_____________________________________________________________________

Notes
Program Name: MBA

Course Name: Corporate Finance Sem: IV

Unit Number – III Unit Name: Investment Decisions

Topic Name – Measurement of cost of capital

 Measurement of cost of capital

Introduction
The various sources from which the long-term requirement of the capital can be met. Each of
these sources involves some cost. The cost of capital can be defined as “the rate at which an
organisation must pay to the suppliers of capital for the use of their funds”.

Milton H. Spencer says ‘cost of capital is the minimum required rate of return which a firm
requires as a condition for undertaking an investment’.

In economic term, the cost of capital is viewed from two different angles:

(1) The cost of raising funds to finance a project. This cost may be in the form of the
interest which the company may be required to pay to the suppliers of funds. This may
be the explicit cost attached with the various sources of capital.
(2) The cost of capital may be in the form of opportunity cost of the funds of the company
i.e., rate of return which the company would have earned if the funds are not invested.

It is the minimum rate of return the firm earns as its investment in order to satisfy the
expectations of investors, who provide funds to the firm.

The cost of capital is simply the return expected by those who provide capital for the business.

Capital includes

• Debt
• Equity
Measurement of Cost of Capital

Specific Cost of Capital

• Cost of capital is measured for different sources of capital structure of a firm.

• It includes cost of debenture, cost of loan capital, cost of equity share capital, cost of
preference share capital, cost of retained earnings etc
 1. Cost of Debt: The debts may be either short-term debts or long-term debts. Very
naturally, the cost of capital in the form of debt is the interest, which the company has
to pay. But this is not the real cost attached with debt capital. The banks are
compensated in the form of interest on their capital. But this is not the real cost
attached with debt capital. The real cost is something less than the rate of interest
which the company has to pay. This is because the interest on debt is a tax-deductible
expenditure. If the amount of interest is considered as a part of expenses, the tax
liability of the company reduces proportionately. As such, while computing the cost of
debt, adjustments are required to be made for its tax impact. The cost of debt capital
is calculated using following formula.
Formula:
Kd =r (1-t)
Suppose the Plum Computer Company can issue debt with a yield of 6 percent. If
Plum's marginal tax rate is 40 percent, what is its cost of debt?
kd = 0.06 (1 − 0.40) = 0.0360 or 3.6 percent

2. Cost of Preference Shares: The cost of capital preference shares is the dividend rate
payable on them. As in case of debentures, the cost capital is adjusted for the amount
excess or less received on the issue of preference shares.
A company issues 10% Preference shares of the face value of Rs. 100 each. Floatation
costs are estimated at 5% of the expected sale price
Kp = DP/NP
DP= Dividend Per Share
NP= Net proceed
Kp = 10/95
= 10.52%

3. Cost of equity capital

Cost of equity is the expected return companies or investors require for making a financial
investment in a business or project. Cost of equity capital is the cost of using the capital of
equity shareholders in the operations. This cost is paid in the form of dividends and capital
appreciation (increase in stock price). his means it's the compensation they expect from the
risk they took by investing in a company or project.
The current market price of a share is Rs. 100. The firm needs Rs. 1,00,000 for expansion. The
expected dividend at the end of the current year is Rs. 4.75 per share with a growth rate of
6%.
Calculate the cost of capital of new equity
• cost of Equity Capital (Ke) = D/P + g
• (i) When current market price of share (P) = Rs. 100
• K = Rs 4.75 / Rs. 100 + 6%
= 0.0475 + 0.06
= 0.1075 or 10.75%.

CAPM
The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between
the expected return and risk of investing in a security. It shows that the expected return on a
security is equal to the risk-free return plus a risk premium, which is based on the beta of that
security. Below is an illustration of the CAPM concept.
CAPM is calculated according to the following formula:
Cost of Equity CAPM
Ke = Rf + (Rm – Rf) x Beta
Where:
Ra = Expected return on a security
Rrf = Risk-free rate
Ba = Beta of the security
Rm = Expected return of the market
For a simple example calculation of the cost of equity using CAPM, use the assumptions listed
below:

Risk-Free Rate = 3.0%

Beta: 0.8
Expected Market Return: 10.0%
Next, by entering this into our formula, we get:
Cost of Equity (Ke) = 3% + 0.8 (10% – 3%)
Ke = 8.6%

Weighted average cost of capital (WACC)

Weighted average cost of capital (WACC) represents a firm's average after-tax cost of capital
from all sources, including common stock, preferred stock, bonds, and other forms of debt.
WACC is referred as a cost of capital because of its frequent and vast utilization especially
when evaluating existing or new projects. Weighted average cost of capital, as the term itself
suggests, is the weighted average of all types of capital present in the capital structure of a
company. WACC is the average rate that a company expects to pay to finance its assets.
Assuming these two types of capital in the capital structure i.e. equity and debt, the WACC
can be calculated by following formula:
WACC = Weight of Equity * Cost of Equity + Weight of Debt * Cost of Debt.
WACC = (E/V * Ke) + (P/V*Kp) + (D/V) * Kd * (1 – Tax rate)
Example Solved
M/s ABC & Co. has the following capital structure as on 31st March 2016.

Particulars Amount (Rs)

12% Debentures 300000
9% Preference Shares 200000
Equity- 5000 shares of Rs. 100 each (8%) 500000
1000000

On the assumption that the applicable income- tax rate for the company is 40%, calculate
the WACC.
Cost of Equity

=5/10*8

=4

Cost of Pref Shares

=2/10*9
 =1.8%

Cost of Debt

= 3/10*12(1-.40)

= 2.16

WACC

= 4. +1.8+2.16

= 8%

Summary
• The cost of capital may be defined as, “the rate at which an organisation must pay to
the suppliers of capital for the use of their funds”.

• There are various methods for measuring the cost of capital:

a) Cost of debt: the cost of capital in the form debt is the interest, which the company
has to pay. But this is not the real cost attached with debt capital. To ascertain the real
cost of debt, adjustments are required to be made for it tax impact.
b) Cost of preference shares: The fixed dividend rate is the cost of capital in case of
preference share.
c) Cost of equity shares: The cost of equity shares basically depends upon the
expectations of equity shareholders.
d) Cost of retained earnings: The cost of retained earnings is in the form of the
opportunity cost in terms of dividend foregone by or withheld from the equity
shareholders.
 Self- Assessment Questions
1. __________is the cost that is used to raise the common equity of a firm by
reinvestment of the internal earnings.
a) Cost of reserve assets
b) Cost of stocks
c) Cost of mortgage
d) Cost of common equity

2. Which of these is NOT an assumption behind use of WACC?

a) The project should be marginal
b) The project should produce a return at least equal to the source of finance used
c) The financing of the project should not change the company's capital structure
d) The project should have the same systematic risk as the average for the company

3. Cost of Capital is the cost incurred for use of sources of funds.

a) True
b) False

4. Cost of capital is____________.

a) Rate of Interest on Term Loan
b) Rate of Dividend on Equity
c) the rate at which the charges are paid to the suppliers of capital
d) Earnings Per Share

5. Weighted Average cost of Capital is denoted by Ke.

a) True
b) False

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_____________________________________________________________________

Notes
Program Name: MBA

Course Name: Corporate Finance Sem: IV

Unit Number – III Unit Name: Investment Decisions

Topic Name – Capital Budgeting and its techniques

 Capital Budgeting and its techniques

INTRODUCTION:

Meaning of Budget

Budget is a financial plan and a list of all planned expenses and revenues.

Meaning of Capital Budgeting

The process through which different projects are evaluated is known as capital budgeting.
Capital budgeting is defined “as the firm’s formal process for the acquisition and investment
of capital. It involves firm’s decisions to invest its current funds for addition, disposition,
modification, and replacement of fixed assets”.

Definitions of Capital Budgeting

Capital budgeting (investment decision) as, “Capital budgeting is long term planning for
making and financing proposed capital outlays.” Charles T.Horngreen

“Capital budgeting consists in planning development of available capital for the purpose of
maximizing the long-term profitability of the concern” – Lynch

“Capital budgeting is concerned with the allocation of the firm source financial resources
among the available opportunities. The consideration of investment opportunities involves
the comparison of the expected future streams of earnings from a project with the immediate
and subsequent streams of earning from a project, with the immediate and subsequent
streams of expenditure”. G.C. Philippatos

Capital budgeting decisions have long term implications on the operations of the business. A
wrong decision may affect the long-term survival of the Company. Capital Budgeting is defined
as the process by which a business determines which fixed asset purchases or project
investments are acceptable and which are not
NEED AND IMPORTANCE OF CAPITAL BUDGETING

1. Huge investments: Capital budgeting requires huge investments of funds, but the available
funds are limited, therefore the firm before investing projects, plan are control its capital
expenditure.

2. Long-term: Capital expenditure is long-term in nature or permanent in nature. Therefore,

financial risks involved in the investment decision are more. If higher risks are involved, it
needs careful planning of capital budgeting.

3. Irreversible: The capital investment decisions are irreversible, are not changed back. Once
the decision is taken for purchasing a permanent asset, it is very difficult to dispose of those
assets without involving huge losses.

4. Long-term effect: Capital budgeting not only reduces the cost but also increases the revenue
in long-term and will bring significant changes in the profit of the company by avoiding over
or more investment or under investment. Over investments leads to be unable to utilize assets
or over

METHODS OF CAPITAL BUDGETING OF EVALUATION

By matching the available resources and projects it can be invested. The funds available are
always living funds. There are many considerations taken for investment decision process such
as environment and economic conditions. The methods of evaluations are classified as
follows:
(A) Traditional methods (or Non-discount methods)
(i) Pay-back Period Methods
(ii) Accounts Rate of Return

(B) Modern methods (or Discount methods)

(i) Net Present Value Method
(ii) Profitability Index Method
(iii) Internal Rate of Return Method
(iv) Discounted Pay-back Period Method
Pay-back Period
Pay-back period is the time required to recover the initial investment in a project. (It is one of
the non- discounted cash flow methods of capital budgeting).
Payback period indicates the period within which the cost of the project will be completely
recovered. In other words, it indicates the period within which the total cash inflows equal to
the total cash outflows. Thus,
Payback period = Cash outlay / Annual cash inflow
Illustration
Payback period for project with 10, 00,000 investment will be

The answer is 4 years.

Acceptance Rule:
Payback period method can be used as an accept or reject criteria or as a method of ranking
the project. If the payback period computed for a project is more than maximum payback
period estimated by the management it would be rejected or vice versa. As a ranking method,
the projects having shortest payback period will be ranked highest.

Merits
The following are the important merits of the pay-back method:
1. It is easy to calculate and simple to understand.
2. Pay-back method provides further improvement over the accounting rate return.
3. Pay-back method reduces the possibility of loss on account of obsolescence.
Demerits
1. It ignores the time value of money.
2. It ignores all cash inflows after the pay-back period.
3. It is one of the misleading evaluations of capital budgeting.

Accounting Rate of Return or Average Rate of Return

Average rate of return means the average rate of return or profit taken for considering the
project evaluation. This method is one of the traditional methods for evaluating the project
proposals.

Accounting rate of return (ARR) computes the average annual yield on the net investment
in the project. ARR is computed by dividing the average profits after depreciation and
taxes by net investments in the project. Thus, ARR can be computed as:
Average Income/Average Investment *100
Or
Average income/Initial Investment*100
Illustration
Calculate ARR for project with 7,80,000 investment and following cash flows
Year Inflow
1 50000
2 120000
3 150000
4 250000
5 310000
Total Inflow 880000

ARR = 176000/780000*100
= 22.56%

Acceptance Rule:
As payback period method, ARR also can be used as accept or reject criteria or as a method
for ranking the projects. As accept or reject criteria, the projects having the ARR more than
minimum rate prescribed by the management will be accepted and vice versa. As a ranking
method, the projects having maximum ARR will be ranked highest.
Merits
1. It is easy to calculate and simple to understand.
2. It is based on the accounting information rather than cash inflow.
3. It is not based on the time value of money.
4. It considers the total benefits associated with the project.

Demerits
1. It ignores the time value of money.
2. It ignores the reinvestment potential of a project.
3. Different methods are used for accounting profit. So, it leads to some difficulties in the
calculation of the project.

Discounted Techniques of Capital Budgeting

Net Present Value
Net present value method is one of the modern methods for evaluating the project proposals.
In this method cash inflows are considered with the time value of the money. Net present
value describes as the summation of the present value of cash inflow and present value of
cash outflow. Net present value is the difference between the total present value of future
cash inflows and the total present value of future cash outflows.
Formula: NPV= PV of inflows- PV of outflows

Merits
1. It recognizes the time value of money.
2. It considers the total benefits arising out of the proposal.
3. It is the best method for the selection of mutually exclusive projects.
4. It helps to achieve the maximization of shareholders’ wealth.

Demerits
1. It is difficult to understand and calculate.
2. It needs the discount factors for calculation of present values.
3. It is not suitable for the projects having different effective lives.
Accept/Reject criteria
If the present value of cash inflows is more than the present value of cash outflows, it would
be accepted. If not, it would be rejected.

