of 10%. The tax

rate applicable to the company is 60%. Compute the cost of debt
capital.

3. C Ltd. issues Rs. 1,00,000, 8% debentures at a discount of 5%. The tax

rate is 60%, compute the cost of debt capital.

4. D Ltd. issues Rs. 10,00,000, 9% debentures at a premium of 10%. The

costs of floatation are 2%. The tax rate applicable is 50%. Compute the
cost of debt-capital.
 Illustration 2: calculation of cost of Debt

A Ltd. issues Rs. 1,00,000, 8% debentures at par. The tax rate

applicable to the company is 50%. Compute the cost of debt capital.

Given:
Kd = ?
I = On Rs. 1,00,000 at 8% Rs. 8,000 p.a
Np = Net proceeds of debenture (a) Par Rs. 1,00,000
t = 50%

Solution: (1-t) (1 Tax rate)

(1-0.50)
0.08 (0.50)

0.04 or 4%

Company (a) Par value

 Illustration 2: calculation of cost of Debt

B Ltd. issues Rs. 1,00,000, 8% debentures at a premium of 10%. The

tax rate applicable to the company is 60%. Compute the cost of debt
capital.
Given:
Kd = ?
I = On Rs. 1,00,000 at 8% Rs. 8,000 p.a
Np = Np = Face Value + Premium = 1,00,000+10,000=1,10,000
t = 60%

Solution: (1-t) (1 Tax rate)

(1-0.60)
0.072 (0.60)

0.0432 or 4.32%

Company (b) premium

 Illustration 2: calculation of cost of Debt

C Ltd. issues Rs. 1,00,000, 8% debentures at a discount of 5%. The

tax rate is 60%, compute the cost of debt capital.

Given:
Kd = ?
I = On Rs. 1,00,000 at 8% Rs. 8,000 p.a
Np = Np = Face Value - Discount= 1,00,000 - 5,000= Rs. 95,000
t = 60%

Solution: (1-t) (1 Tax rate)

(1-0.60)
0.0842 (0.60)

0.05052or 5.052%

Company (C) Discount

 Illustration 2: calculation of cost of Debt

D Ltd. issues Rs. 10,00,000, 9% debentures at a premium of 10%.

The costs of floatation are 2%. The tax rate applicable is 50%.
Compute the cost of debt-capital.
Given:
Kd = ?
I= 9% on Rs. 10,00,000 = 90,000
Np = On Rs. Rs. (10,00,000 + 1,00,000) 2% = 11,00,000 22,000 = Rs.
10,78,000
t = 50%

Solution: (1-t) (1 Tax rate)

(1-0.50)
0.0834 (0.50)

0.0417 or 4.17%

Company (D) premium

 'WEIGHTED AVERAGE COST OF CAPITAL - WACC'
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.
A company has different sources of finance, namely common
stock, retained earnings, preferred stock and debt. Weighted
average cost of capital (WACC) is the average after tax cost of
all the sources.
The computation of the overall cost of capital (K w) involves the following steps.
(a) Assigning weights to specific costs.
(b) Multiplying the cost of each of the sources by the appropriate weights.
(c) Dividing the total weighted cost by the total weights.

The overall cost of capital can be calculated with the help of the
following formula; Where,
Ko = Overall cost of capital
K =KW+KW+KW+KW
w d d p p
Weighted average cost of capital is calculated in the
e e r rKd = Cost of debt
Kp = Cost of preference share
following formula also: Ke = Cost of equity
Kr = Cost of retained earnings
Wd= Percentage of debt of total capital
Wp = Percentage of preference share to
Where,
Kw = Weighted average cost of capital total capital
X = Cost of specific sources of finance We = Percentage of equity to total capital
W = Weight, proportion of specific sources of finance. Wr = Percentage of retained earnings
 Illustration 1: calculation of WACC

