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UNIT 1

UNDERSTANDING CORPORATE FINANCE

1.0 OBJECTIVE
The objective of this unit is to
a) Explain the scope of corporate finance
b) Examine carious possible objectives of the firm
c) Elaborate on the key decisions of finance
d) Elaborate on agency issues
e) Explain how three decisions of the firm are interrelated
f) Describe various activities of finance function

1.1 INTRODUCTION
Finance function in an organisation performs a key role in devising strategies,
evaluation of most profitable opportunities and monitoring of selected projects.
It encompasses cost control, budgeting and evaluation of reasons for failure
and success alike.

With increased local and global competiveness in the markets in this modern
era, projects are no more a situation of exploiting the opportunities by select
individuals and group with financial muscle. With increased access of resources
including capital the field has become much wider with many not only ready
to capitalise on the slightest of available opportunities but also create them of
their own. In this sense finance function in an organisation has assumed greater
significance and has started playing increasing role in decision making process
of strategic importance. This is in sharp contrast to the role of finance function in
the olden days where finance function was mainly confined to routine aspects
of regulatory and monitoring of resources.

The increased importance of finance function in the corporate world has
primarily emerged from the development of capital markets since 1950s.
Advancements in the capital markets with regard to behaviour of prices,
developments of asset pricing models, techniques of risk management,
approaches to valuation etc have placed onerous demands on the finance
function in terms of increased literacy, intelligence and comprehension. An
analytical approach has become almost mandatory in all financial decision
making areas. Subjective approach with qualitative reasoning is being
replaced by objective approach with quantitative details as far as possible.
However, it does not mean to suggest that subjective approach would be
completely and effectively be replaced by quantitative figures.

1.2 STAKEHOLDERS IN THE FIRM
For any decision making the objective of such decision must be absolutely
clear. Clarity of objective provides an unambiguous framework for an
organisation to make suitable decisions especially when there are conflicting
views amongst those who take decisions. Most decisions in an organisation are
collective and conflict of opinions among people is inevitable.

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Many believe that objective of the firm is dependent upon how the
organisation is constituted. There are broadly three kinds of firms
Proprietorship, Partnership and Corporations. Proprietorship is a firm owned by
single individual. Such forms of organisations are small where single individual
contributes the entire capital and solely responsible for all decisions in the firm.
Here the individual and firm are one and same. When resources required
become large, several persons pool together resources and run the enterprise
jointly. Such firms are called partnerships. When resources required (not
necessarily financial alone) become too large to be beyond the scope of few
individuals the firm has to mobilise resources from public at large. Those who
contribute capital are called shareholders. In order to provide an exit to the
shareholders, such shares are normally listed and traded on stocks exchanges
to facilitate the transfer of ownership from those wanting to exit to those
wanting to enter.



While not much conflict is seen in proprietorship and partnership organisations
due to commonality of management and ownership there is a conflicting
situation regarding corporations. Broadly speaking the capital can be provided
either by way of debt or by way of equity. Debt providers are content with fixed
return not linked to fortunes of the firm. Equity providers expect return
dependent upon the performance of the firm. People who contribute equity
capital have two distinct categories a) those with motive to invest to seek
control and management of the enterprise, and b) those with motive to invest
to make financial gain and not much concerned with management and
control the firm. More over these shareholders are sparsely located with little
Figure 1-1: Ownership and Management of a Corporation

Corporation
Shareholders
Managers
Need not be
shareholders
Involved in day-to-day
functioning of the firm
Mostly work for own
professional careers
sacrificing loyalty
Supposed to work in the
i t t f h h ld
Investors
Need not be managers
Sparsely located
Generally no role in the management
of enterprise
Expect financial gains commensurate
with the performance that may not
fructify
If not satisfied with the management
it b lli hi
Debt Holders
Provide capital for fixed
return
Fortunes of returns not linked
with performance
No role in management


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interaction among themselves. The ownership structure of a corporation is
depicted in Figure 1-2 highlighting the differences among the providers of
capital.

1.3 THE AGENCY PROBLEM
The organisation structure of the firm poses a serious question with regard to
management and ownership. Shareholders being owners have a right to
manage the firm. However, if the motive is to earn a reward on capital it is not
necessary that shareholders individually or collectively have the required skills
and knowledge to successfully run the firm. In their own interest they need to
appoint professionals to manage the enterprise they own. These managers are
supposed to act in the interest of shareholders. Relationship between the
managers and shareholders is akin to that of principal and agent, with
managers acting as agents of the principal; the shareholders.

Since management and ownership lies in separate hands the question that
arises is that do the agents always act in the interest of shareholders; referred as
agency problem. Managers have their own goals to pursue, which may conflict
with the interest of the shareholders. Top management living in palatial
bungalows in prime locations jetting around the world and riding expensive
automobiles, at the expense of the firm they work in and supposedly in the
interest of the shareholders, is a common occurrence. The cost of such luxuries
is borne by the firm and is actually a personal reward for the mangers. Though
certain luxuries may be admissible and actually may enhance the productivity
but an overdose of such awards dents the bottom line of the firm and hits the
shareholders. It is indeed difficult to draw a line between use and misuse and
make a distinction.

The conflict of interest between the interest of the shareholders and managers
pursuing their personal enrichment at the expense of the firm is referred to as
agency problem. A similar conflict may arise between other stakeholders in the
firm where interest of one group comes in the way of goals of another group.
Besides managers there are other stakeholders of in the firm. The next
prominent stakeholder is the debt providers. Though debt providers are only
interested in their known and fixed returns, but in order to ensure that these
minimum required returns are generated they may put some restrictive
covenants while providing debt. These covenants such as restrictions on
acquisitions, major expansion plans etc. even though in the long term interest of
all stakeholders constrain the freedom and pursuit the goals of shareholders.