Example : The project X costs Rs.2,500 now, and is expected to generate year end cash inflows
of Rs.900, Rs.800, Rs.700, Rs.600, and Rs.500 in years 1 to 5. The opportunity cost of capital
is assumed to be 10%.
Find out the NPV of the project taking the discounting rate of Rs.1 as follows:
1st year = Rs. 1 = 0.909
2nd year = Rs. 1 = 0.826
3rd year = Rs. 1 = 0.751
4th year = Rs.1 = 0.683
5th year = Rs.1 = 0.620
NPV = [900/(1.10) + 800/(1.10)2 + 700/(1.10)3 + 600/(1.10)4 + 500/(1.10)5] - 2,500 = [(900 ×
0.909) + (800 × 0.826) + (700 x 0.751) + (600 x 0.683) + (500 × 0.620)] - 2500
= 2,725 - 2,500
= (+) Rs. 225
Thus, the project should be accepted as its NPV is positive.
Profitability Index (PI)
Profitability Index (PI) or Benefit-Cost (B/C) Ratio is the ratio of the present value of cash
inflows, at the required rate of return, to the initial cash outflow of the investment. According
to Van Horne, the profitability Index of a project is “the ratio of the present value of future net
cash inflows to the present value of cash outflows”.
Formula:
Profitability Index = Present value of cash inflows/ Present value of cash outflows

Merits
The merits of this method are:
(i) It takes into account the time value of money
(ii) It helps to accept / reject investment proposal on the basis of value of the index.
(iii) It is useful to rank the proposals on the basis of the highest /lowest value of the index.
(iv) It takes into consideration the entire stream of cash flows generated during the life of the
asset.

Demerits
However, this technique suffers from the following limitations:
(i) It is somewhat difficult to compute.
(ii) It is difficult to understand the analytical of the decision on the basis of profitability index.

Accept/Reject criteria: If the Profitability Index is greater than or equal to one, the project
should be accepted otherwise reject.
The initial cash outlay of a project is Rs.1,00,000. It can generate cash inflow of Rs.40,000,
Rs.30,000, Rs.50,000 and Rs.20,000 in 1 through 4 years. Assuming a 10% rate of discount,
find out the PI of the project.
The discount rate of Rs.1 is as follows:
1st year = Rs.1 =0.909
2nd year = Rs.1 = 0.826
3rd year = Rs.1 =0.751
4th year = Rs.1 = 0.683
Solution: Present value of cash inflow = (40,000 × 0.909) + (30,000 × 0.826) + (50,000 × 0.751)
+ (20,000 × 0.683) = Rs.1,12,350 NPV = Rs.1,12,350 – Rs.1,00,000 = Rs.12,350 So,
PI =1,12,350 / 1,00,000 =1.1235
The project should be accepted as PI > 1.
Internal Rate of Return Internal rate of return is time adjusted technique and covers the
disadvantages of the traditional techniques. In other words, it is a rate at which discount cash
flows to zero.
It is expected by the following ratio:
Cash inflow /Investment initial Steps to be followed:
Step1. find out factor Factor is calculated as follows:
F = Cash outlay (or) initial investment /Cash inflow
Step 2. Find out positive net present value
Step 3. Find out negative net present value
Step 4. Find out formula net present value Formula: IRR = Base factor + Positive net present
value * DP Difference in positive and Negative net present value Base factor = Positive discount
rate DP = Difference in percentage
Merits
1. It consider the time value of money.
2. It takes into account the total cash inflow and outflow.
3. It does not use the concept of the required rate of return.
4. It gives the approximate/nearest rate of return.

Demerits
1. It involves complicated computational method.
2. It produces multiple rates which may be confusing for taking decisions.
3. It is assumed that all intermediate cash flows are reinvested at the internal rate of return.

Accept/Reject criteria
If the present value of the sum total of the compounded reinvested cash flows is greater than
the present value of the outflows, the proposed project is accepted. If not, it would be
rejected.

Discounted Payback period

This is an improvement over the pay-back period method in the sense that it considers time
value of money. Thus, discounted pay-back period indicates that period within which the
discounted cash inflows equal the discounted cash outflows involved in a project.

Summary

• Capital budgeting involves analysing long term investment projects for the
organization. The process through which different projects are evaluated is known as
capital budgeting.

• Capital budgeting is defined “as the firm’s formal process for the acquisition and
investment of capital. It involves firm’s decisions to invest its current funds for
addition, disposition, modification and replacement of fixed assets”
 • Non-Discounted Techniques does not consider the time value of money. It includes a)
Payback period- payback period indicates the period within which the cost of the
project will be completely recovered. b) Accounting Rate of Return – it computes the
average annual yield on the net investment in the project.
• Discounted Techniques considers the time value of money – discounted cash flows.
Discounted Techniques consider the future risk of income while evaluating the project

Self -Assessment Question

1. Which of the following is not true about Capital Budgeting?

a) Capital Budgeting decisions have an influence on the future stability of an organization
b) Capital Budgeting decisions include investments to expand the business
c) Capital Budgeting decisions are of an irreversible nature
d) Sunk cost is a part of Capital Budgeting

2. Capital Budgeting decisions are of?

a) Long term nature
b) Short term nature
c) Medium Term Nature
d) None of the above

3. Which of the following method of capital budgeting does not take into account the profit
of the entire life of the project?
a) Payback period method
b) Accounting rate of return method
c) Net present value method
d) Profitability index
4. A project requires an outlay of Rs. 4,00,000 and earns, an annual cash inflow of Rs.
1,00,000 for 4 years. Pay back period without discounting will be
a. 4 years
b. 3 years
c. 2 years
d. 1 year

5. The method of subtracting present value of cash outflows from present value of cash
inflows is known as
a. Net Present Value Method
b. Profitability Index Method
c. Break Even analysis
d. Capital Rationing

6. Internal rate of return can be computed even in the absence of the knowledge about
the firm's cost of capital.
a. TRUE
b. FALSE

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_____________________________________________________________________

Notes

Program Name: MBA

Course Name: Corporate Finance Sem: IV

Unit Number – IV Unit Name: Financing Decisions

Topic Name – Introduction to Capital Structure

 Introduction to Capital Structure

Introduction

The relative proportion of various sources of funds used in a business is termed as financial
structure. Capital structure is a part of the financial structure and refers to the proportion of
the various long-term sources of financing. It is concerned with making the selection of the
sources of the funds in a proper manner, which is in relative degree and proportion. The
capital structure of a company is made up of debt and equity securities that include a firm’s
financing of its assets. It is the permanent financing of a firm represented by long-term debt,
preferred stock and net worth.

Capital structure refers to the mix of sources from which the long-term funds required by a
business are raised, i.e., what should be the proportion of equity share capital, preference
share capital, internal sources, debentures and other sources of funds in the total amount of
capital which an undertaking may raise for establishing its business.

Definition

Gerestenberg, ‘Capital structure of a company refers to the composition or make up of its

capitalization and it includes all long-term capital resources viz., loans, reserves, shares and
bonds’.

Keown et al. defined capital structure as, ‘balancing the array of funds sources in a proper
manner, i.e. in relative magnitude or in proportions’.

Debt come in the form of loans, debentures or issue of bond. Whereas, equity capital
comprises of equity shares, preference shares and retained earnings. This arranged capital
from various sources is used by business for funding day-to-day expenses, acquisitions, capital
expenditures and various other types of investment. Every company aims to achieve optimal
capital structure where there is low weighted average cost of capital and value of owners get
maximized. However, calculation of optimal structure needs a strategical approach and
analytical thinking.
Components of Capital Structure

Capital structure comprises of various sources from where the required funds is raised by
company for meeting its long term capital needs. The different sources of funds taken into
consideration by company are discussed below:

Equity Debt
Equity
Loan
Shares

Pref Shares Debenture

Retained
Earnings

Reserves
and
Surplus

Equity

Shareholder funds is a funds that is contributed by owner of business and is also termed as
ownership capital. It involves issuing shares for acquiring the funds or utilizing retained
earnings for funding the expenses of company.

Debt

Borrowed funds refers to the capital borrowed from external sources in form of loans or
credit. These are termed as outside liabilities of company which requires payment of fixed
interest amount periodically. It leads to create burden on company, however it also benefits
in the form of tax deduction.
Principles of Capital Structure

The following are the principles of capital structure on the basis of which the mix and
combination of debt and equity shall be decided

• Cost Principle: According to this principle, ideal capital structure should minimise cost
of financing and maximise earnings per share. Debt capital is a cheaper form of capital
due to two reasons. First, the expectations of returns of debt capital holders are less
than those of equity shareholders. Secondly, interest is a deductible expenditure for
tax purposes of profits.

• Risk Principle: According to this principle, ideal capital structure should not accept
unduly high risk. Debt capital is a risky form of capital, as it involves contractual
obligations as to the payment of interest and repayment of principal sum, irrespective
of profits or losses of the business. If the organisation issues large amount of
preference shares, out of the earnings of the organisation, less amount will be left for
equity shareholders as dividend on preference shares are required to be paid before
any dividend is paid to equity shareholders. Raising the capital through equity shares
involves least risk, as there is no obligation as to the payment of dividend.

• Control Principle: According to this principle, ideal capital structure should keep
controlling position of owners intact. As preference shareholders and holders of debt
capital carry limited or no voting rights, they hardly disturb the controlling position of
residual owners. Issue of equity shares disturb the controlling position directly as the
control of the residual owners is likely to be diluted.
• Flexibility Principle: According to this principle, ideal capital structure should be able
to cater to additional requirements of funds in future, if any. E.g. If a company has
already raised too heavy debt capital, by mortgaging all the assets, it will be difficult
for it to get further loans in spite of good market conditions for debt capital and it will
have to depend on equity shares only for raising further capital. Moreover,
organisation should avoid capital on such terms and conditions, which limit the
company’s ability to procure additional funds. E.g. If the company accepts debt capital
on the condition that it will not accept further loan capital or dividend on equity shares
will not be paid beyond a certain limit, then it loses flexibility.
• Timing Principle: According to this principle, ideal capital structure should be able to
seize market opportunities, should minimise cost of raising funds and obtain
substantial savings. Accordingly, during the days of boom and prosperity, company
can issue equity shares to get the benefit of investors’ desire to invest and take the
risk. During the days of depression, debt capital may be used to raise the capital, as
the investors are afraid to take any risk.

Determinants of Capital Structure

Size of a company - Small size business firm’s capital structure generally consists of loans
from banks and retained profits. While on the other hand, big companies having goodwill,
stability and an established profit can easily go for issuance of shares and debentures as
well as loans and borrowings from financial institutions.

Period of finance - The period for which finance is needed also influences the capital
structure. When funds are needed for long-term (say 10 years), it should be raised by
issuing debentures or preference shares. Funds should be raised by the issue of equity
shares when it is needed permanently.

Control - The consideration of retaining control of the business is an important factor in

capital structure decisions. If the existing equity shareholders do not like to dilute the
control, they may prefer debt capital to equity capital, as former has no voting rights.

Regulatory framework - Capital structure also influenced by government rules. For

example, banking companies can raise money by issuing share capital alone, no other
security. Similarly, it is compulsory to maintain the debt-equity ratio given to other
companies while raising funds. Various ideal debt-equity ratios like 2: 1; 4: 1; 6: 1 has been
set for different industries. The public issue of shares and debentures is to made under
SEBI guidelines.

Floatation Costs - The cost of Floatation’s called expenses which are spending while
issuing securities. These include the commission of underwriters, brokerage, stationery
expenses, etc. Generally, issuing debt capital’s cost is less than share capital. It attracts
the company towards debt capital.
 Risk - In capital structure decisions, two elements of risk viz., (i) Business risk and (ii)
Financial risk are considered. A firm with high business risk prefers to have low levels of
debt, since the volatility of its earnings is more. A firm with low level of business risk can
have higher debt component in capital structure, since the risk of variations in expected
earnings is lower.

Checklist for Capital Structure Decisions

1. Sales stability. A firm whose sales are relatively stable can safely take on more debt
and incur higher fixed charges than a company with unstable sales. Utility companies,
because of their stable demand, have historically been able to use more financial
leverage than industrial firms.

2. Asset structure. Firms whose assets are suitable as security for loans tend to use debt
rather heavily. General-purpose assets that can be used by many businesses make
good collateral, whereas special-purpose assets do not. Thus, real estate companies
are usually highly leveraged, whereas companies involved in technological research
are not.

3. Operating leverage. Other things the same, a firm with less operating leverage is
better able to employ financial leverage because it will have less business risk.

4. Growth rate. Other things the same, faster-growing firms must rely more heavily on
external capital (see Chapter 11). Further, the flotation costs involved in selling
common stock exceed those incurred when selling debt, which encourages rapidly
growing firms to rely more heavily on debt. At the same time, however, these firms
often face greater uncertainty, which tends to reduce their willingness to use debt.

5. Profitability. One often observes that firms with very high rates of return on
investment use relatively little debt. Although there is no theoretical justification for
this fact, one practical explanation is that very profitable firms such as Intel, Microsoft,
and Coca-Cola simply do not need to do much debt financing. Their high rates of return
enable them to do most of their financing with internally generated funds.
6. Taxes. Interest is a deductible expense, and deductions are most valuable to firms with
high tax rates. Therefore, the higher a firm's tax rate, the greater the advantage of
debt.

7. Control. The effect of debt versus stock on a management's control position can
influence capital structure. If management currently has voting control (over 50
percent of the stock) but is not in a position to buy any more stock, it may choose debt
for new financings. On the other hand, management may decide to use equity if the
firm's financial situation is so weak that the use of debt might subject it to serious risk
of default, because if the firm goes into default, the managers will almost surely lose
their jobs. However, if too little debt is used, management runs the risk of a takeover.
Thus, control considerations could lead to the use of either debt or equity, because
the type of capital that best protects management will vary from situation to situation.
In any event, if management is at all insecure, it will consider the control situation.