A firm has the following capital structure and after-tax costs for the
different sources
of funds
Sourceused :
of Funds Amount Proportion (%) After-tax cost
(%)
Debt 12,000 20 4
Preference Shares 15,000 25 8
Equity Shares 18,000 30 15
Retained Earnings 15,000 25 11
Total 60,000 100
Computation of Weighted Average Cost of Capital Solution:
Source of Proporti After-tax
(WX)
Funds on % (w) cost % (x)
A C D E = (c) x (d)
Debt 20 4 80

Preference 25 8 200
Shares
Equity Shares 30 15 450
Retained 25 11 275
Earnings
 Illustration 11: calculation of WACC

Particulars Amount
ABC Ltd. has the following
capital structure. Equity (expected dividend 10,00,000
You are required to calculate 12%)
the
weighted average cost of 10% Preference Shares 5,00,000
capital. 4% loan 15,00,000
Total 30,00,000

Computation of Weighted Average Cost of Capital

Solution:
Source of Proportion After-tax
(WX)
Funds % (w) cost % (x)

A C D E = (c) x (d)
Equity 33.33 12 399.96
Preference 16.67 10 166.7
Shares
loan 50.00 4 200
Total =100 =766.66
 Cost of Retained Earnings
Retained earnings is one of the sources of finance for investment
proposal; it is different from other sources like debt, equity and
preference shares. Cost of retained earnings is the same as the cost of
an equivalent fully subscripted issue of additional shares, which is
measured by the cost of equity capital.

Cost of Preference Share

Cost of preference share capital is the annual preference share
dividend by the net proceeds from the sale of preference share.

(1-t)

Where,
Kp = Cost of preference share
Dp = Fixed preference dividend
Np = Net proceeds of an equity share
apital Structure Planning or Approaches to select capital Structure

EBIT-EPS: APPROACH

In simple words, EBITEPS

Approach emphasis on
maximizing the earning of
equity share holders. In order
to maximize earning of equity
share holders a firm must use
debt capital in such as way
that that it results increased
earnings per share.
FORMAT FOR COMPUTING EBIT & EPS

Particulars Amount
Sales revenue --------
Less : Variable Cost --------
Contribution [C] --------
Less: Fixed Cost --------
Operating Profit or EBIT --------
Less: Interest of Debt capital --------
Earnings Before Tax [EBT] --------
Less: Tax --------
Earnings After Tax [EAT] --------
Less: Dividend on preference shares --------
Earnings Available to Equity Share Holders --------
[EAESH]
Earnings Per Share= EAESH No. of Equity ---
Shares
Illustration 1: Calculation of EPS
HDFD bank has an existing capital of Rs. 10,00,000
comprising of 1,00,000 equity shares of Rs. 10 each. The
management is planning to raise another Rs. 10,00,000 to
finance its growth programme. There are four possible
financing plansthrough
All 10,00,000 which are given
issue below: equity shares of Rs. 10
of 1,00,000
each
Rs. 5,00,000 in equity and the balance in debentures carrying
10% interest
Entire 10,00,000 through debentures carrying 8% interest
Rs. 5,00,000 in equity and Rs. 5,00,000 through preference
shares carrying 10% dividend
The anticipated operating profits after expansion programmes
amounts to Rs. 2,40,000, the company is subject to 50% tax
bracket. You are required to advice the management in choosing
appropriate
I capital structure
II plan on the basis
III on EPS. IV
Entire 10 Lakhs 5 Lakhs in Entire 10 Lakhs 5 Lakhs in
Equity Equity & through Equity &
5 Lakhs debentures @ 5 Lakhs
Debentures @ 8% Interest preference @
10% Interest 10% dividend
Illustration 1: Calculation of EPS
I II III IV
Entire 10 Lakhs 5 Lakhs in Entire 10 Lakhs 5 Lakhs in
Equity Equity & through Equity &
5 Lakhs debentures @ 5 Lakhs
Debentures @ 8% Interest preference @
10% Interest
Existing capital: Rs. 10 Lakhs 10%
Financial dividend
Plans
Particular
Fresh capital required: 10 Lakhs I II III IV
s
Expected operating Profit [EBIT] 2,40,000 2,40,000 2,40,000 2,40,000
Less: Interest on Debt capital
Plan II: 10% interest on debentures of
Rs. 5 Lakhs No Debt 50,000 80,000 No debt
Plan III: 8% interest on debentures
Earnings Before Taxof 10
[EBT] 2,40,000 1,90,000 1,60,000 2,40,000
LakhsTax at 50% on EBT
Less: 1,20,000 95,000 80,000 1,20,000
Earnings After Tax [EAT] 1,20,000 95,000 80,000 1,20,000
Less: Preference dividend No Pref. No Pref. No Pref.
50,000
Plan IV: 10% dividend on Rs. 5 Lakhs shares shares shares
Earnings Available to Equity Share Holders 1,20,000 95,000 80,000 70,000
No. of equity Shares
Existing (Rs. 10,00,000 Rs. 10 each) 1,00,000 1,00,000 1,00,000 1,00,000
New (Plan- I, II and III) 1,00,000 50,000 No new shares 50,000
Total equity shares (Existing + New) 2,00,000 1,50,000 1,00,000 1,50,000
EPS = EAESH Total equity shares Rs. 0.60 Rs. 0.633 Rs. 0.80 Rs. 0.47
Comments: Since the EPS in plan III is highest, therefore plan III
 Illustration 1I: Calculation of EPS