Similar conflict situations may arise in respect of other stakeholders such as
customers, suppliers and government. This is condensed in Table 1-1.
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1.4 OBJECTIVE OF THE FIRM
In the context of several stakeholders and conflicting interest with the owners
(shareholders) there needs to be an objective that serves the interest of all
stakeholders alike. The framework of decision making must eliminate or minimise
conflicts. In this perspective there are several objectives that come to mind
such as maximisation of profit/EPS, maximisation of market share, minimisation
of cost, maximisation of shareholders wealth etc.

At first sight they all seem to be same, but in fact it is not so. There are situations
which can cause conflicts. Maximisation of profit or EPS would indirectly imply
that the firm sells at higher price (conflict with customers), procures inputs at
lesser cost (conflict with suppliers), save cost of compliances (conflict with
government) etc. While maximisation of profit/EPS serves the interest of the
shareholders it does not mean that interests of other stakeholders are equally
well served. Similarly maximisation of market share sounds good for customers
but it may be sacrificing the interest of the shareholders. Same holds true for
minimisation of cost. The other limitation is that such objective lack quantitative
framework.

The undisputed objective of the firm is maximisation of shareholders wealth.
Shareholders are owners of the residual only i.e. get whatsoever is left only after
obligations of all other stakeholders are served in full. Some may argue that
maximisation of shareholders wealth is a narrow self-serving goal lacking the
holistic view. According to such belief the organisation must exist for the welfare
of the entire society and not one group of the society; i.e. shareholders.
However, such belief is incorrect because this seemingly narrowed objective
encompasses much broader aspect of social welfare. The interest of the
shareholders comes in the last. They own only the residual howsoever small or
big. In case the residual does not exist they fund the gap in resources. If firm
continues to make losses it ultimately winds up and from that situation no one
benefits.
Table 1-1: Stakeholders and Shareholders: Conflict of Interest
Stakeholder Goals Conflict
Managers Personal career growth,
increased remuneration
and perquisites
Increases cost reducing the
benefit to the shareholders
Debt Providers To ensure promised return is
generated and principal is
repaid on time and debt is
secured by assets
Covenants may restrict
freedom of decision making
and may come in the way of
growth of the firm
Government To place suitable laws on
functioning of the firm and
collect taxes
Increases cost for legal and
environmental compliances
Customers Better quality products at
lower price and extended
credit period
Constrains liquidity, demands
investment adversely affecting
shareholders cash flow
Suppliers Supply inputs meeting bare
quality standards at more
than deserved price and
early/cash payment
Constrains liquidity, demands
investment adversely affecting
shareholders cash flow
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Further maximisation of wealth must not be construed as maximisation of profit.
Wealth is much broader term that not only includes current profit but the future
potential. Wealth is long term in nature while profit has limited time horizon. In
case the shares are traded the stock price reflects the present value of the
wealth. Profit is merely one constituent of determination of stock price and
hence the wealth. Therefore stock price provides exact quantification of the
wealth the shareholder would own. The changes in wealth could be measured
by changes in the stock price. Wealth therefore would include present and
future levels of profit, the firms utility to the society at large, interest of other
stakeholders, and the risk associated with the activities the firm undertakes. This
is because the shareholders decide the management and future course of
actions.

Therefore maximisation of shareholders wealth supersedes all other objectives
because of a) the long term view, b) shareholders sub-ordination to other
stakeholders, c) consideration of risks involved, d) quantification, and e)
shareholders control over management.

1.5 DECISIONS OF THE FIRM
From the perspective of financial management the firm is required to make
several decisions each of which influences the present and future activities. All
these decisions must be viewed with an unambiguous and sole objective of
maximisation of shareholders wealth. Finance function is required to make
three important decisions:

1. Investment decision
2. Financing decision, and
3. Dividend decision

1.5.1 Investment Decision
Investment decision relates to the allocation of financial resources to the
contemplated activities of the firm. Alternatively it is referred as capital
budgeting decision and broadly involves determination of requirement of
financial resources including working capital. Investment decision is focussed
on desirability of investment in expansions, acquisition, divestment and finding if
acceptance or rejection of the business idea would add or destroy the value of
the firm i.e. shareholders wealth. Most organisations face a constraint of
capital and have larger number of projects available. Not all projects are
equally rewarding and therefore need to be placed in an order of preferences.
Therefore we need to have a decision making framework to decide the
preferences.

The decision to accept or reject a project is based on what happens to
shareholders wealth. A project is accepted only when it is expected to
increase the shareholders wealth. In case of deciding the priorities of
acceptance the guiding principle is the accept projects that is expected to
result in the greater increase of the shareholders wealth.

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The investment decision can further be classified into two: 1) for fixed assets
referred as capital budgeting decision, and 2) for current assets referred as
working capital decision.

Investment in fixed assets relating to acquisition of land, building, plant and
machinery is concerned with long term growth and survival of the firm. In most
cases the capital outlay is large and the decision irreversible. To that extent it
becomes more risky and demands greater caution and exhaustive evaluation.
In contrast the investment decision relating to current assets referred to as
working capital decision is essentially a short term decision. It is subject to
change continuously and is reviewed periodically. Working capital decisions
can be corrected periodically. Also the capital outlay is rather small.

Characteristically, since working capital decisions are less risky and involve
smaller outlays the decision framework could be different than that of capital
budgeting decision.