8. Management attitudes. Because no one can prove that one capital structure will lead
to higher stock prices than another, management can exercise its own judgment about
the proper capital structure. Some managements tend to be more conservative than
others, and thus use less debt than the average firm in their industry, whereas
aggressive managements use more debt in the quest for higher profits.

9. Lender and rating agency attitudes. Regardless of managers' own analyses of the
proper leverage factors for their firms, lenders' and rating agencies' attitudes
frequently influence financial structure decisions. In the majority of cases, the
corporation discusses its capital structure with lenders and rating agencies and gives
much weight to their advice. For example, one large utility was recently told by
Moody's and Standard & Poor's that its bonds would be downgraded if it issued more
debt. This influenced its decision to finance its expansion with common equity.

10. Market conditions. Conditions in the stock and bond markets undergo both long- and
short-run changes that can have an important bearing on a firm's optimal capital
structure. For example, during a recent credit crunch, the junk bond market dried up,
and there was simply no market at a "reasonable" interest rate for any new long-term
bonds rated below triple B. Therefore, low-rated companies in need of capital were
forced to go to the stock market or to the short-term debt market, regardless of their
 target capital structures. When conditions eased, however, these companies sold
bonds to get their capital structures back on target.

11. The firm's internal condition. A firm's own internal condition can also have a bearing
on its target capital structure. For example, suppose a firm has just successfully
completed an R&D program, and it forecasts higher earnings in the immediate future.
However, the new earnings are not yet anticipated by investors, hence are not
reflected in the stock price. This company would not want to issue stock—it would
prefer to finance with debt until the higher earnings materialize and are reflected in
the stock price. Then it could sell an issue of common stock, retire the debt, and return
to its target capital structure. This point was discussed earlier in connection with
asymmetric information and signaling.

12. Financial flexibility. Firms with profitable investment opportunities need to be able to
fund them.

Summary

• Capital Structure refers to the mix of sources from where the long-term funds required
in a business may be raised.
• The long-term capital requirement is fulfilled through Debt and Equity

• The principles of capital structure management should consider i) Cost principle i.e. it
should minimise the cost of capital ii) Risk principle i.e. it should not accept unduly
high risk. iii) Control principle, i.e. it should keep controlling position of owners intact.
iv) Flexibility principle, i.e. it should be able to cater to additional requirements of
funds in future. v) Timing principle, i.e. it should be able to seize market opportunities,
should minimise cost of raising funds and obtain substantial savings.

Self-Assessment Question
1. What is Capital Structure?
a) A balance between the assets and liabilities of the firm
b) A balance between the revenue and expenditure of the firm
c) A distribution of equity and debt that structures the finances of the
company.
d) All of the above
2. What are the components of capital structure?
a) Debts and Equity
b) Debts, Preferred stock and Equity
c) Debts, revenue and equity
d) All of the above

3. Preference shares and debentures comes under the category of:

a) Short term funds
b) External source of funds
c) Long term funds
d) Both B and C

4. Capital Structure focuses on raising short term funds

a) True
b) False

5. The main aim of capital structure is to

a) Maximise owner’s return and minimise the cost of capital
b) Maximise owner’s return and maximise the cost of capital
c) Minimise owner’s return and minimise the cost of capital
d) Minimise owner’s return and maximise the cost of capital
_____________________________________________________________________

Notes
Program Name: MBA

Course Name: Corporate Finance Sem: IV

Unit Number – VI Unit Name: Working Capital Management

Topic Name – Cash and Receivables Management

 Cash and Receivables Management

MEANING OF WORKING CAPITAL

Capital of the concern may be divided into two major headings. Fixed capital means that
capital, which is used for long-term investment of the business concern. For example,
purchase of permanent assets. Normally it consists of non-recurring in nature. Working
Capital is another part of the capital which is needed for meeting day to day requirement of
the business concern. For example, payment to creditors, salary paid to workers, purchase of
raw materials etc., normally it consists of recurring in nature. It can be easily converted into
cash. Hence, it is also known as short-term capital.

The working capital management is highly depending on cash and receivables management.
The need for working capital financing can be fulfilled with proper cash and receivables
management
Cash Management:
Cash management as the word suggests is the optimum utilization of cash to ensure maximum
liquidity and maximum profitability. It refers to the proper collection, disbursement, and
investment of cash.
Cash Management refers to the collection, handling, control and investment of the
organizational cash and cash equivalents, to ensure optimum utilization of the firm’s liquid
resources. Money is the lifeline of the business, and therefore it is essential to maintain a
sound cash flow position in the organization.
For a small business, proper utilization of cash ensures solvency. Hence, cash management is
a vital business function; it is a function that manages the collection and utilization of cash.
Just like a ‘no cash situation’ in our day to day lives can be a nightmare, for a business it can
be devastating. Especially for small businesses, it can lead to a point of no return. It affects
the credibility of the business and can lead to them shutting down.
Hence, the most important task for business managers is to manage cash. Management needs
to ensure that there is adequate cash to meet the current obligations while making sure that
there are no idle funds. This is very important as businesses depend on the recovery of
receivables. If a debt turns bad (irrecoverable debt) it can jeopardize the cash flow.
Therefore, cash management is also about being cautious and making enough provision for
contingencies like bad debts, economic slowdown, etc.

Objectives of Cash Management

• Fulfil Working Capital Requirement: The organization needs to maintain ample liquid
cash to meet its routine expenses which possible only through effective cash
management.
• Planning Capital Expenditure: It helps in planning the capital expenditure and
determining the ratio of debt and equity to acquire finance for this purpose.
• Handling Unorganized Costs: There are times when the company encounters
unexpected circumstances like the breakdown of machinery. These are unforeseen
expenses to cope up with; cash surplus is a lifesaver in such conditions.
• Initiates Investment: The other aim of cash management is to invest the idle funds in
the right opportunity and the correct proportion.
• Better Utilization of Funds: It ensures the optimum utilization of the available funds
by creating a proper balance between the cash in hand and investment.
• Avoiding Insolvency: If the business does not plan for efficient cash management, the
situation of insolvency may arise. It is either due to lack of liquid cash or not making a
profit out of the money available.

Functions of cash management

In an ideal scenario, an organization should be able to match its cash inflows to its cash
outflows. Cash inflows majorly include account receivables and cash outflows majorly include
account payables.
Practically, while cash outflows like payment to suppliers, operational expenses, payment to
regulators are more or less certain, cash inflows can be tricky. So the functions of cash
management can be explained as follows:
• Inventory management
Higher stock in hand means trapped sales and trapped sales means less liquidity. Hence, an
organization must aim at faster stock out to ensure movement of cash.
• Payables Management
While receivables management is one of the primary areas in the cash management function,
payables management is also important. Payables arise when the organization has made
purchases on credit and needs to make payments for the same within a fixed time.
An organization can take short-term credit from banks and financial institutions. However,
these credit facilities come at a cost and therefore, an organization must ensure that they
maintain a good liquidity position; this will help in timely repayments of debts.
• Receivables Management
An organization raises invoices for its sales. In these cases, the credit period for receiving the
cash can range between 30 – 90 days. Here, the organization has recorded the sales but has
not yet received cash for the transactions. So the cash management function will ensure faster
recovery of receivables to avoid a cash crunch.
If the average time for recovery is shorter, the organization will have enough cash in hand to
make its payments. Timely payments ensure lesser costs (interests, penalties) to the
organization. Receivables management also includes a robust mechanism for follow-ups. This
will ensure faster recovery and it will also assist the business to predict bad debts and
unforeseen situations.
Management of receivables is a financial term that refers to the management of an amount
owed to a business from a customer account. A company can sell goods or services to
customers on credit for a defined period. The amount which the company may receive from
the customers is accounts receivable. For example, a company sells goods worth ₹50,000 to a
customer with a credit period of 30 days. If the selling took place on 1 April 2021 then from
this date to the day the bill gets paid, ₹50,000 is accounts receivable.
As the term suggests, management of your accounts receivable is called receivable
management. Basically, the entire process of defining the credit policy, setting payment terms,
sending payment follow ups and timely collection of the due payments can be defined as
receivables management. Management of Receivables is also known as:
• Payment Collection
• Collection Management
• Accounts Receivables
Aspects Of Receivables Management
Here are some important aspects of receivables management that a finance manager may
consider to improve the growth of a business:
Credit policy
Credit policies are rules and regulations that a company may set while selling goods or services
on credit. A credit policy may comprise decisions based on credit standards, credit terms and
collection efforts. Determining credit policy may involve several things such as deciding the
total duration of the credit which is the credit period and the cash discount the customer may
get. A well-formulated credit policy can allow you to do the following things:
• Understand and determine the customers who require credit
• Decide and set the right payment terms for the customers
• Calculate and set the limits on the accounts with outstanding credits
• Find the procedures which are essential to deal with irresponsible accounts

Credit analysis
Credit analysis can allow you to determine the creditworthiness of a particular customer or
business. It is the documentation that allows lending organisations to determine if a customer
is eligible for credit. Credit analysis can play a significant role in risk management and assist
finance professionals in managing portfolios of clients. It may also help customers by providing
detailed insights into what a company expects from them to offer the credit. During the
process of credit analysis, finance managers may go through the following stages:
• Collecting information regarding the credit history of the client
• Analysing and determining the accuracy of the collected information
• Making a decision of approving or rejecting the credit application

Importance Of Receivables Management

Here are some common benefits of receivables management:
Allows evaluation of customer credit ratings:
Accounts receivables management may allow you to have an in-depth understanding of the
customer's credit rating. It can help you evaluate the borrowing limit of a customer and their
ability to repay the credit amount. Evaluating customer credit ratings can also be helpful in
minimising credit risk. Many finance managers approve the credit application after analysing
the customer credit ratings and gaining full satisfaction.
Helps firms to minimise the investment in receivables:
Receivables management can help you to evaluate if there are enough funds available for
making the investment. It may help you reduce the investment in receivables. You can find the
best methods and strategies that focus on collecting the due account receivables.
With the help of receivables management, you can evaluate the right credit limit and period
to avoid situations like bankruptcy. You can minimise the investment in receivables by
collecting accounts receivable as soon as they become due for payment.

Helps in optimising sales:

With the help of receivables management, you can help businesses and firms optimise their
sales and increase the sales volume. Many businesses gain the attention of potential
customers by providing them with different credit facilities. Receivable management can help
you understand and monitor the credit facilities a business is offering to customers.

Reduces risk of bad debts:

You can notify customers about due payments. Many professionals use receivable
management to charge interest on delayed payments and ensure the timely collection of
payments. It can help you to follow the necessary steps and reduce the risk of bad debts.

Maintains efficient cash:

Maintaining efficient cash can help businesses to remain competitive in the market.
Receivables management can allow you to have a proper track of all the cash flows including
both the inflows and outflows. It may help you to gain a better understanding of the current
financial strength of a business and make decisions accordingly. Before lending any credit to
customers, you can analyse the capabilities of the business and maintain efficient cash.
Receivable management can help you maintain steady cash flow within the organisation.
Summary

• Cash Management refers to the collection, handling, control and investment of the
organizational cash and cash equivalents, to ensure optimum utilization of the firm’s
liquid resources.
• Inventory management, Receivables management and payables management is an
function of cash management.
• Account receivables refer to the outstanding invoices or money which is yet to be paid
by your customers. Receivable management refers to the planning and monitoring of
debt owed to the firm from a customer account. Professionals working in finance and
accounting departments such as finance managers may use this concept to grow sales
and increase profits.

Self- Assessment Question

1. Cash management looks after only liquidity of cash
a) True
b) False

2. The goal of receivables management is to maximize the value of the firm by achieving a
trade-off between
a) Risk & Profitability
b) Liquidity & Profitability
c) Return & Profitability
d) Return & Liquidity

3. A decrease in the firm’s receivable turnover ratio means that –

a) it is collecting credit sales more quickly than before
b) it is collecting credit sales more slowly than before
c) sales have gone down
 d) inventories have gone up

4. Which of the following function is required to be performed by the finance manager in

relation to proper management of receivables?
a) To obtain optimum (not maximum) value of sales.
b) To adopt relaxed policy for administrative expense.
c) To increase opportunity cost of funds blocked in the receivables.
d) To make more purchases at bigger discounts.

5. The cash discount is given to customers for:

a) Early payments
b) Good business relations
c) Bulk purchase
d) Frequent purchases

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_____________________________________________________________________

Notes
Program Name: MBA

Course Name: Corporate Finance Sem: IV

Unit Number – V Unit Name: Dividend Decisions

Topic Name – Dividend Meaning and Types

 Dividend Meaning and Types

Introduction

Dividend

Dividend refers to that portion of profit which is distributed among the owners or
shareholders of the firm.

A dividend’s value is determined on a per-share basis and is to be paid equally to all

shareholders The finance manager has to take few decisions which are inter related like
investment, financing and dividend decisions.

Dividend decision is related to the shareholder’s share in the profits of the company

How a Dividend Works

A dividend’s value is determined on a per-share basis and is to be paid equally to all

shareholders of the same class (common, preferred, etc.). The payment must be approved by
the Board of Directors.

When a dividend is declared, it will then be paid on a certain date, known as the payable date.

Steps of how it works:

1. The company generates profits and retained earnings

2. The management team decides some excess profits should be paid out to
shareholders (instead of being reinvested)

3. The board approves the planned dividend

4. The company announces the dividend (the value per share, the date when it will be
paid, the record date, etc.)

5. The dividend is paid to shareholders

Types of Dividend

Dividends can come in different forms, as well as at different intervals. But all in all, dividends
are one way that companies can entice investors to invest in their company. A few common
types of dividends include:
Cash dividends

These are the most common types of dividends and are paid out by transferring a cash
amount to the shareholders. These dividends are usually paid on a quarterly basis, although
some companies may opt for a monthly, semiannual, or one-time lump-sum payment.

