(I) Finance function: It is one of the main functions of a business organisation, which,

aims at procuring and judiciously utilising the financial resources with a view to maximising the value of the firm thereby the value of the owners i.e., equity shareholders in a company is maximised. Approaches to Finance Function Providing of funds needed by a business on most suitable terms (This approach confines only to raising of funds !econd "pproach relates finance function to cash. This approach implies that finance function is related to every activity in the business Third approach to this function envisages the raising of funds and their effective utilisation. To conclude, finance function covers financial planning, rising of funds, allocation of funds, financial control. Aims of Finance Function "cquiring sufficient funds Proper utilisation of funds Increasing profitability #aximising concern$s value Scope or Content of Finance function %stimating financial requirements &eciding the capital structure !electing a !ource of finance

 !electing a pattern of investment Proper cash management Implementing financial controls Proper use of surpluses. Organisation chart of finance function

Financial Management Meaning 'inancial management refers to that part of management activity which is concerned with the planning and controlling of form$s financial resources. It deals with the finding out various sources for raising funds for the firm. Financial management is that managerial activity which is concerned with the planning and controlling of the firm$s financial resources. It is an integrated decision ma(ing process concerned with acquiring, financing and managing assets to accomplish the overall goal of a business organisation. It can also be stated as the process of planning decisions in order to maximise the shareholder$s wealth. 'inancial managers have a major role in cash management, acquisition of funds and in all aspects of raising and allocating capital. "s far as business organisations are concerned, the objective of financial management is to maximise the value of business. Definition: )'inancial management comprises the forecasting, planning, organising, directing, co*ordinating and controlling of all activities relating to acquisition and application of the financial resources of an underta(ing in (eeping with its financial objective.+ This definition of financial management by ,aymond -hambers aptly sums up the vital role played by it in any organisation. SCOPE OF FINANCIA MANA!EMEN" "s an integral part of the overall management, financial management is mainly concerned with acquisition and use of funds by an organi.ation. /ased on financial management guru %.ra !olomon$s concept of financial management, following aspects are ta(en up in detail under the study of financial management0 a# &etermination of si.e of the enterprise and determination of rate of growth. $# &etermining the composition of assets of the enterprise.

c# &etermining the mix of enterprise$s financing i.e. consideration of level of debt to equity, etc. %# "nalyse planning and control of financial affairs of the enterprise.

The scope of financial management has undergone changes over the years. 1ntil the middle of this century, its scope was limited to procurement of funds under major events in the life of the enterprise such as promotion, expansion, merger, etc. In the modern times, the financial management includes besides procurement of funds, the three different (inds of decisions as well namely, investment, financing and dividend. "ll the three types of decisions would be dealt in detail during the course of this chapter. The given figure depicts the overview of the scope and functions of financial management. It also gives the interrelation between the mar(et value, financial decisions and ris( return trade off. The financial manager, in a bid to maximi.e shareholders$ wealth, should strive to maximi.e returns in relation to the given ris(2 he should see( courses of actions that avoid unnecessary ris(s. To ensure maximum return, funds flowing in and out of the firm should be constantly monitored to assure that they are safeguarded and properly utili.ed.

"he $asic o$&ecti'e centers on: Procurement of funds from various sources li(e, %!-, P!-, debentures, term loans and bonds %ffective utilisation of the funds to maximise the profitability of the firm and wealth of its owners. Functions of a Finance Manager : The twin aspects, procurement and effective utilisation of funds are crucial tas(s faced by a finance manager. The financial manager is required to loo( into the financial implications of any decision in the firm. Thus all decisions involve management of funds under the purview of the finance manager. " large number of decisions involve substantial or material changes in value of funds procured or employed. The finance manager, has to manage funds in such a way so as to ma(e their optimum utilisation and to ensure their procurement in a way that the ris(, cost and control are properly balanced under a given situation. 3e may not, be concerned with the decisions, that do not affect the basic financial management and structure. The nature of job of an accountant and finance manager is different, an accountant4s job is primarily to record the business transactions, prepare financial statements showing results of the organisation for a given period and its financial condition at a given point

of time. 3e is to record various happenings in monetary terms to ensure that assets, liabilities, incomes and expenses are properly grouped, classified and disclosed in the financial statements. "ccountant is not concerned with management of funds that is a specialised tas( and in modern times a complex one. The finance manager or controller has a tas( entirely different from that of an accountant, he is to manage funds. !ome of the important decisions as regards finance are as follows 0 () Estimating the re)uirements of fun%s : " business requires funds for long term purposes i.e. investment in fixed assets and so on. " careful estimate of such funds is required to be made. "n assessment has to be made regarding requirements of wor(ing capital involving, estimation of amount of funds bloc(ed in current assets and that li(ely to be generated for short periods through current liabilities. 'orecasting the requirements of funds is done by use of techniques of budgetary control and long range planning. %stimates of requirements of funds can be made only if all the physical activities of the organisation are forecasted. They can be translated into monetary terms. *) Decision regar%ing capital structure : 5nce the requirements of funds is estimated, a decision regarding various sources from where the funds would be raised is to be ta(en. " proper mix of the various sources is to be wor(ed out, each source of funds involves different issues for consideration. The finance manager has to carefully loo( into the existing capital structure and see how the various proposals of raising funds will affect it. 3e is to maintain a proper balance between long and short term funds and to ensure that sufficient long*term funds are raised in order to finance fixed assets and other long*term investments and to provide for permanent needs of wor(ing capital. In the overall volume of long*term funds, he is to maintain a proper balance between own and loan funds and to see that the overall capitalisation of the company is such, that the company is able to procure funds at minimum cost and is able to tolerate shoc(s of lean periods. "ll these decisions are (nown as 4financing decisions4. +) In'estment %ecision : 'unds procured from different sources have to be invested in various (inds of assets. 6ong term funds are used in a project for fixed and also current assets. The investment of funds in a project is to be made after careful assessment of various projects through capital budgeting. " part of long term funds is also to be (ept for financing wor(ing capital requirements. "sset management policies are to be laid down regarding various items of current assets, inventory policy is to be determined by the production and finance manager, while (eeping in mind the requirement of production and future price estimates of raw materials and availability of funds.

,) Di'i%en% %ecision : The finance manager is concerned with the decision to pay or declare dividend. 3e is to assist the top management in deciding as to what amount of dividend should be paid to the shareholders and what amount be retained by the company, it involves a large number of considerations. %conomically spea(ing, the amount to be retained or be paid to the shareholders should depend on whether the company or shareholders can ma(e a more profitable use of resources, also considerations li(e trend of earnings, the trend of share mar(et prices, requirement of funds for future growth, cash flow situation, tax position of share holders, and so on to be (ept in mind. The principal function of a finance manager relates to decisions regarding procurement, investment and dividends. -) Suppl. of fun%s to all parts of the organisation or cash management : The finance manager has to ensure that all sections i.e. branches, factories, units or departments of the organisation are supplied with adequate funds. !ections having excess funds contribute to the central pool for use in other sections that needs funds. "n adequate supply of cash at all points of time is absolutely essential for the smooth flow of business operations. %ven if one of the many branches is short of funds, the whole business may be in danger, thus, cash management and cash disbursement policies are important with a view to supplying adequate funds at all times and points in an organisation. It should ensure that there is no excessive cash. /) E'aluating financial performance : #anagement control systems are usually based on financial analysis, e.g. ,5I (return on investment system of divisional control. " finance manager has to constantly review the financial performance of various units of the organisation. "nalysis of the financial performance helps the management for assessing how the funds are utilised in various divisions and what can be done to improve it. 0) Financial negotiations : 'inance manager4s major time is utilised in carrying out negotiations with financial institutions, ban(s and public depositors. 3e has to furnish a lot of information to these institutions and persons in order to ensure that raising of funds is within the statutes. 7egotiations for outside financing often requires specialised s(ills. 1) 2eeping in touch 3ith stoc4 e5change )uotations an% $eha'ior of share prices : It involves analysis of major trends in the stoc( mar(et and judging their impact on share prices of the company4s shares.