1.5.2 Financing Decision
After establishing the desirability of investment the next question is how to fund
such investment. There are primarily two sources of funds available equity and
debt as depicted in Figure 1-1. Suppliers of equity capital called shareholders
provide capital with no fixed and assured reward. Shareholders fully recognise
that there may not any residual left for them and therefore assume risk of
getting no reward at all. Debt providers are interested in fixed reward quite
independent of the performance of the firm. Though capital has no colour and
does the same function irrespective of its source the mix of the two has
significant influence on the investment decision and the objective of the firm
i.e. maximisation of shareholders wealth.

How much debt and how much equity must be mobilised is called financing
decision and commonly referred as capital structure decision. One may
wonder how such a decision adds or destroys value. The answer lies in
understanding the linkages of investment and financing decisions. In theory the
capital structure decision can be proved to be immaterial to the value creation
(referred as irrelevance of capital structure and discussed later), but in real
world such may not be the case. Because of the priority of claims of debt
holders over equity holders the capital provided by latter is more risky and
therefore costlier. The cost of debt capital is rather less as it face minimal risk in
terms of return. Therefore the mix of two types of capital determines the overall
cost of capital for the firm; an important input for determining the financial
viability of the project. The risk profile of the nature of capital alters the return
expectations of its suppliers.

A project to be financially viable must meet the return expectations of the
investors as reflected in the cost of capital. The investment decision is
concerned with how adequately the cash flows of the project satisfy the
required return of the suppliers of capital. Changing capital structure implies
changing cost of capital, which in turn determines the acceptance or rejection
of investment decision. Therefore investment decision and financing decision
are intricately linked. The financing decision attempts to answer the question if
there is an optimal capital structure maximising the shareholders wealth.
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1.5.3 Dividend Decision
The third important decision of finance function is the dividend decision. Though
the entire residual belongs to the shareholder the dividend decision relates to
how much of the cash flow should be distributed now, called payout ratio and
how much must be retained to fund the future growth of the firm. Again,
though in theory the decision can be proved to be irrelevant to the value of the
firm (referred as irrelevance of dividend and discussed later) but in practice
several factors may make it relevant.

How much of the profit should be retained for the future growth would impact
the proportion of funds the shareholders would contribute in the investment.
Thus dividend decision affects the future capital structure which has bearing on
the investment decision.

In this perspective dividend decision can be viewed either as independent
decision capable of affecting the value of the firm of its own or as a passive
residual decision i.e. investment decision and financing decisions precede it.



Three decisions as described above are closely interrelated. Investment
decision cannot be made without the capital requirement which can be met
from external equity, retained earnings (internal equity) and debt. The other
input required for investment decision is the cost of capital. All three sources of
capital having different expectations of return have differing costs, put
Figure 1-2: Inter Linkages of the Decisions of the Firm




















Investment Decision

Financing
Decision

Dividend
Decision
Retained
Cash
C
a
s
h

D
i
s
b
u
r
s
e
d

D
e
b
t

E
q
u
i
t
y

C
o
s
t

o
f

C
a
p
i
t
a
l
C
a
s
h

G
e
n
e
r
a
t
e
d

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together determine the overall cost of capital. The outcome of the investment
decision is the cash flows generated which either can be distributed or
retained. Three decisions and their inter linkages are depicted in Figure 1-2.

1.6 FUNCTIONAL VIEW OF ORGANISATION
All decisions of the firm require a collective view from various departments that
constitute an organisation. Though there can be large number of departments
in an organisation depending upon its size, nature and other factors we can
clearly see minimum of four important functions of marketing, production,
finance and human resources. Each of these functions would have sub-goals
that not only may be at cross purposes with each other but also may not be
consistent with the sole objective of the firm of maximisation of shareholders
wealth.

For example marketing department of any organisation would like to pass on
the maximum benefit to the customer for increasing market share, gaining
customers favour in the interest of the firm. In their enthusiasm to gain sales the
importance of top line they tend to lose the bottom line. Similarly, production
department objective of producing standard products only maintaining no
inventory of goods would come in direct conflict with the objectives of
marketing function. Finance function would like to ensure that capital be
deployed most efficiently and hence force faster collection. The sub-goals of
the departments are made to ensure that personnel remain focussed and
these sub-goals are meant to facilitate achievement of the broader objective
of the firm. Some of the objectives of the departments are shown in Figure 1-3.
However they may end up as hindrance and the top management must
ensure congruence of departmental goals with the organisational goals.





















Figure 1-2: Functional Description of a Firm

















Board of Directors
Marketing Production Finance HR
Provide
suitable
manpower,
train and
retain them
to ensure
employee
satisfaction
Produce only on
receipt of
orders, and
standardised
goods
to derive home
the advantages
of economies of
scale
To generate
required
resources at
least cost,
and
put them to
most efficient
use
to optimise use
of capital
Supply
customised
product
ready delivery
at least cost
with extended
credit period
to gain
increased
market share
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1.7 ACTIVITIES OF FINANCE FUNCTION
The activities of finance function can broadly be classified under following two
heads:

1. Raising the required financial resources for the survival and growth of the
firm
2. Monitoring and controlling the end-use of the financial resources

There are many activities that are required for mobilisation of resources.
Management of public issues, raising debt from banks and financial institutions,
coordination with rating agencies, Investment of temporary surplus in
marketable securities etc are some of the activities. These are referred as
treasury functions. In larger organisation coordination with the stock exchanges
and maintaining of investor relations would also form the part of the treasury
function.

Under the second function normally referred as controller function the various
activities are preparation of budgets and MIS, costing, accounting and audits,
taxation. Development of systems and procedures for preventing misuse of
funds also forms the part of this activity.