Stock dividends

Companies may choose to pay dividends in the form of extra shares instead of cash. This can
be a perk for shareholders because these stock dividends are not taxed until the shareholder
sells these shares. But experts say this can also dilute the share price. “Essentially each
shareholder owns the same percentage of the company after receiving the stock dividend as
they did before receiving the stock dividend,” says Johnson.

Scrip dividends

When a company doesn’t have sufficient funds to issue dividends in the near future, it’ll issue
scrip dividends, which is essentially a promissory note that promises to pay shareholders at a
later date. These dividends may or may not include interest.

Property dividends

While less common, some companies pay dividends by giving assets or inventories to
shareholders instead of cash. They use the fair-market value of the asset to determine how
much each shareholder should receive.

Liquidating dividends

This is the type of dividend paid to shareholders during a partial or full liquidation. The
company will return the amount that shareholders originally contributed and, as a result,
these dividends usually aren’t taxable.

Dividend Policy

A dividend policy is the policy a company uses to structure its dividend payout to
shareholders. A company’s dividend policy dictates the amount of dividends paid out by the
company to its shareholders and the frequency with which the dividends are paid out. he
dividend policy used by a company can affect the value of the enterprise. The policy chosen
must align with the company’s goals and maximize its value for its shareholders. While the
shareholders are the owners of the company, it is the board of directors who make the call
on whether profits will be distributed or retained. The directors need to take a lot of factors
into consideration when making this decision, such as the growth prospects of the company
and future projects. There are various dividend policies a company can follow such as:

Types of Dividend Policy

• Residual Dividend Policy

• Regular Dividend Policy
• Irregular Dividend Policy
• Stable Dividend Policy
• No Dividend Policy

Factors affecting Dividend Policy

The main factors affecting dividend decisions are discussed below:

(i) Amount of Earnings: Dividends are paid out of current and past earnings. Thus, earnings
are a major determinant of dividend decision.

(ii) Stability in Earnings: A company having higher and stable earnings can declare higher
dividends than a company with lower and unstable earnings.

(iii) Stability of Dividends: Generally, companies try to stabilise dividends per share. A steady
dividend is given each year. A change is only made if the company's earning potential has
gone up and not just the earnings of the current year.

(iv) Growth Opportunities: Companies having good growth opportunities retain more money
out of their earnings so as to finance the required investment. Therefore the dividend
declared in growth companies is smaller than that in the non-growth companies.

(v) Cash Flow Position: Dividend involves an outflow of cash. Availability of enough case is
necessary for payment or declaration of dividends.

(vi) Shareholders' Preference: While declaring dividends, the management must keep in mind
the preferences of the shareholders. Some shareholders in general desire that at least a
certain amount is paid as dividend. The companies should consider the preferences of such
shareholders.

(vii) Taxation Policy: If the tax on dividends is higher, it is better to pay less by way of
dividends. But if the tax rates are lower, higher dividends may be declared. This is because as
per the current taxation policy, a dividend distribution tax is levied on companies. However,
shareholders prefer higher dividends, as dividends are tax-free in the hands of shareholders.

(viii) Stock Market Reaction: Generally, an increase in dividends has a positive impact on the
stock market and vice-versa. Thus, while deciding on dividends, this should be kept in mind.

(ix) Access to Capital Market: Large and reputed companies generally have easy access to the
capital market and, therefore, may depend less on retained earnings to finance their growth.
These companies tend to pay higher dividends than smaller companies.

(x) Legal Constraints: Certain provisions of the Companies Act place restrictions on payouts as
the dividend. Such provisions must be adhered to while declaring the dividend.

(xi) Contractual Constraints: While granting loans to a company, sometimes, the lender may
impose certain restrictions on the payment of dividends in the future. The companies are
required to ensure that the dividend payout does not violate the terms of the loan agreement
in this regard.

Summary

• A dividend’s value is determined on a per-share basis and is to be paid equally to all

shareholders The finance manager has to take few decisions which are inter related
like investment, financing and dividend decisions.
• A dividend’s value is determined on a per-share basis and is to be paid equally to all
shareholders of the same class. The payment must be approved by the Board of
Directors.
• A company’s dividend policy dictates the amount of dividends paid out by the
company to its shareholders and the frequency with which the dividends are paid out
• Organizations have different approaches to pay dividend
• The dividend is not pain in cash only, there are various ways to pay dividend
 • The dividend policy has effect of various factors like stability and liquidity etc.

Self-Assessment Question

1. Stock dividend is also known as:

a) Scrip Dividend Policy
b) Bonus Share
c) Right Shares
d) None of the above

2. Dividends are paid out of

a) Accumulated Profits
b) Gross Profit
c) Profit after Tax
d) General Reserve

3. Dividend is a return on shareholder’s fund

a) True
b) False

4. Dividend policy determines

a) what portion of earnings will be paid out to stock holders
b) what portion will be retained in the business to finance long-term growth.
c) Only (A) not (B)
d) Both (A) and (B)

5. Which of the following would not have an influence on the optimal dividend policy?
a) The possibility of accelerating or delaying investment projects.
b) A strong share holders’ preference for current income versus capital gains.
c) The costs associated with selling new common stock.
d) All of the statements above can have an effect on dividend policy

*******************************************
 Notes

Program Name: MBA

Course Name: Corporate Finance Sem: IV

Unit Number – I Unit Name: Financial Goals of the Firm

Topic Name – Financial Goals

 Financial Goals

Introduction

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.

The function in a business that acquires funds for a firm and manages them within the firm.
The job of managing a firm’s resources to meet its goals and objectives.

Financial management is the activity concerned with planning, raising, controlling and
administering of funds used in the business.” – Guthman and Dougal

“Financial management is that area of business management devoted to a judicious use of

capital and a careful selection of the source of capital in order to enable a spending unit to
move in the direction of reaching the goals.” – J.F. Brandley

Goals of Financial Management

Profit maximization

Profit maximization is a stated goal of financial management. Profit is the excess of revenue
over expenses. Profit maximization is therefore maximizing revenue given the expenses, or
minimizing expenses given the revenue or a simultaneous maximization of revenue and
minimization of expenses. Revenue maximization is possible through pricing and scale
strategies. By increasing the selling price one may achieve revenue maximization, assuming
demand does not fall by a commensurate scale. By increasing quantity sold by exploiting the
price-elasticity of the demand factor, revenue can be maximized. Expenses minimization
depends on variability of costs with volume, cost consciousness and market conditions for
inputs. So, a mix of factors is called for profit maximization.

Wealth Maximization

Finance managers serve a principal-agent relationship with the company’s shareholders and
act as agents. They must cater to the interest of the shareholders.
The expectation of every shareholder or investor in a company would be to generate a good
amount of return from their investment and safeguard their invested amount. Both the
objectives mentioned here are catered by wealth maximization as a key decisive factor for
every business. It also helps keep the shareholders happy about their investments made in
the business.

Wealth maximization means maximizing the shareholder’s wealth due to an increase in share
price, thereby increasing the company’s market capitalization. The share price increase
directly affects how competitive the company is, its positioning, growth strategy, and profits.

Wealth maximization is the concept of increasing a firm's worth to increase the value of
stockholders' shares. Wealth maximization is also known as net worth maximization. A
stockholder's wealth increases when a company's net worth maximizes. Many businesses
consider it superior to profit maximization. In fact, most large management-controlled firms
are likely to list shareholder wealth maximization as their dominant goal.

A corporation focusing on wealth maximization as its primary goal puts the shareholders'
interests at the heart of every decision. Therefore, a firm needs to appoint professionals such
as experienced CFOs, CEOs, and sales directors to manage shares. This management team
considers crucial factors like the timing, risk, and duration of a company's earnings and
dividend policies. They also examine other factors that may influence or affect market prices.

A share of stock represents ownership in a corporation or business. The objective of any

stockholder or investor is to gain a substantial return on their capital. Wealth maximization
aims to improve their wealth by increasing the marketing share prices.

• Wealth maximization is a chain aiming to maximize shareholder wealth by increasing

the share price, which technically increases market capitalization.

• Less uncertainty is associated with cash flows than profit maximization, and they are
more predictable and consistent. So, profits are less important than cash flows.

• To maximize value for shareholders, a company must first be profitable. Only then can
it consider increasing shareholder wealth.
 • It is related to cash flows than profits, which are more certain and regular, with the
absence of uncertainty associated with profit. However, it is based on a prospective
and not a descriptive idea.

Agency Theory:

• Agency theory is a concept used to explain the important relationships between

principals and their relative agent. The principal is someone who heavily relies on an
agent to execute specific financial decisions and transactions that can result in
fluctuating outcomes.

• Because the principal relies so heavily on the agent to make the right decision, there
may be an assortment of conflicts or disagreements. Agency theory dives into such
relationships.
• In terms of business, the principal is considered to be a shareholder (Stakeholder),
while the agent is considered to be a company executive. Although it may not seem
like it, shareholders and company executives are tightly connected. Each of their
actions greatly affects the position of one another.

• Agency theory is also often referred to as the “agency dilemma” or the “agency
problem.”

Different Agency Theory Relationships

When it comes to business and the concept of agency theory, there several types of
relationships that are closely intertwined and are faced with some sort of disagreement.
Shown below are some of the most in-depth and connected relationships in businesses that
involve a principal-agent relationship and qualify for the agency theory.

1. Shareholders and Company Executives

As mentioned, the shareholder is represented by the principal. It is because the shareholder

invests in an executive’s business, in which the executive is responsible for making decisions
that affect the shareholder’s investment. If the company executive acts negatively and
reduces the worth of the shareholder’s stock, it will spark a disadvantageous relationship. On
the other hand, if the company executive were to act ethically resulting in some sort of
financial boost in the shareholder’s stock, a positive connection will form.

2. Investor and Fund Manager

In such a case, the investor is the principal because they are giving a portion of their income
to the fund manager to allocate on their behalf. If the fund manager were to invest in volatile
stocks and yield a return less than expected from the investor, a negative relationship begins
to form. Conversely, if the fund manager goes above and beyond and nets a profit outside of
the realm of expectation, the investor praises the fund manager and there is a healthy linkage.

3. Board of Directors and CEO

Up in the hierarchy, the board of directors is represented by the principal because their
financial position and status are decided by the CEO. If the CEO were to make a wrong
financial decision that put the organization at a deficit, the board of directors is more likely to
vote against the CEO in the next election.

Oppositely, if the CEO were to introduce a new business sector that provided unprecedented
innovation in the market, they would be praised by the board of directors and would likely
stay in power for years to come. The idea of agency theory is represented by the relationships
expressed above. All of the interactions and disagreements faced by both the principal and
agent are what make up the entire exploration of the concept.

Agency Problem:

• The manager, acting as the agent for the shareholders, or principals, is supposed to
make decisions that will maximize shareholder wealth even though it is in the
manager’s best interest to maximize their own wealth.

• In corporate finance, an agency problem usually refers to a conflict of interest

between a company's management and the company's stockholders.

• A conflict of interest occurs when responsible people misuse their authority and
power for personal benefits

Causes of Agency Problems

As mentioned throughout the text, the agency theory explores the distinctive relationship
between a principal and their agent. Throughout the relationship, there is a number of actions
and decisions that are made by the agent on behalf of the principal.
The same actions and decisions are what generates disagreements and conflict between the
two parties. To explain in more depth, listed below are the main causes of agency problems:

• When a conflict of interest arises between the principal and the agent
• When the agent is making decisions on behalf of the principal that is not in the best
interest of each associated party
• The agent may act independently from the principal in order to obtain previously
agreed upon incentive or bonus
• Confidentiality breach regarding the personal and financial information of the
principal
• Insider trading with the information provided by the principal
• When the principal acts against the recommendations provided by the agent.
• Considering there is power/trust allocation, it is not surprising that there is an entire
theory that explores the relationship and interactions between a principal and an
agent.

SUMMARY
• Profit maximization is maximizing revenue given the expenses, or minimizing expenses
given the revenue or a simultaneous maximization of revenue and minimization of
expenses.

• Wealth maximization is a chain aiming to maximize shareholder wealth by increasing

the share price, which technically increases market capitalization.

• The agency problem refers to the conflict when the agents are liable to look after the
principals’ interests selected for using the power or authority for their perquisite or
corporate finance.
• The agency’s problem is an interesting conflict between its management and
stockholders.
• The agency problem types are stockholder’s vs management, stockholder’s vs
creditors, and stockholders vs other stakeholders.
• Companies can tackle the agency issue by providing rewards for high performance,
enforcing sanctions for poor performance and inappropriate behaviour, implementing
stringent screening procedures, etc.
 Self Assessment Question

1. Finance Function comprises

a) Safe custody of funds only
b) Expenditure of funds only
c) Procurement of finance only
d) Procurement & effective use of funds

2. The only feasible purpose of financial management is

a) Wealth Maximization
b) Sales Maximization
c) Profit Maximization
d) Assets maximization

3. What is the primary goal of financial management?

a. To minimise the risk
b. To maximise the owner’s wealth
c. To maximise the return
d. To raise profit
4. The ultimate concern of Financial Management is:
a) to arrange the funds
b) effective management of all the business
c) receiving the maximum profit
d) to acquire and utilize every aspect of financial resources in order to
maintain the firm activities

5. Agency problem is between

a) Manager and Employees

b) Manager and Government
c) Manager and Shareholders
d) Parent to Subsidiary

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_____________________________________________________________________

Notes

Program Name: MBA

Course Name: Corporate Finance Sem: IV

Unit Number – IV Unit Name: Financing Decisions

Topic Name – Leverages

 Leverages

CONCEPT OF LEVERAGE

In general, leverage refers to accomplish certain things which are otherwise not possible i.e.
lifting of heavy objects with the help of lever. This concept of leverage is valid in business also.
In finance, the term ‘leverage’ is used to describe the firm’s ability to use fixed cost assets or
funds to increase the return to its owners; i.e. equity shareholders. In other words, the fixed
cost funds i.e. debentures & preference share capital act as the fulcrum, which assist the lever
i.e. the firm to lift i.e. to increase the earnings of its owner i.e. the equity shareholders.