O67EC"I8ES OF FINANCIA MANA!EMEN"

%fficient financial management requires the existence of some objectives or goals because judgment as to whether or not a financial decision is efficient must be made in the light of some objective. "lthough various objectives are possible but we assume two objectives of financial management for elaborate discussion. These are0 (# P9OFI" MA:IMISA"ION It has traditionally been argued that the objective of a company is to earn profit, hence the objective of financial management is also profit maximisation. This implies that the finance manager has to ma(e his decisions in a manner so that the profits of the concern are maximised. %ach alternative, therefore, is to be seen as to whether or not it gives maximum profit. 3owever, profit maximisation cannot be the sole objective of a company. It is at best a limited objective. If profit is given undue importance, a number of problems can arise. !ome of these have been discussed below0 The term profit is vague. It does not clarify what exactly it means. It conveys a different meaning to different people. 'or example, profit may be in short term or long term period2 it may be total profit or rate of profit etc. Profit maximisation has to be attempted with a reali.ation of ris(s involved. There is a direct relationship between ris( and profit. #any ris(y propositions yield high profit. 3igher the ris(, higher is the possibility of profits. If profit maximisation is the only goal, then ris( factor is altogether ignored. This implies that finance manager will accept highly ris(y proposals also, if they give high profits. In practice, however, ris( is very important consideration and has to be balanced with the profit objective. Profit maximisation as an objective does not ta(e into account the time pattern of returns. Proposal " may give a higher amount of profits as compared to proposal /, yet if the returns begin to flow say 89 years later, proposal / may be preferred which may have lower overall profit but the returns flow is more early and quic(. Profit maximisation as an objective is too narrow. It fails to ta(e into account the social considerations as also the obligations to various interests of wor(ers, consumers, society, as well as ethical trade practices. If these factors are ignored, a company cannot survive for long. Profit maximisation at the cost of social and moral obligations is a short sighted policy. Arguments in fa'our of profit Ma5imisation 8. It is a barometer to measure the efficiency and economic prosperity

:. " firm will be able to survive the adverse business conditions only if it has earnings to face the situation. ;. It facilitates growth <. It helps to achieve social goals =. It motivates investment >. -redibility of the firm increases ?. !toc( prices will go up in the mar(et Arguments against profit ma5imisation The concept profit is very vague It ignores ris( factor and timing of returns It may allow decision to be ta(en at the cost of 6ong*run stability and profitability of the concern It emphasises more on the short run profitability and short run projects It fails to consider the social responsibility ;ealth Ma5imisation It means maximising the 7et Present @alue (or wealth of a course of action. The 7P@ of a course of "ction is the difference between the present value of its benefits and the present value of its cost. The maximisation of wealth is possible by ma(ing decisions of the firm to get benefits that exceed cost. It ta(es into consideration the time and the ris( of effected benefits. The wealth maximisation is not only for the shareholders but also for the sta(e holders "he ;M goals a%'ocate% on the follo3ing groun%s: It ta(es into consideration the long*run survival and growth of the firm It is consistent with the object of owners economic welfare It suggests the consistent dividend payments to the shareholders The financial decisions result in the capital appreciation It considers ris( and time value of money It considers all future cash flows, dividends and %P!

 The maximisation of firm$s value is reflected in the mar(et price of share. Profit #aximisation partly enables the firm in wealth maximisation !hareholders prefer A# to P# Criticisms The society$s resources are used to the advantage of a particular firm, hence, society welfare is criticised It is a prescriptive idea than a descriptive one ;h. ;ealth Ma5imisation ;or4s< 5f course, there are other goals too li(e0 "chieving a higher growth rate "ttaining a larger mar(et share Baining leadership in the mar(et in terms of products and technology Promoting employee welfare Increasing customer satisfaction 8alue ma5imi=ation The primary objective of '# is to maximise the value of the firm. It facilitates in maximising the value of equity share which serves as an index of the performance of the company. It ta(es into consideration the present and the future earnings, ris( dividend, retention policies, level of gearing. The !hare holder wealth is maximised only if mar(et share increases, hence A# is redefined as value maximisation Other ma5imisation of o$&ecti'es !ales #aximisation Browth #aximisation ,eturn on investment maximisation !ocial objectives Broup of objectives ( Production, inventory, sales, mar(et share, profit

Financial o$&ecti'es of a firm: ,eturn on -apital employed or ,5I @alue addition and profitability Browth in %P! and P% ratio Browth in #@ of !hare Browth in &ividends 5ptimum level of leverage !urvival and growth of the firm #inimisation of finance charges %ffective utilisation of !hort, medium and long term objectives "o achie'e 3ealth ma5imi=ation> the finance manager has to ta4e careful %ecision in respect of: ".pes of %ecisions (# In'estment %ecisions: These decisions determine how scarce resources in terms of funds available are committed to projects which can range from acquiring a piece of plant to the acquisition of another company. 'unds procured from different sources have to be invested in various (inds of assets. 6ong term funds are used in a project for various fixed assets and also for current assets. The investment of funds in a project has to be made after careful assessment of the various projects through capital budgeting. " part of long term funds is also to be (ept for financing the wor(ing capital requirements. "sset management policies are to be laid down regarding various items of current assets. The inventory policy would be determined by the production manager and the finance manager (eeping in view the requirement of production and the future price estimates of raw materials and the availability of funds. In'estment %ecisions

"scertainment of the total volume of funds, a firm can commit "ppraisal and selection of capital investment proposals #easurement of ris( and uncertainty in the investment proposal

 Prioritisation of investment decisions 'und allocation and its rationing &etermination of fixed assets to be acquired &etermination of the level of investments and its management /uy or lease decisions "sset replacement decisions ,estructuring, reorganisation, mergers and acquisitions !ecurities analysts and portfolio management *# Financing %ecisions: These decisions relate to acquiring the optimum finance to meet financial objectives and seeing that fixed and wor(ing capital are effectively managed. The financial manager needs to possess a good (nowledge of the sources of available funds and their respective costs, and needs to ensure that the company has a sound capital structure, i.e. a proper balance between equity capital and debt. !uch managers also need to have a very clear understanding as to the difference between profit and cash flow, bearing in mind that profit is of little avail unless the organisation is adequately supported by cash to pay for assets and sustain the wor(ing capital cycle. 'inancing decisions also call for a good (nowledge of evaluation of ris(, e.g. excessive debt carried high ris( for an organisation$s equity because of the priority rights of the lenders. " major area for ris(*related decisions is in overseas trading, where an organisation is vulnerable to currency fluctuations, and the manager must be well aware of the various protective procedures such as hedging (it is a strategy designed to minimi.e, reduce or cancel out the ris( in another investment available to him. 'or example, someone who has a shop ta(es care of the ris( of the goods being destroyed by fire by hedging it via a fire insurance contract. Finance Decisions

&etermination of the degree or level of gearing &etermination of the pattern of 6T, #T C !T funds ,aising of funds through various instruments "rrangement of funds through various institutions

 -onsideration of interest burden -onsideration of debt level changes and firm$s ban(ruptcy Ta(ing advantage of interest and depreciation in reducing the tax liability of the firm -onsidering the various modes on improving the %P! and mar(et value of the share. -onsideration of cost of capital of individual component and weighted average cost of capital to the firm 5ptimisation of finance mix to improve returns Portfolio management -onsideration of the impact of under capitalisation and over capitalisation -onsideration for foreign exchange ris( exposure /alance between owner$s capital and outside capital %valuation of alternative use of funds ,eview of performance by analysis. +# Di'i%en% %ecisions: These decisions relate to the determination as to how much and how frequently cash can be paid out of the profits of an organisation as income for its ownersDshareholders. The owner of any profit*ma(ing organi.ation loo(s for reward for his investment in two ways, the growth of the capital invested and the cash paid out as income2 for a sole trader this income would be termed as drawings and for a limited liability company the term is dividends.

&ividend decisions

&etermination of dividend and retention policies of the firm -onsideration of the impact of the levels of dividend and retention of earnings on the mar(et value of the share and the future earnings of the company -onsideration of possible requirements of funds by the firm for expansion and diversification proposals for financing existing business requirements

 ,econsideration of distribution and retention policies in boom and recession period -onsidering the impact of legal and cash flow constraints on dividend decisions

( III DEFINI"ION OF COS" OF CAPI"A -ost of capital may be defined as the cut off rate for determining estimated future cash proceeds of a project and eventually deciding whether the project is worth underta(ing or not. It is also the minimum rate of return that a firm must earn on its investment which will maintain the mar(et value of share at its current level. It can also be stated as the opportunity cost of an investment, i.e. the rate of return that a company would otherwise be able to earn at the same ris( level as the investment that has been selected. 'or example, when an investor purchases stoc( in a company, heDshe expects to see a return on that investment. !ince the individual expects to get bac( more than hisDher initial investment, the cost of capital is equal to this return that the investor receives, or the money that the company misses out on by selling its stoc(. It can also be said as the required return necessary to ma(e a capital budgeting project * such as building a new factory * worthwhile. -ost of capital includes the cost of debt and the cost of equity. The cost of capital determines how a company can raise money maybe through a stoc( issue, borrowing, or a mix of the two. This is the rate of return that a firm would receive if it invested its money someplace else with similar ris(. "nother way to thin( of the cost of capital is as the opportunity cost of funds, since this represents the opportunity cost for investing in assets with the same ris( as the firm. Ahen investors are shopping for places in which to invest their funds, they have an

opportunity cost. The firm, given its ris(iness, must strive to earn the investor$s opportunity cost. If the firm does not achieve the return investors expect (i.e. the investor$s opportunity cost , investors will not invest in the firm$s debt and equity. "s a result, the firm$s value (both their debt and equity will decline. The total capital for a firm is the value of its equity plus the cost of its debt (the cost of debt should be continually updated as the cost of debt changes as a result of interest rate changes . The cost of capital is given as0 EcF (8*G EeH dEd Ahere, Ec F Aeighted cost of capital for the firm G F &ebt to capital ratio, & D (& H % Ee F -ost of equity E& F after tax cost of debt & F #ar(et value of the firm4s debt, including ban( loans and leases % F #ar(et value of all equity (including warrants, options, and the equity portion of convertible securities

6asic aspects of the %efinition -ost of -apital is not a cost as such*it is the rate of return firm needs to earn from its project It is the minimum rate of return* which will at least maintain the mar(et value of shares It comprises of three components* The expected normal rate of return at .ero*level ris( Premium for 'inance ris( Premium for /usiness ris( (EFroH b Hf Significance of the cost of capital: As an Acceptance criterion in Capital 6u%geting ? the acceptance or rejection of the project is decided by ta(ing into consideration the cost of capital As a %eterminant of capital mi5 in capital structure %ecision * the objective of maximising the value of the firm and minimi.ing the cost of capital results in optimal capital structure As a $asis for e'aluating the financial performance@ the profitability is compared to projected overall cost of capital and the actual cost of capital of funds raised to finance the project.