In many of the activities the finance function performs the role of conflict
resolution. As we have seen that sub-goals of various departments come in
conflict with each other. In such situations finance function has to resolve the
conflicts in the interest of the overall objective of maximisation of shareholders
wealth. It is in this context finance function becomes more relevant and crucial
to the functioning of the organisation.

KEY TERMS

Agency
Problem

Do the managers who are not owners act as agents of
owners, the shareholders is referred as agency problem.

Investment
Decision

The decision with respect to acceptance and rejection of a
project is called investment decision

Financing
Decision
How much of debt and how much of equity is optimal for the
objective of maximisation of shareholders wealth is called
financing decision

Dividend
Decision
What proportion if the earnings must be distributed and what
proportion retained for future use is referred as dividend
decision.

SUMMARY

The increased importance of finance function in the corporate world has
primarily emerged from the development of capital markets since 1950s.
Advancements in the capital markets with regard to behaviour of prices,
developments of asset pricing models, techniques of risk management,
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approaches to valuation etc have placed onerous demands on the finance
function in terms of increased literacy, intelligence and comprehension.

To understand the role of the firm one need to understand who the
stakeholders in the firm are and what their objectives are. All the stakeholders
such as owners, lenders, employees, customers, suppliers and government have
different expectations from a firm. These different expectations make the
objective of the organisation hazy. This needs to be replaced by an
unambiguous objective.

Large firms typically are managed by professionals who are non-owners and
owned by vast number of individuals who are non-managers. Owners appoint
the managers who must act as agents to their principals. The interests of
managers may not be in the interest of owners and in case of conflict
managers may take a decision favouring them. Such happenings are referred
as agency problem.

In order to resolve the conflicts among the stakeholders there must be an
objective that is capable of resolving all conflicts. The undisputed objective of
the firm is maximisation of shareholders wealth. The objective of maximisation
of shareholders wealth supersedes all other objectives because of a) the long
term view, b) shareholders sub-ordination to other stakeholders, c)
consideration of risks involved, d) quantification, and e) shareholders control
over management.

There are three important decisions a firm has to make the investment
decision, the financing decision and the dividend decision. Investment decision
relates to the allocation of financial resources to the contemplated activities of
the firm. A project is accepted only when it is expected to increase the
shareholders wealth. Of the total resources required, how much debt and how
much equity is called financing decision and commonly referred as capital
structure decision. Though the entire residual belongs to the shareholder the
dividend decision relates to how much of the cash flow should be distributed
now, called payout ratio and how much must be retained to fund the future
growth of the firm. Three decisions of investment, financing and dividend are
closely interrelated. Investment decision cannot be made without the capital
requirement which can be met from external equity, retained earnings (internal
equity) and debt. The other input required for investment decision is the cost of
capital.

The activities of finance function can broadly be classified under two heads: a)
Raising the required financial resources for the survival and growth of the firm,
and b) Monitoring and controlling the end-use of the financial resources.

SELF ASSESSSMENT QUESTIONS

1. What is universally acceptable objective of the firm?

2. What are three important decisions of the firm?

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3. How do investment decision and financing decision effect each other?
Explain.

4. How investment decision and dividend decision are interrelated?

5. What do you understand by agency problem?

6. What are various functions of finance function?

FURTHER READINGS

1. Srivastava & Misra (2008), Financial Management, Oxford University Press,
Chapter 1
2. Prasanna Chandra (2009), Financial Management: Theory and Practice,
Tata McGraw Hill, Chapter 1
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UNIT 2

TIME VALUE OF MONEY


2.0 OBJECTIVE
The objective of this unit is to
a) Explaining what is meant by time value of money
b) How to compute the time value of money
c) What is meant by annuity
d) How to calculate the future value or the present value of money
e) What is the present value and future value of annuities
f) What is meant by Equated Monthly Instalments (EMIs) and how to
compute them
g) How to segregate the components of interest and principal from the
EMIs.

2.1 INTRODUCTION
One of the central themes of finance is the time value of money. It forms the
backbone of most financial analysis starting from simple computation of interest
one can earn from deposit in banks to the complex situations of determining
net present values, valuation of securities, valuation of bonds in the debt
markets, capital budgeting and mergers and acquisition.

It is also widely used in personal finance to determine instalments of loans in
leasing and hire-purchase transactions.

More complex applications of time value of money can be found in
mathematical proposition of finding the value of derivatives.

The applications are too numerous to be listed down. Possibly no financial
analysis would ever be complete without using the concept of time value of
money. In fact one can be certain that analysis is incomplete and most
probably wrong if it does not use the concept of time value of money.

2.2 MEANING OF TIME VALUE
The time value of money recognises the fact that value of money changes with
time. Most commodities lose value with time. With passage of time food gets
deteriorated, water is evaporated, metals get rusted, land loses productivity,
etc. However, such is not the case with money. Money grows with time. Even if
one does not put it to use and instead lends it to someone who puts it to use
and derive the benefits. The user would pay a price for this opportunity.
Because capital is scarce its value enhances with time.

The concept of time value of money recognises that value of the money is
different at different points of time. Since money can be put to productive use,
irrespective of whether it is actually done, the value of money is different
depending upon when it is received or paid. In simpler terms that need no
explanation that the money today is more valuable than the money tomorrow.
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It is not because of the uncertainty involved with time but purely on account of
timing. The difference in the value of money today and tomorrow is referred as
time value of money.