If earnings less, the variable costs exceed the fixed costs i.e. preference dividend & interest
on debenture, or earnings before interest and taxes exceed the fixed return requirement, the
leverage is called favourable. when they do not, the result is unfavourable leverage. Leverage
is also the influence which an independent variable has over a dependent/related variable i.e.
rainfall over production. In financial context, sales & fixed cost over profit.

In very simple words, the term leverage measures relationship between two variables. In
financial analysis, the term leverage represents the influence of one financial variable over
some other financial variable. In financial analysis, generally three types of leverages may be
computed:

1. Operating Leverage

2. Financial Leverage

3. Combined Leverage

1. Operating Leverage

It measures the effect of change in sales quantity on Earnings Before Interest and Taxes
(EBIT). It is computed as:

Operating leverage = contribution/EBIT

Where, contribution = sales – variable cost
EBIT = contribution – fixed cost
Note: in case the contribution exceeds the fixed cost, the operating leverage is favourable.
when C<F, the operating leverages is unfavourable.

Indications:

A high degree of operating leverage means that the component of fixed cost is too high in the
overall cost structure. A low degree of operating average means that the component of fixed
cost is less in the overall cost structure. In other words, operating leverage measures the
impact of percentage increase or decrease in sales on earnings before interest and taxes.

Financial Leverage:

It indicates the firm’s ability to use fixed financial charges to magnify the effects of changes
in EBIT on the firm’s EPS. It indicates the extent to which the Earnings Per Share (EPS) will be
affected with the change in Earnings Before Interest and Tax (EBIT). It is computed as:

Financial leverage = EBIT/ EBT

Where, EBIT = Earnings before interest and tax
EBT = EBIT - I , i.e. Earning before tax I = Interest and Preference dividend
Indications:

A high degree of financial leverage indicates high use of fixed income bearings securities in
the capital structure of the company. A low degree of financial leverage indicates less use of
fixed income bearing securities in the capital structure of the company.

Combined Leverage:

The combined effect of operating leverage and financial leverage measures the impact
of charge in contribution on EPS.

It is computed as:

Operating Leverage X Financial Leverage

= (Sales - Variable Cost/ EBIT) X (EBIT /EBIT – Interest)

The indications given by the combined effect of operating and financial leverages may be
studied under the following possible situations:
1. High Operating Leverage, High Financial Leverage:

It indicates a very risky situation as a slight decrease in sales and/or contribution may affect
the EPS to a very great extent. As far as possible, this situation should be avoided.

2. High Operating Leverage, Low Financial Leverage:

It indicates that a slight decrease in sales and/or contribution may affect EBIT largely due to
existence of high fixed cost but this possibility is already taken care of by low proportion of
debt capital in the overall capital structure.

3. Low Operating Leverage, High Financial Leverage:

It indicates that the decrease in sales/contribution will not affect EBIT greatly as the
component of fixed cost is negligible in the overall cost structure. As such, the company has
accepted the risk of borrowing more debt capital in order to increase EPS to the maximum
possible extent. This may be an ideal situation.

4. Low Operating Leverage, Low Financial Leverage:

It indicates that the decrease in sales/contribution will not affect EBIT largely as the
component of fixed cost is negligible in the overall cost structure. But still, the company has
not accepted the risk of having a large
component of debt capital in its capital structure. It may indicate a very cautious policy
followed (unnecessarily) by the management, as it will not maximise the shareholders’
wealth. At the same time, it may also indicate that the company is not utilising its borrowing
capacity properly and fully.

Solved Example

1. Calculate three leverages from the following information

Sales 60000
Variable Cost 28000
Interest 6000
Fixed cost 19000

Sales= 60000
-VC= 28000
=Contribution= 32000
-FC 19000
=EBIT 13000
 -interest 6000
=EBT 7000

OPL= 32000/13000=2.46
FL = 13000/7000=1.85
Combined L = 2.46*1.85=4.55

Summary

• The term leverage indicates the ability of a firm to earn higher return by employing
fixed assets or debt.

• In financial analysis, leverage represents the influence of one financial variable over
some other related financial variable. These financial variables may be costs, output,
sales revenue, Earning Before Interest and Tax (EBIT), Earning Per Share (EPS) etc.

• There are three commonly used measures of leverage in financial analysis:

o Operating Leverage: Operating leverage is defined as the firm’s ability to use

fixed operating costs to magnify effects of changes in sales on its earnings
before interest and taxes.
o Financial leverage: Financial Leverage is defined as the ability of a firm to use
fixed financial charges to magnify the effects of changes in EBIT /Operating
profits, on the firm’s earning per share.
o Combined Leverage: Combined leverage measures the effect of a % change in
Sales on % change in EPS.

Self-Assessment Question

1. Which of the following is not commonly used measures of leverage in financial analysis?

a) Operating Leverage
b) Financial Leverage
c) Combined Leverage
d) Matrix Leverage
2. ______is the ratio of net operating income before fixed charges to net operating income
after fixed charges.
a) Financial Leverage
b) Operating Leverage
c) Operation Leverage
d) Fiscal Leverage

3) The formula for combined leverage is

a) Financial Leverage X Operating Leverage
b) Financial Leverage + Operating Leverage
c) Financial Leverage / Operating Leverage
d) Financial Leverage - Operating Leverage

4) Operating leverage measures the effect of change in sales quantity on

a) earnings after tax
b) earnings before taxes
c) earnings before interest and taxes
d) Earnings per share

5) The contribution is computed as

a) Sales revenue less cost of capital
b) Sales revenue less variable operating cost
c) Sales revenue less fixed operating cost
d) Sales revenue plus variable operating cost

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____________________________________________________________________

Notes
Program Name: MBA

Course Name: Corporate Finance Sem: IV

Unit Number – II Unit Name: Time Value of Money

Topic Name – Mathematics of loan

 Mathematics of loan

Introduction

Loan

A loan is a form of debt incurred by an individual or other entity. The lender usually a
corporation, financial institution, or government advances a sum of money to the borrower.
In return, the borrower agrees to a certain set of terms including any finance charges, interest,
repayment date, and other conditions.

A loan is a sum of money that one or more individuals or companies borrow from banks or
other financial institutions to financially manage planned or unplanned events. In doing so,
the borrower incurs a debt, which he must pay back with interest and within a given period.

Money (or property) given with the promise that it will be paid back in the future, usually with
interest. In this example Alex borrows Rs. 1,000, and has to pay back Rs. 1,100 next year.

Loan with Discount

a type of loan, usually given for a short period, in which the person who borrows money gets
an amount that is already reduced by the interest and other charges: Discount loans charge
interest on money that the borrower never gets

Imagine you wanted to borrow Rs. 20,000 and pay back twelve months later. The interest and
charges came to Rs. 2,000. You would receive Rs. 18,000 from the lender. However, you would
still have to pay back the whole Rs. 20,000.

Interest rates on discount loans tend to be higher than those on other types of loans.

With a discount loan the lender calculates the interest and other related charges and
discounts them from the face amount before lending to the borrower. However, the borrower
must pay back the whole amount – the principal, the related charges, and the interest.
Interest is what the borrower has to pay on top of the principal when he or she takes out a
loan. Discount loans are typically issued for people who seek a short-term loan. For the
schedule of payments, the lender divides the total by the number of months the arrangement
will last. However, in most cases, the loan is paid back in one lump sum.
Loan with interest

Interest is the price you pay for borrowing money from a lender. That means, when paying
back the loan, you'll pay the amount you borrowed plus an additional sum — which is the
interest.

The interest rate is the amount charged on top of the principal by a lender to a borrower for
the use of assets. An interest rate also applies to the amount earned at a bank or credit
union from a deposit account.

Interest rates thus apply to most lending or borrowing transactions. Individuals borrow
money to purchase homes, fund projects, launch or fund businesses, or pay for college tuition.
Businesses take out loans to fund capital projects and expand their operations by purchasing
fixed and long-term assets such as land, buildings, and machinery. Borrowed money is repaid
either in a lump sum by a pre-determined date or in periodic instalments.

For loans, the interest rate is applied to the principal, which is the amount of the loan. The
interest rate is the cost of debt for the borrower and the rate of return for the lender. The
money to be repaid is usually more than the borrowed amount since lenders require
compensation for the loss of use of the money during the loan period. The lender could have
invested the funds during that period instead of providing a loan, which would have
generated income from the asset. The difference between the total repayment sum and the
original loan is the interest charged.

When the borrower is low risk by the lender, the borrower will usually be charged a lower
interest rate. If the borrower is considered high risk, the interest rate that they are charged
will be higher, which results in a higher cost loan.

Simple Interest Rate

Simple interest is an interest charge that borrowers pay lenders for a loan. It is calculated
using the principal only and does not include compounding interest. Simple interest relates
not just to certain loans. It's also the type of interest that banks pay customers on their
savings accounts.

The formula to determine simple interest is an easy one. Just multiply the loan's principal
amount by the annual interest rate by the term of the loan in years.
The formula for simple interest is straightforward:

Simple Interest=P× r ×n

where:

P=Principal

r=Interest rate

n=Term of loan, in years

If you take out a ₹300,000 loan from the bank and the loan agreement stipulates that the
interest rate on the loan is 4% simple interest, this means that you will have to pay the bank
the original loan amount of ₹300,000 + (4% x ₹300,000) = ₹300,000 + ₹12,000 = ₹ 312,000.

Simple interest usually applies to automobile loans or short-term personal loans.

Compound Interest

Compound interest is the interest on savings calculated on both the initial principal and the
accumulated interest from previous periods.

"Interest on interest," or the power of compound interest, will make a sum grow faster
than simple interest, which is calculated only on the principal amount. Compounding
multiplies money at an accelerated rate. The greater the number of compounding periods,
the greater the compound interest will be. Compound interest can help your investments but
make debt more difficult.

The interest owed when compounding is higher than the interest owed using the simple
interest method. The interest is charged monthly on the principal including accrued interest
from the previous months. For shorter time frames, the calculation of interest will be similar
for both methods. As the lending time increases, however, the disparity between the two
types of interest calculations grows.

The following formula can be used to calculate compound interest:

Compound interest = p X [(1 + interest rate) n − 1]

where:
p = principal
n = number of compounding periods

As an example, take a 3-year loan of ₹ 10,000 at an interest rate of 5%, compounding

annually. What would be the amount of interest? In this case, it would be:

₹10,000 [(1 + 0.05)3 – 1] =₹10,000 [1.157625 – 1] = ₹1,576.25

Loan Amortized

An amortized loan is a type of loan with scheduled, periodic payments that are applied to
both the loan's principal amount and the interest accrued. An amortized loan payment first
pays off the relevant interest expense for the period, after which the remainder of the
payment is put toward reducing the principal amount. Common amortized loans include auto
loans, home loans, and personal loans from a bank for small projects or debt consolidation.

An amortized loan is a form of financing that is paid off over a set period of time. Under this
type of repayment structure, the borrower makes the same payment throughout the loan
term, with the first portion of the payment going toward interest and the remaining amount
paid against the outstanding loan principal. More of each payment goes toward principal and
less toward interest until the loan is paid off.

Loan amortization determines the minimum monthly payment, but an amortized loan does
not preclude the borrower from making additional payments. Any amount paid beyond the
minimum monthly debt service typically goes toward paying down the loan principal. This
helps the borrower save on total interest over the life of the loan.

• To calculate the monthly payment on an amortized loan, follow this equation:

where

• p: the total amount of the loan

• r: the monthly interest rate (annual rate / number of payments per year)
 • n: the total number of payments (number of payment per year x length of loan in
years)

Consider a ₹15,000 auto loan extended at a 6% interest rate and amortized over two
years. The calculation would be as follows:
• ₹ 15,000 / {[(1+0.005)24]-1} / [0.005(1+0.005)24]
• = ₹664.81 per month
With an amortized loan, principal payments are spread out over the life of the loan. This
means that each monthly payment the borrower makes is split between interest and the loan
principal. Because the borrower is paying interest and principal during the loan term, monthly
payments on an amortized loan are higher than for an unamortized loan of the same amount
and interest rate.

Summary

• A loan is a form of debt incurred by an individual or other entity.

• Discount loans charge interest on money that the borrower never gets
• Interest is the price you pay for borrowing money from a lender. There two types of
interest – Simple interest, compound interest
• Loan amortization breaks a loan balance into a schedule of equal repayments based
on a specific loan amount, loan term and interest rate. This loan amortization schedule
lets borrowers see how much interest and principal they will pay as part of each
monthly payment—as well as the outstanding balance after each payment.