Brave Limited is capitalised with 50,000 equity shares of Rs. 10 each.

Company wants another Rs. 5,00,000 for expansion programme. The
following are the different Plans
1. All equity shares
2. Rs. 2,50,000 in equity and the balance in preference shares carrying
10 dividend
3. Rs. 2,50,000 in debentures and the balance in debentures at 10
interest
4. Particulars
All debentures at 8%
Existing interest
capital: Rs. 5 Lakhs Financial Plans
Fresh capital required: 5 Lakhs I II III IV
Tax rate is 50% and the existing EBIT
Expected operating Profit [EBIT]
is Rs. 60,000
60,000
p.a,
60,000
Calculate
60,000
EPS60,000
for four plans
Less: Interest on Debt capital
Plan III: 10% interest on Loan of Rs. 2.5 Lakhs No Debt No Debt 25,000 40,000
Plan IV: 8% interest on debentures of 5 Lakhs
Earnings Before Tax [EBT] 60,000 60,000 35,000 20,000
Less: Tax at 50% on EBT 30,000 30,000 17,500 10,000
Earnings After Tax [EAT] 30,000 30,000 17,500 10,000
Less: Preference dividend No Pref. No Pref.
25,000 No Pref. shares
Plan II: 10% dividend on Rs. 2.5 Lakhs shares shares
Earnings Available to Equity Share Holders 30,000 5,000 17,500 10,000
No. of equity Shares

Existing (Rs. 5,00,000 Rs. 10 each) 50,000
50,000 50,000 50,000
New (In all plans except IV) No new
50,000 25,000 25,000
Total equity shares (Existing + New) shares
1,00,000 75,000 75,000
50,000
EPS = EAESH Total equity shares Rs. 0.30 Rs. 0.67 Rs. 0.23 Rs. 0.20
Assessment of Capital Structure
Capital structure should be constituted in such a way that it minimises
cost of capital and maximize the value of organization. In order to assess
the quality of capital structure financial management provides two
important tools, they are as follows:
1. Capital gearing focuses on the capital structure
by establishing relationship between equity
shares to other fixed income bearing securities.

Capital Gearing Ratio=

Interpretation:

Highly gearedLess equity capital and more fixed cost bearing capital
Low gearedMore equity capital and less fixed cost bearing capital
 High Gear or Low Gear
Data extracted from Balance Sheet of Kingfisher Airline
Sources of Funds Mar '12 Mar '11 Mar '10 Mar '09 Mar '08
Equity Share Capital 577.65 497.78 265.91 265.91 135.8
Share Application Money 0 2.95 7.48 8.11 10.09
Preference Share Capital 553.1 553.1 97 97 0
Reserves -6,213.15 -4,005.02 -4,268.84 -2,496.36 52.99
Revaluation Reserves 0 0 0 0 0
Net worth -5,082.40 -2,951.19 -3,898.45 -2,125.34 198.88
Secured Loans 5,368.76 5,184.53 4,842.43 2,622.52 592.38
Unsecured Loans 2,661.24 1,872.55 3,080.17 3,043.04 342