2.2.1 Importance of Time Value
Time value is important because we need to compare the money available at
different points of time. Generally the evaluation and analysis is carried out on
the basis of money generated or spent at different points of time. For
meaningful comparison we need to compare apples with apples and oranges
with oranges. We cannot mix the two. Likewise we need to compare the value
of money at same point of time for effective and appropriate comparison. To
make a judicious comparison we need to compares the likes and not dislikes.

The application of time value of money is an inevitable tool in financial analysis.
The scope of application of this concept is really vast. Since all financial issues
almost invariably deal with the analysis of cash flows that occur at different
points of time, it makes them non-comparable. For consistency of approach we
need to aggregate these cash flows and they simply cant be added unless
they are assume to occur at the same point of time. To bring these cash flows
at the same point one needs the concept of time value of money.

2.2.2 Sources of Time Value
Why should the value of money be different at different points of time is
because of several reasons. These reasons are
a) presence of inflation,
b) preference of individuals for current consumption over future
consumption, and
c) investment opportunities that make the money grow with time possibly
without taking risk.

Generally speaking money today is more valuable as compared to tomorrow is
because of inflation. By inflation it is meant that the goods would be more
expensive in future than what they are today. As we go deeper into the future
the prices of goods would keep increasing. Hence what can be bought today
with Rs 100, lesser quantity of the same goods can be bought in future. This
applies in general and some products like computers, durables may defy the
trend because technology absorbs the increased cost. In general the presence
of inflation makes money more valuable today than tomorrow.

The second reason having its origin in inflation is the preference of individuals to
consume now rather than later. If we sacrifice todays consumption it may be
done in the hope of having more in future. Possibly one would defer
consumption if more of product were available tomorrow than what is
available today. But due to inflation that is not likely to happen. Therefore,
consumers deserve a reward for postponing the current consumption to future.
This reward is likely to be increased amount of money in future.

Finally, why the money has time value is because capital can be put to
productive use, if not consumed now. Capital is scarce and there are people
who can always put it to productive use. Banks perform the activity of passing
on the capital from those with surplus to those with deficit.
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2.3 RISK AND TIME VALUE OF MONEY
Time value of money should not be construed as return on investment. They are
distinctly different. When one invests the expectations of returns comprise of
two factors
1. a reward for the risk undertaken in the investment and
2. a reward for waiting the investment to return.

The reward for the risk must be commensurate with the risk. Risk can broadly be
defined as uncertainty of the returns. When we talk of time value of money we
refer to the second component of the return that is completely associated with
the element of time and not risk. For the reasons stated in the preceding sub-
section the value of money differs with time we are concerned only with the
factor of deferment of consumption. Time value should not account for the risk
associated with the investment.

2.4 PRESENT VALUE AND FUTURE VALUE
Analysis of cash flow must be done at the same point of time. Usually analysis
involves cash flows that occur at different points of time and they need to be
brought to the same instant of time. Consider an example. Let us consider
investment of Rs 100 in two alternative projects A and B that yield the following
cash flows in 2 years:

Year 0 1 2
Project A - 100.00 80.00 70.00
Project B - 100.00 90.00 60.00

Projects A and B seem equivalent as they return a cash flow of Rs 150 over two
years for investment of Rs 100 toady. But are they really equal? Though initial
investment is same and the aggregate cash flows are also equal but they
occur at different points of time. That makes these projects unequal.

To make the right assessment as to which of the two projects A and B is better
and preferable, we need to compare the cash flows at same point of time. To
do this we bring cash flows occurring at different times at the same point of
time. We have following two choices:

1. To bring the cash flows of the projects to time t = 0, i.e. calculate the
present value of all the cash flows, or
2. To bring the cash flows of the projects to time t = 2 i.e. find the future
value of the cash flows at time t =2.

Present value: Present value answers the question how much is the present
worth of the cash flow that occurs in future.

Future value: Future value answers the question how much worth is the worth of
the cash flow if it has to occur at future date.

Whether we use present value or the future value we would reach the same
decision even though the numbers would be different.

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2.5 COMPOUNDING AND DISCOUNTING
How do we get the present and future values? To know the present value or
future value we need at what rate the value changes with time. The rate of
change in the value of money due to time is normally specified in terms of
percent per period normally a year. For example if the rate of change is 10%
per annum then the value of cash flow of Rs 100 today is equal to Rs 110 after
one year. Similarly a cash flow of Rs 100 a year later would have the present
value of Rs 100/ 1.10 =Rs 90.91.

As time elapses the present cash flows grows and the process of converting the
present cash flow to the future value is referred as compounding.

Similarly, as we go back in time the value of money decreases. The process of
finding the present value (value at time t =0) for the cash flow occurring some
time in future is called discounting.

Figure 2-1 and Figure 2-2 depict the process of compounding and discounting
for the value of money with respect to time.



2.6 FINDING FUTURE VALUE
Let us find the future value of the cash flows of the projects A and B.

We assume that the rate of change of value of money with time is 10% per
annum. It implies that if you are given Rs 100 today and decide not to use it
now and instead deposit in a bank for a year your money grows by 10% to Rs
110. This is the opportunity cost. At the rate of 10% the value after one year
becomes:
Figure 2-1: Compounding Increasing Value with Time

T =0 T =1 T =2 T =4


Figure 2-2: Discounting Decreasing Value with Time


T =0 T =1 T =2 T =4

2-5
Rs 100 + 10% of Rs 100 =100 + 10 =Rs 110

Or P x (1+ r) =100 x (1 + 0.1) =100 x 1.1 = 110; where P is principal amount
invested and r is the rate of change per annum represented in decimal form.