Self-Assessment question

1. Loan with discounts are

a) Cheaper
b) Costlier
c) Can not comment
d) None of the above
2. An amortization payment is made up of what two parts?

a) Interest and Principal

b) Interest and Payment Amount
c) Payment amount and Principal
d) Percent and Interest

3. Kabir paid Rs. 9600 as interest on a loan he took 5 years ago at 16% rate of simple interest.
What was the amount he took as loan?
a) Rs.16400
b) Rs. 12000
c) Rs. 12500
d) Rs. 18000

4. Suresh for 2 years invested Rs. 500 in SBI. He also invested Rs. 300 in ICICI for 4 years. At
the end he received Rs. 220 from both banks as simple interest. What must have been rate
of interest?

a) 10%
b) 12%
c) 11%
d) 5.5%

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_____________________________________________________________________

Notes
Program Name: MBA

Course Name: Corporate Finance Sem: IV

Unit Number – I Unit Name: Financial Goals of the Firm

Topic Name – Responsibilities of Finance Manager

 Responsibilities of Finance Manager

Organization of Finance Function

At the outset, it must be cleared that there is no standard pattern for the organisation of
finance function. It varies from enterprise to enterprise and its characteristics vary in terms
of nature, size, convention etc. In smaller concerns, where the operations are relatively less
complicated and simple, there may not be a separate executive to look after the finance
function. In fact, the proprietor or partners only will be looking after all the functional areas
like production, marketing, finance etc.

In bigger concerns, the execution of finance function becomes a specialised task and may be
handled by an executive who may be the Treasurer, Finance Controller, Finance Manager,
Vice-President (Finance) and so on. He is generally given the charge of credit and collection
accounting, investment and audit departments. He is responsible for preparing annual
financial reports. He reports directly to the President and Board of Directors.

Finance Manager

• The Finance Executive includes any executive role that is responsible for managing
the financial performance of the company.

• This role might include C-level and Senior Vice President-level executives

Responsibilities of Finance Manager:

There are various major responsibilities carried by Finance Executive that contributes for
smooth functioning of organization. Following are the responsibilities of finance executives.
These executive functions of are explained below.

Estimating capital requirements: The company must estimate its capital requirements
(needs) very carefully. This must be done at the promotion stage. The company must estimate
its fixed capital needs and working capital need. If not, the company will become over-
capitalized or under-capitalized.

Determining capital structure: Capital structure is the ratio between owned capital and
borrowed capital. There must be a balance between owned capital and borrowed capital. If
the company has too much owned capital, then the shareholders will get fewer dividends.
Whereas, if the company has too much of borrowed capital, it has to pay a lot of interest. It
also has to repay the borrowed capital after some time. So, the finance managers must
prepare a balanced capital structure.

Estimating cash flow: Cash flow refers to the cash which comes in and the cash which goes
out of the business. The cash comes in mostly from sales. The cash goes out for business
expenses. So, the finance manager must estimate the future sales of the business. This is
called Sales forecasting. He also has to estimate the future business expenses.

Investment Decisions: The business gets cash, mainly from sales. It also gets cash from other
sources. It gets long-term cash from equity shares, debentures, term loans from financial
institutions, etc. It gets short-term loans from banks, fixed deposits, dealer deposits, etc. The
finance manager must invest the cash properly. Long-term cash must be used for purchasing
fixed assets. Short-term cash must be used as a working capital.
Allocation of surplus: Surplus means profits earned by the company. When the company has
a surplus, it has three options, viz.,

It can pay dividend to shareholders.

It can save the surplus. That is, it can have retained earnings.

It can give bonus to the employees.

Deciding additional finance: Sometimes, a company needs additional finance for

modernization, expansion, diversification, etc. The finance manager has to decide on
following questions.

• When the additional finance will be needed?

• For how long will this finance be needed?
• From which sources to collect this finance?
• How to repay this finance?

Additional finance can be collected from shares, debentures, loans from financial institutions,
fixed deposits from public, etc.

Negotiating for additional finance: The finance manager has to negotiate for additional
finance. That is, he has to speak to many bank managers. He has to persuade and convince
them to give loans to his company. There are two types of loans, viz., short-term loans and
long-term loans. It is easy to get short-term loans from banks. However, it is very difficult to
get long-term loans.

Checking the financial performance: The finance manager has to check the financial
performance of the company. This is a very important finance function. It must be done
regularly. This will improve the financial performance of the company. Investors will invest
their money in the company only if the financial performance is good. The finance manager
must compare the financial performance of the company with the established standards. He
must find ways for improving the financial performance of the company.

The routine functions are also called as Incidental Functions.

Duties of Finance Executive

The duties of finance executive are divided in to Recurring and Non-recurring Duties
 • Recurring Duties

Deciding the Financial Needs: In case of a newly started or growing concern, the basic duty
of the finance executive is to prepare the financial plan for the company. Financial plan
decides in advance the quantum of funds required, their duration, etc. The funds may be
needed by the company for initial promotional expenditure, fixed capital, working capital or
for dividend distribution. The finance executive should assess this need of funds properly.

Raising the Funds Required: The finance executive has to choose the sources of funds to fulfill
financial needs. The sources may be in the form of issue of shares, debentures, borrowing
from financial institutions or general public, lease financing etc. The finance executive has
also to decide the proportion in which the various sources should be raised. For this, he may
have to keep in mind basic three principles of cost, risk and control.

Allocation of Funds: The financial executive has to ensure proper allocation of funds. He has
to decide in which fixed assets the company should invest the funds. He has to ensure that
the fixed assets acquired or to be acquired satisfy the present as well as future needs of the
company. The finance executive has to ensure that sufficient funds are made available for
investing in current assets, as it is the lifeblood of the business activity. Non-availability of
funds to invest in current assets in the form of say cash, receivable, inventory etc. may halt
the business operations

• Non-recurring Duties

The non-recurring duties of the finance executive may involve preparation of financial plan at
the time of company promotion, financial readjustments in times of liquidity crisis, valuation
of the enterprise at the time of acquisition and merger thereof etc.

SUMMARY

• The Finance Executive includes any executive role that is responsible for managing the
financial performance of the company

• Finance Executives plays an important role in performing function of financial

management
 • Some of the duties of finance executive consist of assessing the funds requirement for
the business activity, procurement of funds, allocation of funds, allocation of income
and control of funds.

• They perform recurring and nonrecurring duties like financial plan, financial
readjustments and valuation of the enterprise

Self- Assessment Question

1. Which of the following is not the responsibility of Finance Manager?

a) Credit Management
b) Brand dimension
c) Arrangement of funds
d) using means of financial resources for financial activities

2. Which of the following is non-recurring duty of Finance Manager?

a) Deciding the Financial Needs
b) Raising the Funds Required
c) Allocation of Funds
d) Preparing Financial Plan

3. Finance executives has to make sure the maintenance of liquidity.

a) True
b) False

4. Finance Executives perform recurring duties only.

a) True
b) False

5. One of the recurring duties of a finance Manager is

a) Evaluation of performance
b) Liquidity crisis management
c) Valuation of the company
d) company promotion

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_____________________________________________________________________

Notes
Program Name: MBA

Course Name: Corporate Finance Sem: IV

Unit Number – III Unit Name: Investment Decisions

Topic Name – Risk Analysis in Capital Budgeting

 Risk Analysis in Capital Budgeting

INTRODUCTION

Capital budgeting and Risk

Uncertainties can exist when the outcome of an event is not known for certain, and when
dealing with assets whose cash flows are expected to extend beyond one year, certainly,
there’s element of risk in that situation. The evaluation of risk therefore depends, on decision
maker ability to identify and understand the nature of uncertainty surrounding the key
variables and on the other, having the tools and methodology to process its risk implications

Risk analysis gives management better information about the possible outcomes that may
occur so that management can use their judgment and experience to accept an investment
or reject it. Since risk analysis is costly, it should be used relatively in costly and important
projects. Risk and uncertainty are quite inherent in capital budgeting decisions. This is so
because investment decisions and capital budgeting are actions of today which bear fruits in
future which is unforeseen. Future is uncertain and involves risk.

The projection of probability of cash inflows made today is not certain to be achieved during
future. Seasonal fluctuations and business cycles both deliver heavy impact upon the cash
inflows and outflows projected for different project proposals. The cost of capital which offers
cut-off rates may also be inflated or deflated under business cycle conditions. Inflation and
deflation are bound to affect the investment decision in future period rendering the degree
of uncertainty more severe and enhancing the scope of risk. Technological developments are
other factors that enhance the degree of risk and uncertainty by rendering the plants or
equipment’s obsolete and the product out of date. Tie up in the procurement in quantity
and/or the marketing of products may at times fail and frustrate a business unless possible
alternative strategies are kept in view. All these circumstances combined affect capital
budgeting decisions. It is therefore necessary to allow discounting factor to cover risk

Sensitivity Analysis

Sensitivity analysis helps a business estimate what will happen to the project if the
assumptions and estimates turn out to be unreliable. Sensitivity analysis involves changing the
assumptions or estimates in a calculation to see the impact on the project's finances. In this
way, it prepares the business's managers in case the project doesn't generate the expected
results, so they can better analyze the project before making an investment.

Calculation

In capital budgeting calculations, sensitivity analysis changes one assumption or estimate at a

time to see how the results change. For example, a business may expect to earn ₹500, ₹1,000,
and ₹1,000 in the first three years of a project. If the business makes an initial investment of
₹2,500, it will recoup its expenses in three years. However, the project may perform better
than expected, generating ₹2,000 yearly in its second and third year. The business will then
break even in two years.

Certainty Equivalent Approach

Certainty Equivalent Factor (CEF) is the ratio of assured cash flows to uncertain cash flows.
under this approach, the cash flows expected in a project are converted into risk-less
equivalent amount. The adjustment factor used is called CEF. This varies between 0 and 1. A
co-efficient of 1 indicates that cash flows are certain. The greater the risk in cash flow, the
smaller will be CEF ‘for receipts’, and larger will be the CEF ‘for payments’. While employing
this method, the decision maker estimates the sum he must be assured of receiving, in order
that he is indifferent between an assured sum and expected value of a risky sum.

Method of Computation under CE approach:

Step 1: Convert uncertain cash flows to certain cash flows by multiplying it with the CEF.

Step 2: Discount the certain cash flows at the risk free rate to arrive at NPV.

Decision Rule: If the resultant NPV is positive project can be accepted.

Illustration: NZ ltd. is considering to take a new project. The management of the company use
Certainty Equivalent (CE) approach to evaluate such type of projects.

Following information is available for the project:

Year CFAT CEF

 1 1,15,000 .90

2 1,15,000 .85

3 1,15,000 .75

4 1,15,000 .70
5 1,15,000 .65
Projects requires initial investment of ` 3,00,000. The Company’s cost of capital is 12% and risk
free borrowing rate is 7%. Advise the company whether it should take project or not?

Solution

Adjusted Present
Year CFAT CEF PV factor
CFAT Value

1 1,15,000 .90 103500 .935 96772

2 1,15,000 .85 97750 .873 85336

3 1,15,000 .75 86250 .816 70380

4 1,15,000 .70 80500 .763 61422

5 1,15,000 .65 74750 .713 53297

• Total Present Value 3,67,207 (-) Initial Investment (3,00,000)

• Net present value 67,207
• Since NPV is positive, project can be accepted.

Probability

the concept of probability is fundamental to the use of the risk analysis techniques. it may be
defined as the likelihood of occurrence of an event. if an event is certain to occur, the
probability of its occurrence is one but if an event is certain not to occur, the probability of its
occurrence is zero. thus, probability of all events to occur lies between zero and one.
probability distribution can be used to compute expected values.

For this purpose following procedure is adopted:

step 1: establish probability distribution

step 2: Multiply values with probability of each outcome

step 3: aggregate the result of step 2

Illustration: X ltd. is considering to start a new project for which it has gathered following data:
Cash flow Probability

30,0000 .1

60,0000 .4

1,20,0000 .4

1,50,0000 .1

Calculate the expected cash flow.

Solution:

Cash flow probability expected Cash flow

3,0000 .1 300

6,0000 .4 2,400

12,0000 .4 4,800

15,0000 .1 1,500

CF =9,000
Summary

• Capital budgeting involves analysing long term investment projects for the
organization. The process through which different projects are evaluated is known as
capital budgeting.

• Risk and uncertainty are quite inherent in capital budgeting decisions. This is so
because investment decisions and capital budgeting are actions of today which bear
fruits in future which is unforeseen.

• Risk analysis gives management better information about the possible outcomes that
may occur so that management can use their judgment and experience to accept an
investment or reject it.

• In capital budgeting, sensitivity analysis changes one assumption or estimate at a time

to see how the results change, the cash flows expected in a project are converted into
risk-less equivalent amount using CEF

Self -Assessment Question

1. Which of the Capital Budgeting technique does not consider the risk?
a) Pay-Back Period
b) Sensitivity Analysis
c) CEA
d) Standard Deviation

2. Which of the following is true for an investment proposal with the most significant
relative risk?
a) It will have the lowest opportunity loss
b) It will have the highest expected net present value
c) It will have the highest standard deviation of the net present value
d) It will have the highest coefficient of variation of the net present value
3. Risk in Capital budgeting implies that the decision-maker knows___________of the cash
flows.
a) Variability
b) Probability
c) Certainty
d) None of the above

4. In Certainty-equivalent approach, adjusted cash flows are discounted at:

a) Accounting Rate of Return
b) Internal Rate of Return
c) Hurdle Rate
d) Risk-free Rate

5. Which of the following is a risk factor in capital budgeting?

a) Industry specific risk factors
b) Competition risk factors
c) Project specific risk factors
d) All of the above

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_____________________________________________________________________

Notes
Program Name: MBA

Course Name: Corporate Finance Sem: IV

Unit Number – IV Unit Name: Financing Decisions

Topic Name – Theories of Capital Structure

 Theories of Capital Structure

Introduction

Capital structure refers to the mix of sources from which the long-term funds required by a
business are raised, i.e., what should be the proportion of equity share capital, preference
share capital, internal sources, debentures and other sources of funds in the total amount of
capital which an undertaking may raise for establishing its business.