 As a $asis for ta4ing other financial %ecisions@ 6i(e &ividend policy, capitalisation of profits, ma(ing the rights issue, wor(ing capital. Classification of cost: Aistorical an% future cost: 3- are /oo( cost related to past. 'uture cost is the estimated cost related to the future. Specific an% composite cost0 !- refers to cost of a specific source of capital, while composite cost is combined cost of various sources of capital. It is the A"--, in case of more than one form of source of capital composite cost is resorted to E5plicit cost an% implicit cost: %- is the discount rate which equates the P@ of cash inflows in other words, it is I,,. Implicit cost is also (nown as opportunity cost, it is the cost foregone in order to ta(e up a particular project. A'erage cost an% marginal cost0 "- is the combined cost of various sources of capital2 #- is the average cost of capital which has to be incurred to obtain additional funds required by the firm. Pro$lems in %etermination of COC: -onceptual controversies regarding the relationship between the cost of capital and the capital structure0 few are of the opinion that a firm can minimise the A"-- and increase the value of the firm by debt financing. 5thers believe that the cost of capital is unaffected by the changes in the capital structure. Problems with regard to considering the various costs Problems in computing the cost of equity0 it is a difficult tas( to calculate the expected rate of return on equity. Problems in computing cost of retained earnings0 (5pportunity cost of dividends of shareholders is ignored often Problems in assigning weights MEASB9EMEN" OF COS" OF CAPI"A The cost of capital is useful in determining a financial plan. " company has to employ a combination of creditor$s and owner$s funds. "s more than one type of capital is used in a company, the composite cost of capital can be determined after the cost of each type of funds has been obtained. The first step is, therefore, the calculation of specific cost which is the minimum financial obligation required to secure the use of capital for a particular source. In order to calculate the specific cost of each type of capital, recognition should be given to the explicit and the implicit cost. The explicit cost of any source of capital may be defined as the discount rate that equals that present value of the cash inflows that are

incremental to the ta(ing of financing opportunity with the present value of its incremental cash outflows. Implicit cost is the rate of return associated with the best investment opportunity for the firm and its shareholders that will be foregone if the project presently under consideration by the firm was accepted. The explicit cost arises when funds are raised and when funds are used, implicit cost arises. 'or capital budgeting decisions, cost of capital is nothing but the explicit cost of capital. 7ow the different components of cost of capital i.e. %ach source of finance has been discussed in detail. COS" OF DE6" " bond is a long term debt instrument or security. /onds issued by the government do not have any ris( of default. The government honour obligations on its bonds. /onds of the public sector companies in India are generally secured, but they are not free from the ris( of default. The private sector companies also issue bonds, which are also called debentures in India. " company in India can issue secured or unsecured debentures. In the case of a bond or debenture, the rate of interest is generally fixed and (nown to investors. The principal of a redeemable bond or bond with a maturity is payable after a specified period, called maturity period. "he chief characteristics of a $on% or %e$enture are as follo3s: 'ace value0 'ace value is called par value. " bond or debenture is generally issued at a par value of ,s. 899 or ,s. 8,999, and interest is paid on face value. Interest rate: Interest rate is fixed and (nown to bondholders or debenture holders. Interest paid on a bond or debenture is tax deductible. The interest rate is also called coupon rate. -oupons are detachable certificates of interest. Maturit.: " bond or debenture is generally issued for a specified period of time. It is repaid on maturity. 9e%emption 'alue0 The value that a bondholder or debenture holder will get on maturity is called redemption or maturity value. " bond or debenture may be redeemed at par or at premium (more than par value or at discount (less than par value . Mar4et 'alue: " bond or debenture may be traded in a stoc( exchange. The price at which it is currently sold or bought is called the mar(et value of the bond or debenture. #ar(et value may be different from par value or redemption value.

COS" OF ECBI"D It may prima facie appear that equity capital does not carry any cost. /ut this is not true. The mar(et share price is a function of return that equity shareholders expect and get. If

the company does not meet their requirements, it will have an adverse effect on the mar(et share price. "lso, it is relatively the highest cost of capital. !ince expectations of equity holders are high, higher cost is associated with it. -ost of equity capital is the rate of return which equates the present value of expected dividends with the mar(et share price. The calculation of equity capital cost raises a lot of problems. Its purpose is to enable the corporate manager, to ma(e decisions in the best interest of equity holders. In theory the management strives to maximi.e the position of equity holders and the effort involves many decisions. &ifferent methods are employed to compute the cost of equity capital. (a) Di'i%en% Price Approach: 3ere, cost of equity capital is computed by dividing the current dividend by average mar(et price per share. This dividend price ratio expresses the cost of equity capital in relation to what yield the company should pay to attract investors. 3owever, this method cannot be used to calculate cost of equity of units suffering losses.

($) EarningE Price Approach: The advocates of this approach co*relate the earnings of the company with the mar(et price of its share. "ccordingly, the cost of ordinary share capital would be based upon the expected rate of earnings of a company. The argument is that each investor expects a certain amount of earnings, whether distributed or not from the company in whose shares he invests. Thus, if an investor expects that the company in which he is going to subscribe for shares should have at least a :9I rate of earning, the cost of ordinary share capital can be construed on this basis. !uppose the company is expected to earn ;9I the investor will be

,s for each share of ,s. 899. This approach is similar to the dividend price approach2 only it see(s to nullify the effect of changes in the dividend policy. This approach also

does not seem to be a complete answer to the problem of determining the cost of ordinary share since it ignores the factor of capital appreciation or depreciation in the mar(et value of shares. (c) Di'i%en% Price F !ro3th Approach: %arnings and dividends do not remain constant and the price of equity shares is also directly influenced by the growth rate in dividends. Ahere earnings, dividends and equity share price all grow at the same rate, the cost of equity capital may be computed as follows0 Ee F (&DP H B Ahere, & F -urrent dividend per share P F #ar(et price per share B F "nnual growth rate of earnings of dividend. (d Earnings Price F !ro3th Approach: This approach is an improvement over the earlier methods. /ut even this method assumes that dividend will increase at the same rate as earnings, and the equity share price is the regulator of this growth as deemed by the investor. 3owever, in actual practice, rate of dividend is recommended by the /oard of &irectors and shareholders cannot change it. Thus, rate of growth of dividend subsequently depends on director$s attitude. The dividend method should, therefore, be modified by substituting earnings for dividends.

(e) 9eali=e% Diel% Approach: "ccording to this approach, the average rate of return ,eali.ed in the past few years are historically regarded as Jexpected return$ in the future. The yield of equity for the year is0

Though, this approach provides a single mechanism of calculating cost of equity, it has unrealistic assumptions. If the earnings do not remain stable, this method is not practical.

(f) Capital Asset Pricing Mo%el Approach (CAPM): This model describes the linear relationship between ris( and return for securities. The ris( a security is exposed to be diversifiable and non*diversifiable. The diversifiable ris( can be eliminated through a portfolio consisting of large number of well diversified securities. The non*diversifiable ris( is assessed in terms of beta coefficient (b or K through fitting regression equation between return of a security and the return on a mar(et portfolio.

Thus, the cost of equity capital can be calculated under this approach as0 Ee F 'ro H b (#r. L 'ro Ahere, Ee F -ost of equity capital 'or F ,ate of return on security b F /eta coefficient #r. F ,ate of return on mar(et portfolio

Therefore, required rate of return F ris( free rate H ris( premium The idea behind -"P# is that investors need to be compensated in two ways* time value of money and ris(. The time value of money is represented by the ris(*free rate in the formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents ris( and calculates the amount of compensation the investor needs for ta(ing on additional ris(. This is calculated by ta(ing a ris( measure (beta which compares the returns of the asset to the mar(et over a period of time and compares it to the mar(et premium. The -"P# says that the expected return of a security or a portfolio equals the rate on a ris(*free security plus a ris( premium. If this expected return does not meet or beat the required return, then the investment should not be underta(en. The shortcomings of this approach are0 (a %stimation of betas with historical data is unrealistic2 and (b #ar(et imperfections may lead investors to unsystematic ris(. &espite these shortcomings, the capital asset pricing approach is useful in calculating cost of equity, even when the firm is suffering losses. The basic factor behind determining the cost of ordinary share capital is to measure the expectation of investors from the ordinary shares of that particular company. Therefore, the whole question of determining the cost

of ordinary shares hinges upon the factors which go into the expectations of particular group of investors in a company of a particular ris( class.