Data extracted from Balance Sheet of Infosys

Sources of Funds Mar '13 Mar '12 Mar '11 Mar '10 Mar '09
Total Share Capital 287 287 287 287 286
Equity Share Capital 287 287 287 287 286
Share Application
Money 0 0 0 0 0
Preference Share
Capital 0 0 0 0 0
35,772.0 29,470.0 24,214.0 21,749.0 17,523.0
Reserves 0 0 0 0 0
Revaluation Reserves 0 0 0 0 0
36,059.0 29,757.0 24,501.0 22,036.0 17,809.0
Networth 0 0 0 0 0
FINANCIAL MANAGEMENT UNIT II1

CAPITAL STRUCTURE
THEORIES

SYLLABUS
UNIT III

Operating and Financial Leverage Measurement of Leverages

Effects of Operating and Financial Leverage on Profit Analyzing
Alternate Financial Plans - Combined Financial and Operating
Leverage Capital Structure Theories - Traditional approach - M.M.
Hypotheses without Taxes and with Taxes Net Income Approach
(NI) Net
Operating Income Approach (NOI) - Determining capital structure in
practice.
 LEVERAGES

The concept of leverages revolves around two aspects,

Firstthe effects that fixed interest cost capital (Debentures and bonds
or long term loans) have on the returns that shareholders earn.
Second, impact of fixed cost on the earnings of company and
shareholder
finance manager determine degree of leverage by assessing three
types of leverages
 [A] OPERATING LEVERAGE:

Operating leverage is a measure to establish relation

between a firm's fixed cost and variable cost and its
impact of profits.

operating Leverage=

EBIT: Earnings Before Interest and

Tax
Contribution = Sales Variable
cost
Interpretation:
Criteria Outcome Impact on Profitability
(EBIT)
When, C>FC Favourable Positive EBIT
When, C<FC Unfavourable Negative EBIT
 [B] FINANCIAL LEVERAGE

It determines the impact of using debt financing (debentures

and bonds or long term loans) on the earnings of shareholders.

Financial Leverage=

EBIT: Earnings Before Interest and Tax

EBT: Earnings Before Tax [EBIT Interest(i)]
EPS: Earnings Per Share

Interpretation:
Criteria Outcome Impact on Profitability
(EBT)
When, EBIT > Interest Favourable Positive EBT
payable
When, EBIT < Interest Unfavourable Negative EBT
[C] COMBINED LEVERAGE

As the name suggests, Combined leverage represents the total effect

of the operating and financial leverages on the earning per
share[EPS]. In other words, combined leverage shows the total risks
associated with the firm. It is the product of both the leverages.

Formula for calculating Operating leverage (OL)

1. Combined Leverage=Operating Leverage Financial
Leverage
Interpretation:

The combined leverage can work in either direction. It would be

favourable if sales increase and unfavourable in the reverse
scenario.
 STEPS IN CALCULATION OF LEVERAGES AND EPS:
GENERAL INCOME STATEMENT FORMAT

Particulars Amoun
t
Sales revenue --------
Less : Variable Cost --------
Contribution [C] --------
Less: Fixed Cost --------
Operating Profit or EBIT --------
Less: Interest of Debt capital --------
Earnings Before Tax [EBT] --------
 Illustration 1: Calculation of Leverages
A company has sales of Rs. 60,00,000, variable cost of Rs.
40,00,000, fixed cost of Rs. 5,00,000 and debt of Rs.
30,00,000 at 10% rate of interest. Calculate operating,
financial, operating and combined leverages.