Theories of Capital Structure:

A business requires the most beneficial capital structure. So, many capital structure theories
are available to take as a reference; amongst them, we will discuss the four most essential
ones:

We will classify these views in the form of the following four theories
of capital structure.
(a) Net Income Approach
(b) Net Operating Income Approach Traditional Approach
(d) Modigliani - Miller Approach

For this purpose, following assumptions have been made:

1. Firms use only long-term debt capital or equity share capital to raise funds.
2. Corporate Income Tax does not exist.
3. Firms follow policy of paying 100% of its earnings by way of dividend.
4. Operating earnings are not expected to grow.

Following definitions and symbols are also used.

S = Market Value of equity shares
B = Market Value of debt
V = Total Market Value of firm
NOI = Net Operating Income i.e. EBIT
I = Total Interest Payments
NI = Net Income available to equity shareholders.
i.e. EBIT - I = EBT
Overall cost of capital = EBIT
V
a) Net Income Approach:
According to this approach as proposed by Durand, there exists a direct relationship between
the capital structure and valuation of the firm and cost of capital. By the introduction of
additional debt capital in the capital structure, the valuation of the firm can be increased and
cost of capital can be reduced and vice versa.
As per NI Approach:
• Kd and Ke will remain constant.
• Ko will decrease with the help of use of Debt.
• MV of Equity and Firm will increase with the help of use of Debt.

b) Net Operating Income Approach:

According to this approach, also proposed by Durand, the valuation of the firm and its cost of
capital are independent of its capital structure. Any change in the capital structure does not
affect the value of the firm or cost of capital, though the further introduction of debt capital
may increase equity capitalisation rate and vice versa.
As per NOI Approach:
• Kd, Ko and MV of Firm will remain constant in case of without tax structure.
• Kd will remain constant in case of with tax structure, with the increase in
Debt, MV of firm will increase and Ko will decrease
c) Traditional Approach:
This is the mean between two extreme approaches of net income approach on one hand and
net operating income on another. It believes the existence of what may be called ‘Optimal
Capital Structure’. It believes that up to a certain point, additional introduction of debt capital,
despite increase in cost of debt capital and equity capitalisation rate individually, the overall
cost of capital will reduce and total value of the firm will increase. Beyond firm will tend to
reduce. Thus, for the judicious mix of debt and equity capital, it is possible for the firm to
minimise overall cost of capital and maximise total value of the firm. Such a capital structure
where overall cost of capital is minimum and total value of the firm is maximum is called
‘Optimal Capital Structure’.

As per Traditional Approach:

• Kd, Ke, Ko and MV of Equity and MV of Firm are variable
• Company has to select capital structure with lowest Ko or highest MV of Firm
 (a) The cost of debt capital, Kd, remains constant more or less up to a certain level and
thereafter rises.
(b) The cost of equity capital Ke, remains constant more or less or rises gradually up to a
certain level and thereafter increases rapidly.
(c) The average cost of capital, Kw, decreases up to a certain level remains unchanged
more or less and thereafter rises after attaining a certain level.

d) Modigliani - Miller (MM) Approach:

This approach closely resembles net operating income approach. According to this approach,
value of the firm and its cost of capital are independent of its capital structure. It argues, that
overall cost of capital is the weighted average of cost of debt capital and cost of equity capital.
Cost of equity capital depends upon shareholders’ expectations. Now, if shareholders expect
10% from a certain company, they already take into consideration debt capital in the capital
structure. For every increase in debt capital the expectations of the shareholders also increase
as in the eyes of shareholders, risk in the company also increases. Thus, each change in the
mix of debt capital and equity capital is automatically offset by change in the expectations of
the shareholders, which in turn is attributable to change in risk element. As such, they argue
that, leverage i.e. mix in debt capital and equity capital, has nothing to do with overall cost of
capital and overall cost of capital is equal to the capitalisation rate of pure equity stream of a
risk class. Hence, leverage has no impact on share market prices or cost of
capital.

Summary

• Capital Structure refers to the mix of sources from where the long-term funds required
in a business may be raised.
• Capital Structure theories describe the relationship between cost of capital, capital
structure and value of firm.

• The theories are based on many assumption

• Major theories are NI and NOI approach, other two are based on these two theories

• The capital structure theories use the following assumptions for simplicity: 1) The
firm uses only two sources of funds: debt and equity. 2) The effects of taxes are
 ignored. 3) There is no change in investment decisions or in the firm's total assets. 4)
No income is retained.

Self-Assessment Question
1. The Modigliani-Miller theorem is disregarded by economists because
a) It is outdated
b) It is unrealistic and euphoric
c) It has been conclusively proven wrong
d) All the above
2. Traditional Approach is_______.
a) Similar to NOI approach
b) Similar to NI approach
c) Intermediate of NI and NOI
d) None of these
3. Which of these is a theory of capital structure?
a) Net Income
b) Modigliani-Miller Theorem
c) Net Operating Income
d) All of the Above

4. A critical assumption of the net operating income (NOI) approach to valuation is that:
a) Debt and equity levels remain unchanged.
b) Dividends increase at a constant rate.
c) Ko remains constant regardless of changes in leverage.
d) Interest expense and taxes are included in the calculation.

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_____________________________________________________________________

Notes
Program Name: MBA

Course Name: Corporate Finance Sem: IV

Unit Number – V Unit Name: Dividend Decisions

Topic Name – Theories of Dividend

 Theories of Dividend

Introduction

Dividend

Dividend refers to that portion of profit which is distributed among the owners or
shareholders of the firm.

A dividend’s value is determined on a per-share basis and is to be paid equally to all

shareholders The finance manager must take few decisions which are inter related like
investment, financing, and dividend decisions. Dividend decision is related to the
shareholder’s share in the profits of the company

Dividend Theory

The firm should pay dividend if the payment will lead to the maximisation of the wealth of
the owners and if not, then the firm should retain profits to finance investment programmes.

The relationship between dividends and value of the firm should, therefore, be the decision
criterion.

There are conflicting opinions regarding the impact of dividends on the valuation of a firm.

According to one school of thought, dividends are irrelevant so that the amount of dividend
paid has no effect on the valuation of a firm. (IRRELEVANCE THEORY)

On the other hand, certain theories consider the dividend decision as relevant to the value of
the firm measured in terms of the market price of the shares. (RELEVANCE THEORY)

Some of the major different theories of dividend in financial management are as follows: 1.
Walter’s model 2. Gordon’s model 3. Modigliani and Miller’s hypothesis.

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.

Walter’s model is based on the following assumptions:

1. The firm finances all investment through retained earnings; that is debt or new equity is
not issued;

2. The firm’s internal rate of return (r), and its cost of capital (k) are constant;

3. All earnings are either distributed as dividend or reinvested internally immediately.

4. Beginning earnings and dividends never change. The values of the earnings pershare (E),
and the divided per share (D) may be changed in the model to determine results, but any
given values of E and D are assumed to remain constant forever in determining a given value.

5. The firm has a very long or infinite life.

Walter’s formula to determine the market price per share (P) is as follows:

P = D/K +r(E-D)/K/K

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

ii) The present value of the infinite stream of stream gains.

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. Walter’s model is based on the assumption that r is constant. In fact decreases as more
investment occurs. This reflects the assumption that the most profitable investments are
made first and then the poorer investments are made. The firm should step at a point where
r = k. This is clearly an erroneous policy and fall to optimise the wealth of the owners.

3. A firm’s cost of capital or discount rate, K, does not remain constant; it changes directly
with the firm’s risk. Thus, the present value of the firm’s income moves inversely with the cost
of capital. By assuming that the discount rate, K is constant, Walter’s model abstracts from
the effect of risk on the value of the firm.

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.

1. The firm is an all-Equity firm
2. No external financing is available
3. The internal rate of return (r) of the firm is constant.
4. The appropriate discount rate (K) of the firm remains constant.
5. The firm and its stream of earnings are perpetual
6. The corporate taxes do not exist.
7. The retention ratio (b), once decided upon, is constant. Thus, the growth rate (g) = br is
constant forever.

8. K > br = g if this condition is not fulfilled, we cannot get a meaningful value for the share.

According to Gordon’s dividend capitalisation model, the market value of a share (Pq) is equal
to the present value of an infinite stream of dividends to be received by the share. Thus:
Gordon's Model

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).

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.

1. The firm operates in perfect capital market

2. Taxes do not exist

3. The firm has a fixed investment policy

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:

Multiplying both sides of equation by the number of shares outstanding (n), we obtain the
value of the firm if no new financing exists.

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

The above equation of M – M valuation allows for the issuance of new shares, unlike Walter’s
and Gordon’s models. Consequently, a firm can pay dividends and raise funds to undertake
the optimum investment policy. Thus, dividend and investment policies are not confounded
in M – M model, like waiter’s and Gordon’s models.

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.

1.The assumption that taxes do not exist is far from reality.

2. M-M argue that the internal and external financing are equivalent. This cannot be true if
the costs of floating new issues exist.

3. According to M-M’s hypothesis the wealth of a shareholder will be same whether the firm
pays dividends or not. But, because of the transactions costs and inconvenience associated
with the sale of shares to realise capital gains, shareholders prefer dividends to capital gains.

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.

5. M-M argues that, even if the assumption of perfect certainty is dropped and uncertainty is
considered, dividend policy continues to be irrelevant. But according to number of writers,
dividends are relevant under conditions of uncertainty.

Summary

• The firm should pay dividend if the payment will lead to the maximisation of
the wealth of the owners and if not then the firm should retain profits to
finance investment programmes. The relationship between dividends and
value of the firm should, therefore, be the decision criterion.
• There are conflicting opinions regarding the impact of dividends on the
valuation of a firm. According to one school of thought, dividends are
irrelevant so that the amount of dividend paid has no effect on the valuation
of a firm. (IRRELEVANCE THEORY)
• On the other hand certain theories consider the dividend decision as relevant
to the value of the firm measured in terms of the market price of the shares.
(RELEVANCE THEORY)
 Self-Assessment Question

1. Irrelevant approach of dividend is propounded by:

a) Gordon
b) Modigliani and Miller
c) Walter
d) None of the above
2. Myron Gordon believe that the required return on equity increases as the dividend
payout ratio is decreased. Their argument assumes that

a) Investors are indifferent between dividends and capital gains.

b) Investors require that the dividend yield and capital gains yield equal a constant.
c) Capital gains are taxed at a higher rate than dividends.
d) Investors view dividends as being less risky than potential future capital gains.

3. In retention growth model, percent of net income firms usually pay out as shareholders
dividends, is classified as –
a. Payout ratio
b. Payback ratio
c. Growth retention ratio
d. Present value of ratio

4. Which of the following is an argument for the relevance of dividends?

a) Informational content.
b) Reduction of uncertainty.
c) Some investor’s preference for current income.
d) All of the above.

5. As per Modigliani-Miller hypothesis of dividend irrelevance price of share at year zero is

a) D0 + P0/1 + Ke
b) (D1 + P1)× (1 + Ke)
c) D1 + P/1+Ke
d) 1-(D0 + P0)÷Ke

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_____________________________________________________________________

Notes
Program Name: MBA

Course Name: Corporate Finance Sem: IV

Unit Number – II Unit Name: Time Value of Money

Topic Name – Introduction to time value of money

 Introduction to time value of money

Introduction

The time value of money is a basic financial concept that holds that money in the present is
worth more than the same sum of money to be received in the future. This is true because
money that you have right now can be invested and earn a return, thus creating a larger
amount of money in the future. (Also, with future money, there is the additional risk that the
money may never actually be received, for one reason or another). The time value of money
is sometimes referred to as the net present value (NPV) of money.

• The time value of money is a basic financial concept that holds that money in the
present is worth more than the same sum of money to be received in the future.

• money that you have right now can be invested and earn a return, thus creating a
larger amount of money in the future.

How the Time Value of Money Works

A simple example can be used to show the time value of money. Assume that someone offers
to pay you one of two ways for some work you are doing for them: They will either pay you
$1,000 now or $1,100 one year from now.

Which pay option should you take? It depends on what kind of investment return you can
earn on the money at the present time. Since $1,100 is 110% of $1,000, then if you believe
you can make more than a 10% return on the money by investing it over the next year, you
should opt to take the $1,000 now.

On the other hand, if you do not think you could earn more than 9% in the next year by
investing the money, then you should take the future payment of $1,100 – as long as you trust
the person to pay you then.

Future Value

The time value of money is an important concept not just for individuals, but also for making
business decisions. Companies consider the time value of money in making decisions about
investing in new product development, acquiring new business equipment or facilities, and
establishing credit terms for the sale of their products or services.

By future value (FV) we mean the amount of money an investment will grow to over some
period of time at some given interest rate. In other words, future value is the cash value of an
investment at some time in future.

A specific formula can be used for calculating the future value of money so that it can be
compared to the present value:

Time Value of Money Formula

Where:

FV = the future value of money

PV = the present value
i = the interest rate or other return that can be earned on the money
t = the number of years to take into consideration
n = the number of compounding periods of interest per year
Using the formula above, let us look at an example where you have $5,000 and can expect to
earn 5% interest on that sum each year for the next two years. Assuming the interest is only
compounded annually, the future value of your $5,000 today can be calculated as follows:

FV = $5,000 x (1 + (5% / 1) ^ (1 x 2)

= $5,512.50

Present Value of Future Money

The formula can also be used to calculate the present value of money to be received in the
future. You simply divide the future value rather than multiplying the present value. This can
be helpful in considering two varying present and future amounts.