;EI!A"ED A8E9A!E COS" OF CAPI"A (;ACC) "s you (now the capital funding of a company is made up of two components0 debt and equity. 6enders and equity holders each expect a certain return on the funds or capital they have provided. The cost of capital is the expected return to equity owners (or shareholders and to debt holders, so weighted average cost of capital tells the return that both sta(eholders Mequity owners and lenders * can expect. A"--, in other words, represents the investors$ opportunity cost of ta(ing on the ris( of putting money into a company. !ince every company has a capital structure i.e. Ahat percentage of debt comes from retained earnings, equity shares, preference shares, and bonds, so by ta(ing a weighted average, it can be seen how much interest the company has to pay for every rupee it borrows. This is the weighted average cost of capital. The weighted average cost of capital for a firm is of use in two major areas0 in consideration of the firm$s position and in evaluation of proposed changes necessitating a change in the firm$s capital. Thus, a weighted average technique may be used in a quasi* marginal way to evaluate a proposed investment project, such as the construction of a new building. Thus, weighted average cost of capital is the weighted average after tax costs of the individual components of firm$s capital structure. That is, the after tax cost of each debt and equity is -alculated separately and added together to a single overall cost of capital.

The cost of weighted average method is preferred because the proportions of various sources of funds in the capital structure are different. To be representative, therefore, cost of capital should ta(e into account the relative proportions of different sources of finance. !ecurities analysts employ A"-- all the time when valuing and selecting investments. In discounted cash flow analysis, A"-- is used as the discount rate applied to future cash flows for deriving a business4s net present value. A"-- can be used as a hurdle rate against which to assess return on investment capital performance. It also plays a (ey role in economic value added (%@" calculations. Investors use A"-- as a tool to decide whether or not to invest. The A"-- represents the minimum rate of return at which a company produces value for its investors. 6et4s say a company produces a return of :9I and has a A"-- of 88I. /y contrast, if the company4s return is less than A"--, the company is shedding value, which indicates that investors should put their money elsewhere. Therefore, A"-- serves as a useful reality chec( for investors.

CA CB A"ION OF ;ACC

!o the A"-- of this company is ?.N=I. /ut there are problems in determination of weighted average cost of capital. These mainly relate to computation of equity capital and the assignment of weights to the cost of specific source of financing. "ssignment of weights can be possible either on the basis of marginal weighting or historical weighting. The most serious limitation of marginal weighting is that it does not consider the long run implications of firm$s current financing. The validity of the assumption of historical weighting is that choosing between the boo( value weights and mar(et value weights. Ahile the boo( value weights may be operationally convenient, the mar(et value basis is theoretically more consistent, sound and a better indicator of firm$s capital structure. The desirable practice is to employ mar(et weights to compute the firm$s cost of capital. This rationale rests on the fact that the cost of capital measures the cost of issuing securities M stoc(s as well as bonds M to finance projects, and that these securities are issued at mar(et value, not at boo( value.

( I@ e'erage: 6everage refers to the ability of a firm in employing long term funds having a fixed cost, to enhance returns to the owners. In other words, leverage is the amount of debt that a firm uses to finance its assets. The use of various financial instruments or borrowed capital, to increase the potential return of an investment. "DPES OF E8E9A!E The term 6everage in general refers to a relationship between two interrelated variables. In financial analysis it represents the influence of one financial variable over some other related financial variable. These financial variables may be costs, output, sales revenue, %arnings before Interest and Tax (%/IT , %arning per share (%P! etc. There are three commonly used measures of leverage in financial analysis. These are0 (i) 5perating 6everage (ii) 'inancial 6everage (iii) -ombined 6everage OPE9A"IN! E8E9A!E 5perating leverage (56 maybe defined as the employment of an asset with a fixed cost in the hope that sufficient revenue will be generated to cover all the fixed and variable costs. The use of assets for which a company pays a fixed cost is called operating leverage. Aith fixed costs the percentage change in profits accompanying a change in volume is greater than the percentage change in volume. The higher the turnover of operating assets, the greater will be the revenue in relation to the fixed charge on those assets.

Operating le'erage is a function of three factors: (i ,upee amount of fixed cost,

(ii @ariable contribution margin, and (iii @olume of sales. 5perating leverage is the ratio of net operating income before fixed charges to net operating income after fixed charges. &egree of operating leverage is equal to the percentage increase in the net operating income to the percentage increase in the output.

5,

5perating leverage is directly proportional to business ris(. #ore operating leverage leads to more business ris(, for then a small sales decline causes a big profit. This can be illustrated graphically as0

FINANCIA E8E9A!E: 'inancial leverage ('6 maybe defined as Jthe use of funds with a fixed cost in order to increase earnings per share.$ In other words, it is the use of company funds on which it pays a limited return. 'inancial leverage involves the use of funds obtained at a fixed cost in the hope of increasing the return to common stoc(holders. &egree of financial leverage is the ratio of the percentage increase in earnings per share (%P! to the percentage increase in earnings before interest and taxes (%/IT .

Impact of financial le'erage: Ahen the dDf bDw the earnings from assets financed by fixed cost funds and costs of these funds are distributed to the equity stoc(holders, they will get additional earnings without increasing their own investment. -onsequently, the %P! and the ,ate of return on %!will go up. 5n the contrary, if the firm acquires fixed cost funds at a higher cost than the earnings from those assets then the %P! and return on equity capital will decrease.

Significance of financial le'erage: Planning of capital structure Profit planning imitations of F E tra%ing on e)uit. &ouble*edged weapon /eneficial only to companies having stability in earnings Increases ris( and rate of interest ,estriction from financial instruments

DE!9EE OF COM6INED E8E9A!E -ombined leverage maybe defined as the potential use of fixed costs, both operating and financial, which magnifies the effect of sales volume change on the earning per share of the firm. &egree of combined leverage (&-6 is the ratio of percentage change in earning per share to the percentage change in sales. It indicates the effect the sales changes will have on %P!.

Cuestion : E5plain the concept of capital structure < Ans3er : " finance manager for procurement of funds, is required to select such a finance mix or capital structure that maximises shareholders wealth. 'or designing optimum capital structure he is required to select such a mix of sources of finance, so that the overall cost of capital is minimum. -apital structure refers to the mix of sources from where long term funds required by a business may be raised i.e. what should be the proportion of equity share capital, preference share capital, internal sources, debentures and other sources of funds in total amount of capital which an underta(ing may raise for establishing its business. In planning the capital structure, following must be referred to 0 8 There is no definite model that can be suggestedDused as an ideal for all business underta(ings. This is due to varying circumstances of various business underta(ings. -apital structure depends primarily on a number of factors li(e, nature of industry, gestation period, certainty with which the profits will accrue after the underta(ing commences commercial production and the li(ely quantum of return on investment. It is thus, important to understand that different types of capital structure would be required for different types of underta(ings.

: Bovernment policy is a major factor in planning capital structure. 'or instance, a change in the lending policy of financial institutions may mean a complete change in the financial pattern. !imilarly, rules and regulations for capital mar(et formulated by !%/I affect the capital structure decisions. The finance managers of business concerns are required to plan capital structure within these constraints. Optimum capital structure : The capital structure is said to be optimum, when the company has selected such a combination of equity and debt, so that the company4s wealth is maximum. "t this, capital structure, the cost of capital is minimum and mar(et price per share is maximum. /ut, it is difficult to measure a fall in the mar(et value of an equity share on account of increase in ris( due to high debt content in the capital structure. In reality, however, instead of optimum, an appropriate capital structure is more realistic. 'eatures of an appropriate capital structure are as below 0 () Profita$ilit. : The most profitable capital structure is one that tends to minimise financing cost and maximise of earnings per equity share. *) Fle5i$ilit. : The capitals structure should be such that the company is able to raise funds whenever needed. +) Conser'ation : &ebt content in capital structure should not exceed the limit which the company can bear. ,) Sol'enc. : -apital structure should be such that the business does not run the ris( of insolvency. -) Control : -apital structure should be devised in such a manner that it involves minimum ris( of loss of control over the company.