Particulars Amoun
t
Sales 60,00,0
00
Less: Variable cost 40,00,0
00
Contribution [C] 20,00,0
00
Less: Fixed Cost 5,00,00
0
Operating Profit or EBIT 15,00,0
00
Less: Interest on Debt Capital (10% on Rs. 30,00,000 ) 3,00,00
0
Comments: Earnings Before Tax [EBT] 12,00,0
Since, EBIT is > Interest payable, this means firm has sufficient operating profits to pay
00
interest on debt capital and therefore it has favourable financial.
Financial Leverage= = 1.25
Since, Contribution is > Fixed cost, this means firm has sufficient
Operating sales revenue
Leverage= = to meet
1.33its
fixed cost and
Combined therefore it has favourable
Leverage=Operating operating
Leverage leverage and
Financial positive operating
Leverage = profit.
1.6625
1.25
Combined
1.33leverage is also favourable.
Capital Structure Theories
Different kinds of theories have been propounded by different
authors to explain the relationship:
Capital StructureCost of CapitalValue of the firm

The important theories are as follows:

1. Net Income approach
2. Net Operating Income approach
3. The traditional approach
4. Modigliani and Miller approach
NET INCOME APPROACH

According to this approach, a firm can minimize the

weighted average cost of capital (WACC) and increase the
value of the firm as well as the market price of the equity
shares by using debt financing to maximum possible extent.
This approach is based upon the following assumptions:
The cost of debt (Kd)is less than the cost of equity (Ke)
There are no taxes
The risk perception of investors is not changes by the use of
debt.
Net Income Approach was presented by Durand.
 TEST OF NET INCOME APPROACH THEORY
According to this approach, a firm can minimize the weighted average cost
of capital (WACC) and increase the value of the firm as well as the market
price of the equity shares by using debt financing to maximum possible
extent.
Consider a fictitious company with below figures. All figures in Rs.

Earnings before Interest Tax (EBIT) = 1,00,000

Debentures(Debt part) = 3,00,000
Cost of Debentures (Debt) = 10%
Cost of Equity = 14%

ating the value of a company = Total Market Value of Shares (S) + Debentures (D)
EBIT = 1,00,000
Less: Interest cost (10% of 300,000) = 30,000
Earnings after Interest Tax = 70,000
(since tax is assumed to be absent)
Earning available to equity share holders = 70,000
Market value of Equity Shares (70,000 = 5,00,000
14%)
Market value of Debt = 3,00,000
Total Market value = (S + D) = 8,00,000
Overall cost of capital = EBIT(Total value of firm)
= 100,000800,000
1. Value of a company (V) = Total Market Value of =
Shares (S) + Debentures (D) 12.5%
2. Market value of Equity shares (S) = Earning available to equity share holders Cost
of Equity
 TEST OF NET INCOME APPROACH THEORY
According to this approach, a firm can minimize the weighted average cost
of capital (WACC) and increase the value of the firm as well as the market
price of the equity shares by using debt financing to maximum possible
extent.
Consider a fictitious company with below figures. All figures in Rs.

Earnings before Interest Tax (EBIT) = 1,00,000

Debentures(Debt part) = 3,00,000
Cost of Debentures (Debt) = 10%
Cost of Equity = 14%

sume that the proportion of debt increases from 300,000 to 400,000 and everything else remain
(EBIT)
Less: Interest cost (10% of 300,000)
Earnings after Interest Tax
(since tax is assumed to be absent)
Shareholders' Earnings
Market value of Equity (60,000/14%)
Market value of Debt
Total Market value
Overall cost of capital
= 100,000
= 40,000
= 60,000
= 60,000
= 428,570 (approx)
= 400,000
= 828,570
= EBIT/(Total value of firm)
= 100,000/828,570
= 12% (approx.)

1. Value of a company (V) = Total Market Value of Shares (S) + Debentures (D)
2. Market value of Equity shares (S) = Earning available to equity share holders
Cost of Equity
CONCLUSIVE SUMMARY (NI APPROACH)
As observed, in case of Net Income Approach, with increase in debt
proportion, the total market value of the company increases and cost of
capital decreases.

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 (use of more debt
capital) 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.
 NET OPERATING INCOME APPROACH
According to this approach, change in capital structure of a
company does not affect the market value of the firm and
overall cost of capital remains constant irrespective of the
method of financing.