In our original example, we considered the options of someone paying your $1,000 today
versus $1,100 a year from now. If you could earn 5% on investing the money now, and wanted
to know what present value would equal the future value of $1,100 – or how much money
you would need in hand now in order to have $1,100 a year from now – the formula would
be as follows:
PV = $1,100 / (1 + (5% / 1) ^ (1 x 1) = $1,047

The calculation above shows you that, with an available return of 5% annually, you would
need to receive $1,047 in the present to equal the future value of $1,100 to be received a
year from now.

The financial firms use this idea of TVM for the following purposes:

• It helps in comparing the investment alternatives available in the market. Investors

assess the returns and other conditions to make a final decision on what option to
choose.
• Investors choose the best investment proposals based on the evaluation, considering
the TVM.
• Lenders decide the interest rates for loans, mortgages, etc., based on the present and
future value of an amount.
• The value of money, when known, helps in fixing appropriate wages and prices of
products.

Perpetuity

An annuity is a stream of cash flows. A perpetuity is a type of annuity that lasts forever, into
perpetuity. The stream of cash flows continues for an infinite amount of time. In finance, a
person uses the perpetuity calculation in valuation methodologies to find the present value
of a company's cash flows when discounted back at a certain rate.

Meaning

A perpetuity is a security that pays for an infinite amount of time. In finance, perpetuity is a
constant stream of identical cash flows with no end.

The perpetuity an annuity in that there is no set maturity date for the investment. A
perpetuity is a series of cash flows that keep paying out forever. The perpetuity will keep
yielding returns infinitely, whereas an annuity will cease providing these dividends at a certain
point in the future.

Examples include businesses, real estate, and certain types of bonds.

A perpetuity, in finance, refers to a security that pays a never-ending cash stream. It is
essentially an annuity with no termination date.

The present value of a perpetuity is determined by simply dividing the amount of the regular
cash flows by the discount rate. A growing perpetuity includes a growth rate that increases
the cash flows received each period going forward. Perpetuities today are uncommon
financial products, but the concept of a perpetuity is nonetheless important in finance.

Perpetuity Present Value Formula

The formula to calculate the present value of a perpetuity, or security with perpetual cash
flows, is as follows:

PV= C/(1+r)1+C/(1+r)2… = C/r

where: PV=present value

c = cash flow

r = discount rate

The basic method used to calculate a perpetuity is to divide cash flows by some discount rate.
The formula used to calculate the terminal value in a stream of cash flows for valuation
purposes is a bit more complicated. It is the estimate of cash flows in year 10 of the company,
multiplied by one plus the company’s long-term growth rate, and then divided by the
difference between the cost of capital and the growth rate.

Simply put, the terminal value is some amount of cash flows divided by some discount rate,
which is the basic formula for a perpetuity.

Perpetuity Example

For example, if a company is projected to make $100,000 in year 10, and the company’s cost
of capital is 8%, with a long-term growth rate of 3%, the value of the perpetuity is as follows:

=$100,000×1.030.08−0.03=$103,0000.05=$2.06 million

This means that $100,000 paid into a perpetuity, assuming a 3% rate of growth with an 8%
cost of capital, is worth $2.06 million in 10 years. Now, a person must find the value of that
$2.06 million today. To do this, analysts use another formula referred to as the present value
of a perpetuity.

Summary

• TVM is the fundamental financial concept that revolves around the changing value of
money over time. It states how the present value of money is greater than its future
value. The value that money holds currently and in the future is assessed based on its
potential earning capacity.
• It is the potential earning capacity of the money that decides its current and future
value.
• TVM helps investors make the best investment decisions, knowing the future returns
they should expect from what they invest.

• A perpetuity is a series of cash flows that keep paying out for infinite period.

• A perpetuity, in finance, refers to a security that pays a never-ending cash stream. It

is essentially an annuity with no termination date.

• The present value of a perpetuity is determined by simply dividing the amount of the
regular cash flows by the discount rate. A growing perpetuity includes a growth rate
that increases the cash flows received each period going forward

Self-Assessment question
1. Time value of money indicates that
a) A unit of money obtained today is worth more than a unit of money obtained in
future
b) A unit of money obtained today is worth less than a unit of money obtained in
future
c) There is no difference in the value of money obtained today and tomorrow
d) None of the above
2. The present value of future earnings shall be greater than investment

a) True
b) False

3. Time value of money supports the comparison of cash flows recorded at different time
period by

a) Discounting all cash flows to a common point of time

b) Compounding all cash flows to a common point of time
c) Using either a or b
d) None of the above.

4. Interest paid (earned) on only the original principal borrowed (lent) is often referred to
as?
(a) Compound interest
(b) Future value
(c) Present value
(d) Simple interest

5. The value of money to be received in the future is _______the value of the same amount
of money in hand today?
(a) Higher than
(b) Lower than
(c) The same as
(d) None of the above

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_____________________________________________________________________

Notes
Program Name: MBA

Course Name: Corporate Finance Sem: IV

Unit Number – VI Unit Name: Working Capital Management

Topic Name – Working Capital Management - Introduction

 Working Capital Management - Introduction

MEANING OF WORKING CAPITAL

Capital of the concern may be divided into two major headings. Fixed capital means that
capital, which is used for long-term investment of the business concern. For example,
purchase of permanent assets. Normally it consists of non-recurring in nature. Working
Capital is another part of the capital which is needed for meeting day to day requirement of
the business concern. For example, payment to creditors, salary paid to workers, purchase of
raw materials etc., normally it consists of recurring in nature. It can be easily converted into
cash. Hence, it is also known as short-term capital.

DEFINITION OF WORKING CAPITAL

According to the definition of Weston and Brigham, “Working Capital refers to a firm’s
investment in short-term assets, cash, short-term securities, accounts receivables and
inventories”. According to the definition of Bonneville, “Any acquisition of funds which
increases the current assets, increase working capital also for they are one and the same”.
According to the definition of Shubin, “Working Capital is the amount of funds necessary to
cover the cost of operating the enterprises.”

CONCEPT OF WORKING CAPITAL

Working capital has two concepts:

(i) Gross working capital and (ii) Net working capital.

Gross Working Capital

Gross Working Capital is the general concept which determines the working capital concept.
Thus, the gross working capital is the capital invested in total current assets of the business
concern. Gross Working Capital is simply called as the total current assets of the concern.

Current assets are those which can be converted into cash within an accounting year (or
operating cycle) and include cash, short-term securities, debtors, (accounts receivable or book
debts) bills receivable and stock (inventory).
GWC = CA

GWC focuses on

• Optimization of investment in current

• Financing of current assets

Net Working Capital

Net Working Capital is the specific concept, which, considers both current assets and current
liability of the concern. Net Working Capital is the excess of current assets over the current
liability of the concern during a particular period. If the current assets exceed the current
liabilities it is said to be positive working capital; it is reverse, it is said to be Negative working
capital.

NWC = C A – CL

Current liabilities (CL) are those claims of outsiders which are expected to mature for payment
within an accounting year and include creditors (accounts payable), bills payable, and
outstanding expenses.

NWC can be positive or negative.

• Positive NWC = CA > CL

• Negative NWC = CA < CL

NWC focuses on

• Liquidity position of the firm

• Judicious mix of short-term and long-term financing

Types of Working Capital

1. Gross working capital – Refers to firms’ investments in current assets which are converted
in to cash during an accounting year such as cash, bank balance, short term investments,
debtors, bills receivable, inventory, short term loans and advances etc.
2. Net working capital – Refers to difference between current assets and current liabilities or
excess of total current assets over total current liabilities.

3. Permanent Working Capital- It is also known as Fixed Working Capital. It is the capital; the
business concern must always maintain certain amount of capital at minimum level. The level
of Permanent Capital depends upon the nature of the business. Permanent or Fixed Working
Capital will not change irrespective of time or volume of sales.

4. Temporary Working Capital- It is also known as variable working capital. It is the amount of
capital which is required to meet the Seasonal demands and some special purposes. It can be
further classified into Seasonal Working Capital and Special Working Capital. The capital
required to meet the seasonal needs of the business concern is called as Seasonal Working
Capital. The capital required to meet the special exigencies such as launching of extensive
marketing campaigns for conducting research, etc.

Determinants of Working Capital

Nature of business

Some businesses are such that due to their very nature, their requirement of fixed capital is
more rather than working capital. These businesses may sell services and not the
commodities and that too on cash basis. As such, no funds are blocked in piling the inventories
and no funds are blocked in receivables. E.g. Public utility services like railways, electricity
boards, infrastructure oriented projects etc. Their requirement of working capital is less.
Whereas if the organisation is a trading organisation, the requirement of working capital will
be on the higher side, as huge amount of funds get blocked in mainly two types of current
assets, stock and receivables.

Size of the organisation

In small-scale organisations, requirement of working capital is quite high due to high amount
of overheads, high buying costs and high selling costs. As such, medium sized organisations
have an edge over the small-scale organisations. However, if the business grows beyond a
certain limit, the requirement of working capital may be adversely affected by the increasing
size.
Phase of trade cycles

During the inflationary conditions, the working capital requirement will be on the higher side
as the company may like to buy more raw material, may increase the production to take the
advantage of favourable market conditions and due to increased sales more funds are blocked
in stocks and receivables. During the depression, the requirement of working capital will be
on the lower side due to reduced operations but more working capital may be required due
to piling up of inventories and due to non-payment of dues by customers in time. As such, in
both the extreme situations of trade cycles, requirement of working capital may be high

Trading terms

The terms on which the organisation makes the purchases and sales affect the requirement
of working capital in a big way. If the purchases are required to be made on cash basis and
sales are to be made on credit basis to cope with competition existing in the market, it will
result into high requirement of working capital. Whereas, if the purchases can be made on
credit basis and sales can be made on cash basis, it will reduce the requirement of working
capital, as a part of working capital requirement can be financed out of credit offered by the
suppliers.

Length of production cycle

The term production cycle refers to the time duration from the stage raw material is acquired
till the stage the finished product is manufactured. The principle will be “longer the duration
of production cycle, higher the requirement of working capital”. In some businesses like
machine tool industry, the time gap between the acquisition of raw material till the
completion of production is quite high. As such, more amount is blocked in raw materials or
work in progress or finished goods and even in receivables. Requirement of working capital is
always very high in this case, whereas in case of the industries like paper industry or sugar
industry, the production cycle is very short. As such, the requirement of working capital, at
least for stocks, may be very less.

Profitability

High profitability reduces the strain on working capital as the profit to the extent they are
earned in cash can be used for financing the requirement of working capital. However, the
profit that reduces the strain on working capital is the post-tax profit (i.e. the profit earned
after paying off the tax liability) and post-dividend profit (i.e. the profit remaining in the
business after paying the dividend on the shares.)

Working Capital Policy

In general, working capital policies involve determining the sources of finance. It also
determines the allocation of these finances towards current assets and liabilities. Broadly,
three strategies can help optimize working capital financing for a business, namely, hedging,
aggressive, and conservative, as per the risk levels involved.

1. Conservative Policy
An organization undertakes this strategy only when it requires minimizing risk to the furthest.
Under this policy, the management regulates the credit limits stringently to ensure low risk.
Moreover, current assets are always above par against the current liabilities to ascertain
sufficient availability of funds.
Organizations majorly utilize long-term funding options to finance fixed and fluctuating
current assets. The use of short-term sources is kept to a minimum for low-risk.
Observing a conservative working capital financing policy, hence, leads to underutilization of
funds, thus cutting down on returns and compromising growth.

2. Aggressive Policy
As the name may suggest, aggressive policies involve the maximum risk, and thus, also bring
the potential for multiplied growth.
When observing this strategy, companies ensure their current assets, such as the value of
debtors, are minimized by ensuring timely payments or minimum credit sales. At the same
time, management also maintains that payments to creditors are delayed to the furthest.
Organizations aiming at accelerated growth can opt for this working capital policy. However,
since it involves immense risk, strong business acumen, and deft handling of finances are
critical.

3. Hedging Policy/Matching Policy

Also known as the matching policy, adopting this strategy ensures that the current assets of a
company are always in sync with short-term liabilities.

In essence, this working capital financing policy aims to balance the two extreme strategies,
both in terms of risk and growth potential. Most organizations observing this strategy use
long-term sources of finance to invest in fixed current assets and resort to short-term funding
options for current asset financing.

Summary:

• Working capital refers to the funds invested in current assets, i.e. investment in stocks,
sundry debtors, cash and other current asset. The objective of working capital
management is to ensure Optimum Investment in current assets.
• Working Capital is required to perform day to day operations
• Total Current assets is Gross working capital and difference between CA and CL is Net
working capital
• There are certain factors affecting working capital requirement such as nature of
business, size of organisation, trading terms, length of production cycle, profitability,
etc.
• There various approaches called as working capital policy

Self- Assessment Question

1. Which of the following is not determinant of working capital?
a) Nature and size of business
b) Manufacturing cycle
c) Government policy
d) Production policy

2. There are two concepts of working capital – gross and____.

a) Zero
 b) Net
c) Cumulative
d) Distinctive

3. working Capital refers to the firm’s investment in current assets.

a) Zero
b) Net
c) Gross
d) Distinctive

4. In finance, “working capital” means the same thing as _______ assets.

a) Current
b) Fixed
c) Total
d) All the above

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