Further for the second year the amount becomes 110 x (1.1) = Rs 121.00, with Rs.
110 becoming principal amount for second period. The interest for the first
period becomes entitled for interest during the second period. The earning of
interest over interest is called compounding. The future value of an amount P at
rate of change of r after n periods is given by Equation 2-1

Future Value F =P x (1+r)
n
Equation 2-1

Using Equation 2-1 we find the future values of all the cash flows of Project A
and B at time T =2 as shown below:

Year 0 1 2
Project A - 100.00 80.00 70.00
70.00
88.00
- 121.00
Future value of Project A 37.00

Project B - 100.00 90.00 60.00
60.00
99.00
-121.00
Future value of Project B 38.00

The future value at time T =2 implies that if all the cash flows that occur at time t
=0, 1, and 2 are combined they are equivalent to Rs 37 for Project A and Rs 38
for Project B. Clearly, despite the fact that the net cash flows for Project A and
Project B were at Rs 50 (Rs 150 Rs 100), Project B is preferable than Project A.

2.7 FINDING PRESENTVALUE
As we find the future value of a cash flow that occurs today, in similar fashion
we can find the present value of the cash flow that occur in future. The process
used to find present value is called discounting. The present value for the future
cash flow is given by Equation 2-2 (an alternative form of Equation 2-1) as
below:
n
) r + 1 (
F
= P ..Equation 2-2

While computing the future value we transformed the cash flows at different
periods to time T =2, in computation of present value we would convert the
cash flows of different periods to time T =0. The underlying concept is the value
all the cash flows at same instant of time.

The value at T =0 could be found by discounting the cash flows using Equation
2-2. The present values of the cash flows are computed below:

2-6
Year 0 1 2
Project A - 100.00 80.00 70.00
- 100.00
72.73
57.85
Present value 30.58
of Project A

Project B - 100.00 90.00 60.00
- 100.00
81.82
49.59
Present Value 31.41
of Project B

Again it is clear that Project B is preferable to Project A since the present value
of B at Rs 31.41 is higher than that of A at Rs 30.58.

2.7.1 Reconciling Present and Future Values
The above analysis of present and future values

Future Value at T =2 Present Value at T =0
Project A Rs 37.00 Rs 30.58
Project B Rs 38.00 Rs 31.41

The future values and present values as stated above are different. But are they
equivalent? Certainly yes. Let us examine if it is so. We may do so by converting
either i) the future values to the present values, or ii) present values to future
values.

The value of cash flows at T =2 is equal to present value of

37.00/ 1.10
2
=Rs 30.58, and 38/1.10
2
=31.41

Similarly, future value of the cash flows at T =0 are

30.58 x 1.10
2
=Rs 37.00, and 31.41 x 1.10
2
=Rs 38.00

Since the present values and future values are equivalent we can make our
judgement about desirability of project on either basis and yet we would reach
the same conclusion.

2.7.2 Future Value and Present Value Tables
The future values and present values are so frequently used that tables
providing these values become very handy. These tales are provided at the
end of the study material as Appendices 1 and 2 for different rates from 1% to
20% and from periods of one year to 30 years.

2.7.3 Impact of Compounding and Discounting:
Compounding increases value of money with time. There would be increase in
value as we move one period ahead from Period 1 to Period 2. What about
2-7
increase in value in one period from Period 11 to Period 12. The increase in
latter case would be much higher. The effects of compounding become larger
and larger as time progresses. It is because of the reason that growth applies
not only to the original sum at T =0 but also to the money earned over last 10
year on it.

1. The money grows at increasing rate as time elapses.
2. The impact of compounding is more and more pronounced as the rate
of interest increases.

Like compounding, the effect of discounting is more pronounced if the cash
flows are more distant in future. Discounting decreases value.
1. The decrease in value would be at increasing rate for more distant future
cash flows.
2. Discounting is more pronounced as the discount rate increases.

2.8 ANNUITY
Sometimes same cash flows occur at evenly spaced intervals. We also make
investment on a periodic basis with same amount of investment in each period,
like a recurring deposit in a bank, premium paid for life insurance, or investing in
provident fund every month. The tenure of investment is fixed and known at the
time of making the investment. We either receive or pay a fixed some in each
period for specified number of periods.

A stream of equal cash flows on a recurring basis at uniform intervals of time is
referred as annuity. Though the term annuity refers to annual periods but it can
be used for any interval of time other than a year but they must be equally
spaced.

2.9 FUTURE VALUE OF ANNUITY
Future value often referred as terminal value can be found using the principle
of compounding. Compounding is used for every cash flow to find the value at
maturity. The first cash flow would last till maturity while the second cash flow
would last one period less. The last cash flow would be invested only for one
period.

For example consider a deposit of Rs 100 in a bank account every year for a
period of 5 years that pays 10% per annum. The maturity value or terminal value
(MV or TV) can be found by treating the each years stream as a separate
investment with first year payment being invested for five years, second year
payment invested for 4 years and so on with last payment at 5
th
year invested
for one year. What would be the value of such savings at the end of 5 years?
Figure 2-3 depicts the outcome of such investment where each contribution is
treated independently.