This approach is based upon the following assumptions or features:

The overall capitalization rate remains constant irrespective of the
degree of leverage.
(This means WACC (Weightage Average Cost of Capital) remains constant with the
increase in debt, the cost of equity increases.)

The business risk remains constant at entry level of debt equity mix.
(Increase in debt in the capital structure results in increased risk for shareholders. As a
compensation of investing in highly leveraged company, the shareholders expect
higher return resulting in higher cost of equity capital.)

There are no corporate taxes

This approach was put forth by Durand and totally differs from the
Net Income Approach.
 NET OPERATING INCOME APPROACH

According to this approach, change in capital structure of a company does

not affect the market value of the firm and overall cost of capital remains
constant irrespective of the method of financing.
Consider a fictitious company with below figures. All figures in Rs.
Earnings before Interest Tax (EBIT) = 100,000
Bonds (Debt part) = 300,000
Cost of Bonds issued (Debt) = 10%
WACC = 12.5%
Calculating the value of the company:
(EBIT) = 100,000
WACC = 12.5%
Market value of the company = EBIT/WACC
= 100,000/12.5%
= 800,000
Total Debt = 300,000
Total Equity = Total market value-total debt
= 800,000-300,000
= 500,000
Shareholders' earnings = EBIT-interest on debt
= 100,000-10% of 300,000
= 70,000
Cost of equity = 70,000/500,000
= 14%

Market value of the company = EBIT WACC

 NET OPERATING INCOME APPROACH

According to this approach, change in capital structure of a company does

not affect the market value of the firm and overall cost of capital remains
constant irrespective of the method of financing.
Consider a fictitious company with below figures. All figures in Rs.
Earnings before Interest Tax (EBIT) = 100,000
Bonds (Debt part) = 300,000
Cost of Bonds issued (Debt) = 10%
WACC = 12.5%
Now, assume that the proportion of debt increases from 300,000 to 400,000 and
everything else remains same.
EBIT) = 100,000
WACC = 12.5%
Market value of the company = EBIT/WACC
= 100,000/12.5%
= 800,000
Total Debt = 400,000
Total Equity = Total market value-total debt
= 800,000-400,000
= 400,000
Shareholders' earnings = EBIT-interest on debt
= 100,000-10% of 400,000
= 60,000
Cost of equity = 60,000/400,000
= 15%
As observed, in case of Net Operating Income approach, with the increase in debt
proportion, the total market value of the company remains unchanged, but the cost of
 TRADITIONAL APPROACH

Traditional approach to capital structure suggests that there exist

an optimal debt to equity ratio where the overall cost of capital is
the minimum and market value of the firm is the maximum.

Assumptions/Features of Modigliani and Miller Approach

1. As per this approach, debt should exist in the capital structure only up
to a specific point, beyond which, any increase in leverage would result
in reduction in value of the firm.
2. The rate of interest on debt remains constant for a certain period and
thereafter with increase in leverage, it increases.
3. The expected rate by equity shareholders remains constant or increase
gradually. After that the equity shareholders starts perceiving a financial
risk and then from the optimal point and the expected rate increases
speedily.
4. As a result of activity of rate of interest and expected rate of return, the
WACC first decreases and then increases. The lowest point on the curve
is optimal
Traditional capital structure.
approach, advocated by Ezta Solomon and Fred Weston is
a midway approach also known as intermediate approach.
 MODIGLIANI AND MILLER (MM) APPROACH

This suggests that the valuation of a firm is irrelevant to the capital

structure of a company. Whether a firm is highly leveraged or has lower
debt component, it has no bearing on its market value. Rather, the market
value of a firm is dependent on the operating profits of the company.

Assumptions/Features of Modigliani and Miller Approach

1. There are no taxes.

2. Transaction cost for buying and selling securities as well as bankruptcy
cost is Nil.
3. There is symmetry of information. This means that an investor will have
access to same information that a corporate would and investors would
behave rationally.
4. The cost of borrowing is the same for investors as well as companies.
5. Debt financing does not affect companies EBIT

Modigliani and Miller approach to capital theory, devised in 1950s

advocates capital structure irrelevancy theory.