Cuestion : E5plain the ma&or consi%erations in the planning of capital structure < Ans3er : The ; major considerations evident in capital structure planning are ris(, cost and control, they assist the management in determining the proportion of funds to be raised from various sources. The finance manager attempts to design the capital structure in a manner, that his ris( and cost are least and there is least dilution of control from the existing management. There are also subsidiary factors as, mar(etability of the

issue, maneuverability and flexibility of capital structure and timing of raising funds. !tructuring capital, is a shrewd financial management decision and is something that ma(es or mars the fortunes of the company. The factors involved in it are as follows 0 () 9is4 : ,is(s are of : (inds vi.. financial and business ris(. 'inancial ris( is of : (inds as below 0 i) 9is4 of cash insol'enc. : "s a business raises more debt, its ris( of cash insolvency increases, as 0 a the higher proportion of debt in capital structure increases the commitments of the company with regard to fixed charges. i.e. a company stands committed to pay a higher amount of interest irrespective of the fact whether or not it has cash. and b the possibility that the supplier of funds may withdraw funds at any point of time. Thus, long term creditors may have to be paid bac( in installments, even if sufficient cash to do so does not exist. !uch ris( is absent in case of equity shares. ii) 9is4 of 'ariation in the e5pecte% earnings a'aila$le to e)uit. share@ hol%ers : In case a firm has a higher debt content in capital structure, the ris( of variations in expected earnings available to equity shareholders would be higher2 due to trading on equity. There is a lower probability that equity shareholders get a stable dividend if, the debt content is high in capital structure as the financial leverage wor(s both ways i.e. it enhances shareholders4 returns by a high magnitude or reduces it depending on whether the return on investment is higher or lower than the interest rate. In other words, there is relative dispersion of expected earnings available to equity shareholders, that would be greater if capital structure of a firm has a higher debt content. The financial ris( involved in various sources of funds may be understood with the help of debentures. " company has to pay interest charges on debentures even in case of absence of profits. %ven the principal sum has to be repaid under the stipulated agreement. The debenture holders have a charge against the company4s assets and thus, they can enforce a sale of assets in case of company4s failure to meet its contractual obligations. &ebentures also increase the ris( of variation in expected earnings available to equity shareholders through leverage effect i.e. if return on investment remains higher than interest rate, shareholders get a high return and vice versa. "s compared to debentures, preference shares entail a slightly lower ris( for the company, as the payment of

dividends on such shares is contingent upon the earning of profits by the company. %ven in case of cumulative preference shares, dividends are to be paid only in the year in which company earns profits. %ven, their repayment is made only if they are redeemable and after a stipulated period. 3owever, preference shares increase the variations in expected earnings available to equity shareholders. 'rom the company4s view point, equity shares are least ris(y, as a company does not repay equity share capital except on its liquidation and may not declare dividends for years. Thus, as seen here, financial ris( encompasses the volatility of earnings available to equity shareholders as also, the probability of cash insolvency. *) Cost of capital : -ost is an important consideration in capital structure decisions and it is obvious that a business should be atleast capable of earning enough revenue to meet its cost of capital and also finance its growth. Thus, along with ris(, the finance manager has to consider the cost of capital factor for determination of the capital structure. +) Control : "long with cost and ris( factors, the control aspect is also an important factor for capital structure planning. Ahen a company issues equity shares, it automatically dilutes the controlling interest of present owners. In the same manner, preference shareholders can have voting rights and thereby affect the composition of /oard of directors, if dividends are not paid on such shares for : consecutive years. 'inancial institutions normally stipulate that they shall have one or more directors on the board. Thus, when management agrees to raise loans from financial institutions, by implication it agrees to forego a part of its control over the company. It is thus, obvious that decisions concerning capital structure are ta(en after (eeping the control factor in view. ,) "ra%ing on e)uit. : " company may raise funds by issue of shares or by borrowings, carrying a fixed rate of interest that is payable irrespective of the fact whether or not there is a profit. Preference shareholders are also entitled to a fixed rate of dividend, but dividend payment is subject to the company4s profitability. In case of ,5I the total capital employed i.e. shareholders4 funds plus long term borrowings, is more than the rate of interest on borrowed funds or rate of dividend on preference shares, the company is said to trade on equity. It is the finance manager4s main objective to see that the return and overall wealth of the company both are maximised, and it is to be (ept in view while deciding on the sources of finance. Thus, the effect of each proposed method of new finance on %P! is to be carefully analysed. This, thus, helps in deciding whether funds should be raised by internal equity or by borrowings.

-) Corporate ta5ation : 1nder the Income tax laws, dividend on shares is not deductible while interest paid on borrowed capital is allowed as deduction. -ost of raising finance through borrowings is deductible in the year in which it is incurred. If it is incurred during the pre*commencement period, it is to be capitalised. -ost of share issue is allowed as deduction. 5wing to such provisions, corporate taxation > plays an important role in determination of the choice between different sources of financing. /) !o'ernment Policies : Bovernment policies is a major factor in determining capital structure. 'or instance, a change in the lending policies of financial institutions would mean a complete change in the financial pattern followed by companies. "lso, rules and regulations framed by !%/I considerably affect the capital issue policy of various companies. #onetary and fiscal policies of government also affect the capital structure decisions. 0) egal re)uirements : The finance manager has to (eep in view the legal requirements at the time of deciding as regards the capital structure of the company. 1) Mar4eta$ilit. : To obtain a balanced capital structure, it is necessary to consider the company4s ability to mar(et corporate securities. G) Maneu'era$ilit. : #aneuverability is required to have as many alternatives as possible at the time of expanding or contracting the requirement of funds. It enables use of proper type of funds available at a given time and also enhances the bargaining power when dealing with the prospective suppliers of funds. (H) Fle5i$ilit. : It refers to the capacity of the business and its management to adjust to expected and unexpected changes in circumstances. In other words, the management would li(e to have a capital structure providing maximum freedom to changes at all times. (() "iming : -losely related to flexibility is the timing for issue of securities. Proper timing of a security issue often brings substantial savings due to the dynamic nature of the capital mar(et. Intelligent management tries to anticipate the climate in capital mar(et with a view to minimise cost of

raising funds and the dilution resulting from an issue of new ordinary shares. (*) Si=e of the compan. : !mall companies rely heavily on owner4s funds while large companies are usually considered, to be less ris(y by investors and thus, they can issue different types of securities. (+) Purpose of financing : The purpose of financing also, to some extent affects the capital structure of the company. In case funds are required for productive purposes li(e manufacturing, etc. the company may raise funds through long term sources. 5n the other hand, if the funds are required for non* productive purposes, li(e welfare facilities to employees such as schools, hospitals, etc. the company may rely only on internal resources. (,) Perio% of Finance : The period for which finance is required also affects the determination of capital structure. In case funds are required for long term requirements say O to 89 years, it would be appropriate to raise borrowed funds. 3owever, if the funds are required more or less permanently, it would be appropriate to raise borrowed funds. 3owever, if the funds are required more or less permanently, it would be appropriate to raise them by issue of equity shares. (-) Nature of enterprise : The nature of enterprise to a great extent affects the company4s capital structure. /usiness enterprises having stability in earnings or enjoying monopoly as regards their products may go for borrowings or preference shares, as they have adequate profits to pay interestDfixed charges. 5n the contrary, companies not having assured income should preferably rely on internal resources to a large extent. (/) 9e)uirement of in'estors : &ifferent types of securities are issued to different classes of investors according to their requirement. (0) Pro'ision for future : Ahile planning capital structure the provision for future requirement of capital is also required to be considered.

Cuestion : !i'e in %etail the 'arious capital structure theories <

Ans3er : " firm4s objective should be directed towards the maximisation of the firm4s value2 the capital structure or leverage decision are to examined from the view point of their impact on the value of the firm. If the value of the firm can be affected by capital structure or financing decision, a firm would li(e to have a capital structure that maximises the mar(et value of the firm. There are broadly < approaches in the regard, which analyses relationship between leverage, cost of capital and the value of the firm in different ways, under the following assumptions 0 8 There are only : sources of funds vi.. debt and equity. : The total assets of the firm are given and the degree of leverage can be altered by selling debt to repurchase shares or selling shares to retire debt. ; There are no retained earnings implying that entire profits are distributed among shareholders. < The operating profit of firm is given and expected to grow. = The business ris( is assumed to be constant and is not affected by the financing mix decision. > There are no corporate or personal taxes. ? The investors have the same subjective probability distribution of expected earnings. The approaches are as below 0

() Net Income Approach (NI Approach) : The approach is suggested by &urand. "ccording to it, a firm can increase its value or lower the overall cost of capital by increasing the proportion of debt in the capital structure. In other words, if the degree of financial leverage increases, the weighted average cost of capital would decline with every increase in the debt content in total funds employed, while the value of the firm will increase. ,everse would happen in a converse situation. It is based on the following assumptions 0 i There are no corporate taxes. ii The cost of debt is less than cost of equity or equity capitalisation rate.

iii The use of debt content does not change the ris( perception of investors as a result of both the E d (&ebt capitalisation rate and E e (equity capitalisation rate remains constant. The value of the firm on the basis of 7et Income "pproach may be ascertained as follows 0 @ F ! H & Ahere, @ F @alue of the firm ! F #ar(et value of equity & F #ar(et value of debt ! F 7IDE e Ahere, ! F #ar(et value of equity 7I F %arnings available for equity shareholders E e F %quity -apitalisation rate 1nder, 7I approach, the value of a firm will be maximum at a point where weighted average cost of capital is minimum. Thus, the theory suggests total or maximum possible debt financing for minimising cost of capital. 5verall cost of capital F %/ITD@alue of the firm

*) Net Operating Income Approach (NOI) : This approach is also suggested by &urand, according to it, the mar(et value of the firm is not affected by the capital structure changes. The mar(et value of the firm is ascertained by capitalising the net operating income at the overall cost of capital, which is constant. The mar(et value of the firm is determined as 0 @ F %/ITD5verall cost of capital Ahere, @ F #ar(et value of the firm %/IT F %arnings before interest and tax ! F @ * &

Ahere, ! F @alue of equity & F #ar(et value of debt @ F #ar(et value of firm -ost of equity F %/ITD(@ * &

Ahere, @ F #ar(et value of the firm %/IT F %arnings before interest and tax & F #ar(et value of debt It is based on the following assumptions 0 i The overall cost of capital remains constant for all degree of debt equity mix. ii The mar(et capitalises value of the firm as a whole. Thus, the split between debt and equity is not important. iii The use of less costly debt funds increases the ris( of shareholders. This causes the equity capialisation rate to increase. Thus, the advantage of debt is set off exactly by increase in equity capitalisation rate. iv There are no corporate taxes. v The cost of debt is constant. 1nder, 75I approach since overall cost of capital is constant, thus, there is no optimal capital structure rather every capital structure is as good as any other and so every capital structure is optimal.