The maturity value of such a recurring investment for an interest rate of r is
found mathematically as
=100(1+r)
5
+100(1+r)
4
+ 100(1+r)
3
+ 100 (1+r)
2
+ 100 (1+r)
=100(1.1)
5
+100(1.1)
4
+ 100(1.1)
3
+ 100 (1.1)
2
+ 100 (1.1)
=100 x 1.6105 +100 x 1.4641 + 100 x 1.3310 + 100 x 1.2100 + 100 x 1.1
=Rs 771.56
2-8

The terminal value as computed above is stated in terms of a formula through
Equation 2-3.

n
1
n
r) (1 n) (r, FVA 1, Rs of Annuity of Value Future Equation 2-3
The value in Equation 2-3 is referred as Future Value Annuity Factor at interest
rate of r for n periods. Alternative form of Equation 2-3 is given below as
Equation 2-4
1
.

r
1 - r) + (1
= n) FVA(r,
years, n for r% at Factor Annuity Value Future
n
.Equation 2-4
2.10 PRESENT VALUE OF ANNUITY
We considered the issue of making investment on a periodic basis and
determined the value of the investment at a future date in the earlier section
by compounding the each cash flow.

How do we find the value of the uniform stream of cash flow that occurs at
regular intervals of time in future? To do so we reverse the process i.e.
compounding is replaced by discounting. In the earlier section the issue was
considered by making a recurring deposit in the bank for 5 years and found the
terminal value. We now try to find the present value of the cash flow of Rs 100
that is available at the end of each year for 5 years.

1
Equation 2-3 is a geometric progression with subsequent value increased by a factor of (1+r). The sum of
geometric progression Sn is derived as follows:
r
1 - r) + (1
= S or,
1 - r) + (1 = S x r
: (2) from (1) g Subtractin
) 2 .......( ) r + 1 ( + r) + (1 + .. .......... r) + (1 + r) + (1 + r) + (1 + r) + (1 = S ) r + 1 (
get we r) + (1 by sides both g Multiplyin
) 1 ........( r) + (1 + .. .......... r) + (1 + r) + (1 + r) + (1 + r) + (1 + 1 = S
n
n
n
n
n 1 - n 4 3 2
n
1 - n 4 3 2
n

Figure 2-3: Future Value of Annuity
Figures in Rs
Time 1 2 3 4 5 End of 5
Amount 100.00 100.00 100.00 100.00 100.00
110.00
121.00
133.10
146.41
161.05
Terminal value of the cash flows after 5 years 771.56
2-9

Figure 2-4 gives the present value of Rs 100 occurring at the beginning of each
period by using Equation 2-2 with rate of change at 10% per annum.

The present value of recurring cash flows for an interest rate of r is found
mathematically as
=100/ (1+r)
5
+100/ (1+r)
4
+100/ (1+r)
3
+ 100/ (1+r)
2
+ 100/ (1+r)
1

=100/ (1.1)
5
+ 100/ (1.1)
4
+100/ (1.1)
3
+ 100/ (1.1)
2
+ 100 / (1.1)
1

=100 x 0.6209 + 100 x 0.6830 +100 x 0.7513 + 100 x 0.8264 + 100 x 0.9091
=Rs 379.07

Mathematically, the present value of an amount of Rs 1 received for n years at
interest rate of r is represented as Equation 2-5.

n
1
n
r) (1
1
n) (r, PVA 1, Rs. of Annuity of Value Present

Equation 2-5
The value is in Equation 2-5 is referred as Present Value Annuity Factor. These
values are derived from following formula
2
:
n
n
r) r(1
1 - r) + (1
= n) PVA(r,
years, n for r% at Factor Annuity Value Present

...Equation 2-6
2.11 PERIODICITY OF COMPOUNDING AND DISCOUNTING

2
Equation 2-6 is a geometric progression with subsequent value decreased by a factor of 1/ (1+r). The sum of
geometric progression Sn is derived as follows:
n
n
n
n -
n
1) - (n - 3 - 2 - 1 -
n
-n -4 -3 -2 -1
n
r) + r(1
1 - r) + (1
= S or,
r) + (1 - 1 = S x r
: (2) from (1) g Subtractin
) 2 .......( r) + (1 + .. .......... r) + (1 + r) + (1 + r) + (1 + r) + (1 = S ) r + 1 (
get we r) + (1 by sides both g Multiplyin
) 1 ........( r) + (1 + .. .......... r) + (1 + r) + (1 + r) + (1 + r) + (1 = S



Figure 2-4: Present Value of Annuity
Figures in Rs
Time 0 1 2 3 4 5
Amount 100.00 100.00 100.00 100.00 100.00
90.91
82.64
75.13
68.30
62.09
379.07 Present value of annuity of 5 years
2-10
How do we compute the present and future values if the periodicity of rate of
growth is changed from annual to some other period? As a simple exposition
consider Rs 100 growing at the rate of 10% per annum but the compounding
period is reduced to 6 months. It means that the money would grow at the rate
of 5% every six months. After 6 months the sum would be Rs 105. For the second
six months Rs 105 becomes the principal and it would become 105 x 1.05 = Rs
110.25. In case of annual periodicity of compounding the sum would be Rs 110.
The extra amount of Rs 0.25 comes from interest over interest in the second
period of 6 months.

If the periodicity is increased to 3 months the computation of amount would be
as follows:
Time Amount Interest % Interest Closing balance
1
st
quarter 100.0000 2.5% 2.5000 102.5000
2
nd
quarter 102.5000 2.5% 2.5625 105.0625
3
rd
quarter 106.0625 2.5% 2.6265 107.6890
4
th
quarter 107.6890 2.5% 2.6922 110.3812

We may generalise the above in the following Equation 2-7.

Future Value F =P x (1+r/m)
mxn
.Equation 2-7
Where r=annual rate of interest m =total number of periods and
n =number of years

Similarly we may generalise the present value of the future cash flows by
Equation 2-8 by re-arranging the Equation 2-7.
mxn
r/m) + (1
F
= P Value, Present .. Equation 2-8

Continuous Compounding & Discounting
The maturity value of the deposit keeps increasing as periodicity increases from
quarterly to monthly to daily. How far can we reduce the interval of
compounding what ultimate value can be achieved? In the ultimate case the
compounding becomes continuous. In case of continuous compounding the
future value and discounted value may be given by following Equation 2-9 and
2-10 respectively.