+) "ra%itional Approach : The traditional approach, also called an intermediate approach as it ta(es a midway between 7I approach, that the value of the firm can be increased by increasing financial leverage and 75I approach, that the value of the firm is constant irrespective of the degree of financial leverage. "ccording to this approach the firm should strive to reach the optimal capital structure and its total valuation through a judicious use of debt and equity in capital structure. "t the optimal capital structure, the overall cost of capital will be minimum and the value of the firm is maximum. It further states, that the value of the firm increases with financial leverage upto a certain point. /eyond this, the increase in financial leverage will increase cost of equity, the overall cost of capital may still reduce. 3owever, if financial leverage increases beyond an acceptable limit, the ris( of debt investor may also increase, consequently cost of debt also starts increasing. The increasing cost of equity owing to increased financial ris( and increasing cost of debt ma(es the overall cost of capital to increase. Thus, as per the traditional approach the cost of capital is a function of financial leverage and the value of firm can be affected by the judicious mix of debt and equity in capital structure. The

increase of financial leverage upto a point favourably affect the value of the firm. "t this point, the capital structure is optimal C the overall cost of capital will be the least.

,) Mo%igliani an% Miller Approach(MM Approach) : "ccording to this approach, the total cost of capital of particular firm is independent of its method and level of financing. #odigliani and #iller argued that the weighted average cost of capital of a firm is completely independent of its capital structure. In other words, a change in the debt equity mix does not affect the cost of capital. They argued, in support of their approach, that as per the traditional approach, cost of capital is the weighted average of cost of debt and cost of equity, etc. The cost of equity, is determined from the level of shareholder4s expectations. That is if, shareholders expect a particular rate of return, say 8= I from a particular company, they do not ta(e into account the debt equity ratio and they expect 8= I as they find that it covers the particular ris( which this company entails. !uppose, the debt content in the capital structure of the company increases, this means, that in the eyes of shareholders, the ris( of the company increases, since debt is a more ris(y mode of finance. Thus, the shareholders would now, expect a higher rate of return from the shares of the company. Thus, each change in the debt equity mix is automatically set*off by a change in the expectations of the shareholders from the equity share capital. This is because, a change in the debt*equity ratio changes the ris( element of the company, which in turn changes the expectations of the shareholders from the particular shares of the company. #odigliani and #iller, thus, argue that financial leverage has nothing to do with the overall cost of capital and the overall cost of capital is equal to the capitalisation rate of pure equity stream of its class of ris(. Thus, financial leverage has no impact on share mar(et prices nor on the cost of capital. They ma(e the following propositions 0 i The total mar(et value of a firm and its cost of capital are independent of its capital structure. The total mar(et value of the firm is given by capitalising the expected stream of operating earnings at a discount rate considered appropriate for its ris( class. ii The cost of equity (Ee is equal to the capitalisation rate of pure equity stream plus a premium for financial ris(. The financial ris( increases with more debt content in the capital structure. "s a result, Ee increases in a manner to offset exactly the use of less expensive sources of funds. iii The cut off rate for investment purposes is completely independent of the way in which the investment is financed. Assumptions :

i * The capital mar(ets are assumed to be perfect. This means that investors are free to buy and sell securities. * They are well*informed about the ris(*return on all type of securities. * There are no transaction costs. * They behave rationally. * They can borrow without restrictions on the same terms as the firms do. ii The firms can be classified into 4homogenous ris( class4. They belong to this class, if their expected earnings have identical ris( characteristics. iii "ll investors have the same expectations from a firms4 %/IT that is necessary to evaluate the value of a firm. iv The dividend payment ratio is 899 I. i.e. there are no retained earnings. v There are no corporate taxes, but, this assumption has been removed. #odigliani and #iller agree that while companies in different industries face different ris(s resulting in their earnings being capitalised at different rates, it is not possible for these companies to affect their mar(et values, and thus, their overall capitalisation rate by use of leverage. That is, for a company in a particular ris( class, the total mar(et value must be same irrespective of proportion of debt in company4s capital structure. The support for this hypothesis lies in the presence of arbitrage in the capital mar(et. They contend that arbitrage will substitute personal leverage for corporate leverage. 'or instance 0 There are : companies P and Q in the same ris( class. -ompany P is financed by only equity and no debt, while -ompany Q is financed by a combination of debt and equity. The mar(et price of shares of -ompany Q would be higher than that of -ompany P, mar(et participants would ta(e advantage of difference by selling equity shares of -ompany Q, borrowing money to equate their personal leverage to the degree of corporate leverage in -ompany Q and use them for investing in -ompany P. The sale of shares of -ompany Q reduces its price until the mar(et value of the company Q, financed by debt and equity, equals that of -ompany P, financed by only equity. Criticism : These propositions have been criticised by numerous authorities. #ostly criticism is as regards, perfect mar(et and arbitrage assumption. ## hypothesis argue that through personnel arbitrage investors would quic(ly eliminate any inequalities between the value of leveraged firms and that of unleveraged firms in the same ris( class. The basic argument

here, is that individual arbitrageurs, through the use of personal leverage can alter corporate leverage, which is not a valid argument in the practical world, as it is extremely doubtful that personal investors would substitute personal leverage for corporate leverage, as they do not have the same ris( characteristics. The ## approach assumes availability of free and upto date information, this also is not normally valid. To conclude, one may say that controversy between the traditionalists and the supporters of ## approach cannot be resolved due to lac( of empirical research. Traditionalists argue that the cost of capital of a firm can be lowered and the mar(et value of shares increased by use of financial leverage. /ut, after a certain stage, as the company becomes highly geared i.e. debt content increases, it becomes too ris(y for investors and lenders. Thus, beyond a point, the overall cost of capital begins to rise, this point indicates the optimal capital structure. #odigliani and #iller argues, that in the absence of corporate income taxes, overall cost of capital begins to rise.

( III

In'estment %ecisions: These decisions determine how scarce resources in terms of funds available are committed to projects which can range from acquiring a piece of plant to the acquisition of another company. 'unds procured from different sources have to be invested in various (inds of assets. 6ong term funds are used in a project for various fixed assets and also for current assets. The investment of funds in a project has to be made after careful assessment of the various projects through capital budgeting. " part of long term funds is also to be (ept for financing the wor(ing capital requirements. "sset management policies are to be laid down regarding various items of current assets. The inventory policy would be determined by the production manager and the finance manager (eeping in view the requirement of production and the future price estimates of raw materials and the availability of funds. IN"9ODBC"ION 'inancing and investment of funds are two crucial financial functions # "he in'estment of fun%s also terme% as capital $u%geting requires a number of decisions to be ta(en in a situation in which funds are invested and benefits are expected over a long period. "he term capital $u%geting means planning for capital assets# It involves proper project planning and commercial evaluation of projects to (now in advance technical feasibility and financial viability of the project. "he capital $u%geting %ecision means a decision as to whether or not money should be invested in long*term projects such as the setting up of a factory or installing a machinery or creating additional capacities to manufacture a part which at present may be purchased from outside. It includes a financial analysis of the various proposals regarding capital expenditure to evaluate their impact on the financial condition of the company and to choose the best out of the various alternatives. In any business the commitment of funds in land, buildings, equipment, stoc( and other types of assets must be carefully made. 5nce the decision to acquire a fixed asset is ta(en, it becomes very difficult to reverse that decision. The expenditure on plant and machinery and other long term assets affects operations over a period of years. It becomes a commitment that influences long term prospects and the future earning capacity of the firm. 3owever, -apital /udgeting excludes certain investment decisions, wherein, the benefits of investment proposals cannot be directly quantified. 'or example, management may be considering a proposal to build a recreation room for employees. The decision in this case will be based on qualitative factors, such as management L employee relations, with less consideration on direct financial returns. 3owever, most investment proposals considered by management will require quantitative estimates of the benefits to be

derived from accepting the project. " bad decision can be detrimental to the value of the organisation over a long period of time.

PB9POSE OF CAPI"A 6BD!E"IN! The capital budgeting decisions are important, crucial and critical business decisions due to following reasons0 (# Su$stantial e5pen%iture: -apital budgeting decisions involves the investment of substantial amount of funds. It is therefore necessary for a firm to ma(e such decisions after a thoughtful consideration so as to result in the profitable use of its scarce resources. The hasty and incorrect decisions would not only result into huge losses but may also account for the failure of the firm. *# ong time perio%: The capital budgeting decision has its effect over a long period of time. These decisions not only affect the future benefits and costs of the firm but also influence the rate and direction of growth of the firm. +# Irre'ersi$ilit.: #ost of the investment decisions are irreversible. 5nce they are ta(en, the firm may not be in a position to reverse them bac(. This is because, as it is difficult to find a buyer for the second*hand capital items. ,# Comple5 %ecision: The capital investment decision involves an assessment of future events, which in fact is difficult to predict. 'urther it is quite difficult to estimate in quantitative terms all the benefits or the costs relating to a particular investment decision.

CAPI"A 6BD!E"IN! P9OCESS The extent to which the capital budgeting process needs to be formali.ed and systematic procedures established depends on the si.e of the organisation2 number of projects to be considered2 direct financial benefit of each project considered by itself2 the composition of the firm4s existing assets and management4s desire to change that composition2 timing of expenditures associated with the projects that are finally accepted. (# Planning: The capital budgeting process begins with the identification of potential investment opportunities. The opportunity then enters the planning phase when the potential effect on the firm4s fortunes is assessed and the ability of the management of the firm to exploit the opportunity is determined. 5pportunities having little merit are rejected and promising opportunities are advanced in the form of a proposal to enter the evaluation phase. *# E'aluation: This phase involves the determination of proposal and its investments, inflows and outflows. Investment appraisal techniques, ranging from the simple paybac( method and accounting rate of return to the more sophisticated discounted cash flow techniques, are used to appraise the proposals. The technique selected

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should be the one that enables the manager to ma(e the best decision in the light of prevailing circumstances. Selection: -onsidering the returns and ris(s associated with the individual projects as well as the cost of capital to the organisation, the organisation will choose among projects so as to maximi.e shareholders$ wealth. Implementation: Ahen the final selection has been made, the firm must acquire the necessary funds, purchase the assets, and begin the implementation of the project. Control: The progress of the project is monitored with the aid of feedbac( reports. These reports will include capital expenditure progress reports, performance reports comparing actual performance against plans set and post completion audits. 9e'ie3: Ahen a project terminates, or even before, the organisation should review the entire project to explain its success or failure. This phase may have implication for firms planning and evaluation procedures. 'urther, the review may produce ideas for new proposals to be underta(en in the future.

Factors influencing capital $u%geting "vailability of funds !tructure of capital Taxation policy Bovernment policy 6ending policies of financial institutions Immediate need of the project %arnings -apital return %conomical value of the project Aor(ing capital "ccounting practice Trend of earnings CAPI"A 6BD!E"IN! "ECANICBESEME"AOD In order to maximi.e the return to the shareholders of a company, it is important that the best or most profitable investment projects are selected. /ecause the results for ma(ing a bad long*term investment decision can be both financially and strategically devastating, particular care needs to be ta(en with investment project selection and evaluation. There are a number of techniques available for appraisal of investment proposals and can be classified as presented below0

5rgani.ations may use any or more of capital investment evaluation techniques2 some organi.ations use different methods for different types of projects while others may use multiple methods for evaluating each project. These techniques have been discussed below M net present value, profitability index, internal rate of return, modified internal rate of return, paybac( period, and accounting (boo( rate of return. Pa.$ac4 Perio%: The paybac( period of an investment is the length of time required for the cumulative total net cash flows from the investment to equal the total initial cash outlays. "t that point in time, the investor has recovered the money invested in the project. "s with other methods discussed, the first steps in calculating the paybac( period are &etermining the total initial capital investment and the annual expected after*tax net cash flows over the useful life of the investment. Ahen the net cash flows are uniform over the useful life of the project, the number of years in the paybac( period can be calculated using the following equation0

Ahen the annual expected after*tax net cash flows are not uniform, the cumulative cash inflow from operations must be calculated for each year by subtracting cash outlays for operations and taxes from cash inflows and summing the results until the total is equal to the initial capital investment. A%'antages: " major advantage of the paybac( period technique is that it is easy to compute and to understand as it provides a quic( estimate of the time needed for the organi.ation to recoup the cash invested. The length of the paybac( period can also serve as an estimate of a project$s ris(2 the longer the paybac( period, the ris(ier the project as long*term predictions are less reliable. The paybac( period technique focuses on quic( payoffs. In some industries with high obsolescence ris( or in situations where an organi.ation is short on cash, short paybac( periods often become the determining factor for investments. imitations: The major limitation of the paybac( period technique is that it ignores the time value of money. "s long as the paybac( periods for two projects are the same, the paybac( period technique considers them equal as investments, even if one project generates most of its net cash inflows in the early years of the project while the other project generates most of its net cash inflows in the latter years of the paybac( period. " second limitation of this technique is its failure to consider an investment$s total profitability2 it only considers cash flows from the initiation of the project until its paybac( period and ignores cash flows after the paybac( period. 6astly, use of the paybac( period technique may cause organi.ations to place too much emphasis on short paybac( periods thereby ignoring the need to invest in long*term projects that would enhance its competitive position. Accounting (6oo4) 9ate of 9eturn: The accounting rate of return of an investment measures the average annual net income of the project (incremental income as a percentage of the investment.

The numerator is the average annual net income generated by the project over its useful life. The denominator can be either the initial investment or the average investment over the useful life of the project. !ome organi.ations prefer the initial investment because it is objectively determined and is not influenced by either the choice of the depreciation

method or the estimation of the salvage value. %ither of these amounts is used in practice but it is important that the same method be used for all investments under consideration. A%'antages: The accounting rate of return technique uses readily available data that is routinely generated for financial reports and does not require any special procedures to Benerate data. This method may also mirror the method used to evaluate performance on the operating results of an investment and management performance. 1sing the same procedure in both decision*ma(ing and performance evaluation ensures consistency. 6astly, the calculation of the accounting rate of return method considers all net incomes over the entire life of the project and provides a measure of the investment$s profitability. imitations: The accounting rate of return technique, li(e the paybac( period technique, ignores the time value of money and considers the value of all cash flows to be equal. "dditionally, the technique uses accounting numbers that are dependent on the organi.ation$s choice of accounting procedures, and different accounting procedures, e.g., depreciation methods, can lead to substantially different amounts for an investment$s net income and boo( values. The method uses net income rather than cash flows2 while net income is a useful measure of profitability, the net cash flow is a better measure of an investment$s performance. 'urthermore, inclusion of only the boo( value of the invested asset ignores the fact that a project can require commitments of wor(ing capital and other outlays that are not included in the boo( value of the project. Net Present 8alue "echni)ue: The net present value technique is a discounted cash flow method that considers the time value of money in evaluating capital investments. "n investment has cash flows throughout its life, and it is assumed that a rupee of cash flow in the early years of an investment is worth more than a rupee of cash flow in a later year. The net present value method uses a specified discount rate to bring all subsequent net cash inflows after the initial investment to their present values (the time of the initial investment or year 9 . Theoretically, the discount rate or desired rate of return on an investment is the rate of return the firm would have earned by investing the same funds in the best available

alternative investment that has the same ris(. &etermining the best alternative opportunity available is difficult in practical terms so rather than using the true opportunity cost, organi.ations often use an alternative measure for the desired rate of return. "n organi.ation may establish a minimum rate of return that all capital projects must meet2 this minimum could be based on an industry average or the cost of other investment opportunities. #any organi.ations choose to use the cost of capital as the desired rate of return2 the cost of capital is the cost that an organi.ation has incurred in raising funds or expects to incur in raising the funds needed for an investment. The overall cost of capital of a firm is a proportionate average of the costs of the various components of the firm$s financing. " firm obtains funds by issuing preferred or common stoc(2 borrowing money using various forms of debt such a notes, loans, or bonds2 or retaining earnings. The costs to the firm are the returns demanded by debt and equity investors through which the firm raises the funds. The net present value of a project is the amount, in current rupees, the investment earns after yielding the desired rate of return in each period. Net present 'alue I Present 'alue of net cash flo3 @ "otal net initial in'estment The steps to calculating net present value are (8 determine the net cash inflow in each year of the investment, (: select the desired rate of return, (; find the discount factor for each year based on the desired rate of return selected, (< determine the present values of the net cash flows by multiplying the cash flows by the discount factors, (= total the amounts for all years in the life of the project, and (> subtract the total net initial investment. A%'antages (# 7P@ method ta(es into account the time value of money. *# The whole stream of cash flows is considered. +# The net present value can be seen as the addition to the wealth of share holders. The criterion of 7P@ is thus in conformity with basic financial objectives. ,# The 7P@ uses the discounted cash flows i.e., expresses cash flows in terms of current rupees. The 7P@s of different projects therefore can be compared. It implies that each project can be evaluated independent of others on its own merit.

imitations (# It involves difficult calculations.

*# The application of this method necessitates forecasting cash flows and the discount rate. Thus accuracy of 7P@ depends on accurate estimation of these two factors which may be quite difficult in practice. +# The ran(ing of projects depends on the discount rate. 6et us consider two projects involving an initial outlay of ,s. := 6a(hs each with following inflow 0

Internal 9ate of 9eturn Metho%: 6i(e the net present value method, the internal rate of return method considers the time value of money, the initial cash investment, and all cash flows from the investment. 1nli(e the net present value method, the internal rate of return method does not use the desired rate of return but estimates the discount rate that ma(es the present value of subsequent net cash flows equal to the initial investment. 1sing this estimated rate of return, the net present value of the investment will be .ero. This estimated rate of return is then compared to a criterion rate of return that can be the organi.ation$s desired rate of return, the rate of return from the best alternative investment, or another rate the organi.ation chooses to use for evaluating capital investments. The procedures for computing the internal rate of return vary with the pattern of net cash flows over the useful life of an investment. The first step is to determine the investment$s total net initial cash disbursements and commitments and its net cash inflows in each year of the investment. 'or an investment with uniform cash flows over its life, the following equation is used0

If A is the annuit. %iscount factor> then

5nce " has been calculated, the discount rate is the interest rate that has the same discount factor as " in the annuity table along the row for the number of periods of the useful life of the investment. This computed discount rate or the internal rate of return will be compared to the criterion rate the organi.ation has selected to assess the investment$s desirability.

Ahen the net cash flows are not uniform over the life of the investment, the determination of the discount rate can involve trial and error and interpolation between interest rates. It should be noted that there are several spreadsheet programs available for computing both net present value and internal rate of return that facilitate the capital budgeting process.

Desira$ilit. FactorEProfita$ilit. In%e50 In above Illustration the students may have seen how with the help of discounted cash flow technique, the two alternative proposals for capital expenditure can be compared. In certain cases we have to compare a number of proposals each involving different amounts of cash inflows. 5ne of the methods of comparing such proposals is to wor( out what is (nown as the J&esirability factor$, or JProfitability index$. In general terms a project is acceptable if its profitability index value is greater than 8. Mathematicall.:

A%'antages The method also uses the concept of time value of money and is a better project evaluation technique than 7P@. imitations Profitability index fails as a guide in resolving capital rationing (discussed later in this chapter where projects are indivisible. 5nce a single large project with high 7P@ is selected, possibility of accepting several small projects which together may have higher 7P@ than the single project is excluded. "lso situations may arise where a project with a lower profitability index selected may generate cash flows in such a way that another project can be ta(en up one or two years later, the total 7P@ in such case being more than the one with a project with highest Profitability Index. The Profitability Index approach thus cannot be used indiscriminately but all other type of alternatives of projects will have to be wor(ed out.

Cuestion : ho3 %oes the cash flo3 anal.sis help a $usiness entit. < Ans3er 0 cash flow analysis is an important tool with the finance manager for ascertaining the changes in cash in hand and ban( balances as from one date to another, during the accounting year and also between two accounting periods. It shows inflows and outflows of cash i.e. sources and applications of cash during a particular period. The procedure for preparation of cash flow statement, its objectives and requirements are covered in "!*;. It is an important tool for short*term analysis, li(e other financial statements, it is analysed to reveal significant relationships. Two major areas, that analysts examine while studying a cash flow statement are discussed as below0 () cash generating efficienc. : it is the ability of a company to generate cash from its current or continuing operations. 'ollowing ratios are used for the purpose. i) cash flo3 .iel% : cash flow yield F net cash flow from operating activitiesDnet income ii) cash flo3 to sales : cash flow to sales F net cash flow from operating activitiesDnet sales iii) cash flo3s to assets : cash flow to assets F net cash flow from operating activitiesDaverage total assets

*) Free cash flo3 : strictly cash flow is the amount of cash that remains after deducting funds that the company has to commit to continue operating at its planned level. !uch commitment has to cover current or continuing operations, interest, income tax, dividend, net capital expenditures and so on. If the cash flow is positive, it means the company has met all its planned commitment and has cash available to reduce debt or expand. " negative free cash flow means the company will have to sell investments, borrow money or issue stoc( in short*term to continue at its planned level.

+) others : besides measuring cash efficiency and free cash flow, with the help of cash flow statement, the financial analysts also calculates a

number of ratios based on cash figures rather than on earning figures. !ome of which are as below0 i price per shareDfree cash flow per share ii operating cash flowDoperating profit it shows that accrual adjustments are not having severe effect on reported profits. iii self*financing investment ratio F internal fundingDnet investment activities it indicates how much of the funds generated by the business are re* invested in assets.

Cuestion : Discuss the estimation of future cash flo3s< Ans3er : In order touse any technique of financial evaluation, data as regards cash flows from theproject is necessary, implying that costs of operations and returns from theproject for a considerable period in future should be estimated. 'uture, isalways uncertain and predictions can be made about it only with reference tocertain probability levels, but, still would not be exact, thus, cash flows areat best only a probability. 'ollowing are the various stages or steps used indeveloping relevant information for cash flow analysis 0 ()Estimation of costs : To estimate cash outflows, information as regards followingare needed which may be obtained from vendors or contractors or by internalestimates 0 i -ost of new equipment2 ii -ost of removal and disposal of old equipment less scrapvalue2 iii -ost of preparing the site and mounting of newequipment2 and iv -ost of ancillary services required for new equipmentsuch as new conveyors or new power supplies and so on. The vendor may haverelated data on costs of similar equipment or the company may have to estimatecosts from its own experience. /ut,

cost of a new project specially the oneinvolving long gestation period, must be estimated in view of the changes inprice levels in the economy. 'or instance high rates of inflation has causedvery high increases in the cost of various capital projects. The impact ofpossible inflation on the value of capital goods must thus, be assessed andestimated in wor(ing out estimated cash outflow. #any firms wor( out a specificindex showing changes in price levels of capital goods such as buildings,machinery, plant and machinery, etc. The index is used to estimate the li(elyincrease in costs for future years and as per it, estimated cash outflows areadjusted. "nother adjustment required in cash outflows estimates is thepossibility of delay in the execution of a project depending on a number offactors, many of which are beyond the management4s control. It is imperativethat an estimate may be made regarding the increase in project cost due to delaybeyond expected time. The increase would be due to many factors as inflation,increase in overhead expenditure, etc. *)Estimation of a%%itional 3or4ing capitalre)uirements : The next step is toascertain additional wor(ing capital required for financing increased activityon account of new capital expenditure project. Project planners often do notta(e into account the amount required to finance the increase in additionalwor(ing capital that may exceed amount of capital expenditure required. 1nlessand until this factor is ta(en into account, the cash outflow will remainincomplete. The increase in wor(ing capital requirement arises due to the needfor maintaining higher sundry debtors, stoc(*in*hand and prepaid expenses, etc.The finance manager should ma(e a careful estimate of the requirements ofadditional wor(ing capital. "s the new capital project commences operation, cashoutflows requirement should be shown in terms of cash outflows. "t the expiry ofthe useful life of the project, the wor(ing capital would be released and can bethus, treated as cash inflow. The impact of inflation is also to be brought intoaccount, while wor(ing out cash outflows on account of wor(ing capital. In aninflationary economy, wor(ing capital requirements may riseprogressively eventhough there is increase in activity of a new project. This is because the valueof stoc(, etc. may rise due to inflation, hence, additional wor(ing capitalrequirements on this account should be shown as cash outflows. +)Estimation of pro%uction an% sales : Planning for a new project requires anestimate of the production that it would generate and the sale that it wouldentail. -ash inflows are highly dependent on the estimation of production andsales levels. This dependence is due to peculiar nature of fixed cost. -ashinflows tend to increase considerably after the sales are above the brea(*evenpoint. If in a year, sales are below the brea(*even point, which is quitepossible in a large capital intensive project in the initial year of itscommercial production, the company may even have cash outflows in terms oflosses. 5n the basis of additional production units

that can be sold and priceat which they may be sold, the gross revenues from a project can be wor(ed out.In doing so however, possibility of a reduction in sale price, introduction ofcheaper or more efficient product by competitors, recession in the mar(etconditions and such other factors are to be considered. ,)Estimation of cash e5penses : In thisstep, the amount of cash expenses to be incurred in running the project after itgoes into commercial production are to be estimated. It is obvious thatwhichever level of capacity utilisation is attained by the project, fixed costsremains the same. 3owever, variable costs vary with changes in the level ofcapacity utilisation. -);or4ing out cash inflo3s : The difference between gross revenues and cash expenses hasto be adjusted for taxation before cash inflows can be wor(ed out. In view ofdepreciation and other taxable expenses, etc. the tax liability of the companymay be wor(ed out. The cash inflow would be revenues less cash expenses andliability for taxation. 5ne problem is oftreatment of dividends and interest. !ome accountants suggest that interestbeing a cash expense is to be deducted and dividends to be deducted from cashinflows. 3owever, this seems to be incorrect. /oth dividends and interestinvolve a cash outflow, the fact remains that these constitute cost of capital, hence, ifdiscounting rate, is itself based on the cost of capital, interest on long termfunds and dividends to equity or preference shareholders should not be deductedwhile wor(ing out cash inflows. The rate of return yielded by a project at acertain rate of return is compared with cost of capital for determining whethera particular project can be ta(en up or not. If the cost of capital becomespart of cash outflows, the comparison becomes vitiated. Thus, capital cost li(einterest on long term funds and dividends should not be deducted from grossrevenues in order to wor( out cash inflows. -ash inflows can also be wor(ed outbac(wards, on adding interest on long term funds and depreciation to net profitsand deducting liability for taxation for the year.