10 - 2 Equation . .......... .......... e x F =
e
1
x F = P Value, Present
9 - 2 Equation ...... .......... .......... .......... . e x P = F Value, Future
rt -
rt
rt


For a two year deposit of Rs. 100 the maximum maturity value (with continuous
compounding) at 10% is 100 x e
0.10x2
=Rs 122.1403 as against Rs 121.00 over a
two year period with annual compounding.

2.12 EQUATED MONTHLY INSTALMENTS
In personal fianc for housing, car loans etc the concept of time value of
money is extensively used. Time value of money forms the basis of fixing the
periodic repayment. In most cases these repayments are in regular equally
2-11
spaced in time and equal instalments payable at specific intervals usually
monthly called Equated Monthly Instalments (EMIs).

The EMIs are regular periodic payments whose present value, discounted at
specified rate of interest, adds to the loan value. Through EMIs the lender
recovers the original amount as well as the desired interest on the loan.

As an example consider a loan of Rs 1,00,000 repayable in 5 yearly instalments
with interest rate of 10%. Referring to Appendix A-4 for 10% for 5 periods we find
PVA(10%,5) at 3.7908 implying that present value of Rs 1 received each year for
5 years is Rs 3.7908 at 10%. Therefore for a loan of Rs 1,00,000 the annual
instalment of Rs 26,379.75 (1,00,000/3.7908) may be fixed.

2.12.1 Finding out EMIs with EXCEL
The EMIs are fixed in such a manner that the cash flows of the bank yield the
desired return of 10% p.a. This can easily be done with the help of EXCEL using
PMT function, as displayed below:

Principal Amount (Rs.) 20000 Interest rate (%) 10%
Period (years) 3

EMI (Rs. Per month) =-PMT(10%/12,3*12,20,000,0,1)

The syntax for PMT function uses five fields; 1) interest rate for the period 2)
number of instalments (periods), 3) value of the loan (the loan amount), 4)
residual value at the end of the period of loan (taken as 0 if all loan has to be
repaid), and finally 5) a field describing the nature of payment, 1 for payment
in advance and 0 for payment in arrears. This is shown in Figure 2-5.

Figure 2-5: Calculating Equated Monthly Instalments (Payable in Advance)

2-12

2.12.2 Segregating the EMIs into Principal and Interest
Each EMI paid consists of two parts i) interest on the outstanding loan and ii)
repayment towards principal. It would be wrong to assume that the interest
and principal repayment would be same in each EMI. Since in the beginning
the loan is at maximum and therefore the interest component in the EMI is the
largest. As we pay instalment
1. The amount of interest decreases, and
2. The amount of principal repayment increases

However, though the two components vary in each instalment the total of the
two remains same for entire duration of the loan.

The procedure to segregate the amount into interest and principal repayment
would be as follows;
a) For the first instalment the entire loan amount would carry interest at 10%,
b) Calculate the interest on principal (for the first EMI entire loan would be
outstanding) at the given rate,
c) Subtract the interest in (b) from the EMI, to get the repayment,
d) Reduce the principal outstanding by the amount in (c). This would be
the principal outstanding for next period,
e) Repeat steps (b) to (d) till the last EMI.

Using the above procedure the EMI of Rs 26,379.75 for the loan of Rs 1,00,000
for 5 years at 10% EMI is shown in Table 2-1.

Table 2-1: Segregating EMIs in Interest & Principal
Figures in Rs
Year Principal
outstanding
at
beginning
Instalment
paid
Interest Principal
repayment
1 1,00,000.00 26,379.75 10,000.00 16,379.75
2 83,620.25 26,379.75 8,362.03 18,017.73
3 65,602.53 26,379.75 6,560.25 19,819.50
4 45,783.03 26,379.75 4,578.30 21,801.45
5 23,981.58 26,379.75 2,398.16 23,981.59

2-13
2.13 FINDING PRESENTAND FUTURE VALUES OF ANNUITY USING EXCEL
Future value of an annuity can be found using EXCEL. We need three inputs
the rate of interest per period, the number of periods for which the amount is
received/paid, and the amount in each period. Then we may go to Insert-
Function FV and find the value as shown in Figure 4-5.

Figure 4-5: Finding Future Value of an annuity using EXCEL


Like future value of an annuity we can also find present value of an annuity
using EXCEL. We need three inputs the rate of interest per period, the number
of periods for which the amount is received/paid, and the amount in each
period. Then we may go to Insert- Function PV and find the value as shown in
Figure 4-7.

Figure 4-7: Finding Present Value of an annuity using EXCEL


2-14
SOLVED PROBLEMS

Example 2-1: Compounding and Future Value
You have Rs 50,000 available today for investment. A bank has offered 12% interest
payable annually.
1. What would be the maturity value of the investment after 5 years?
2. What would be the value of investment if compounding is done a) every 6
months, b) every 3 months.

Solution:
1. The maturity value of the investment after 5 year at 12% is given by:

50,000 x (1 +0.12)
5
=50,000 x 1.7623 =Rs 88,117.08

2. If interest is payable 6 monthly the rate would be 6% and number of periods would
be 5 x 2 =10. For quarterly compounding the interest rate is 3% with number of
periods at 5 x 4 =20. Therefore the maturity value would be

For 6 monthly compounding: 50,000 x (1 +0.06)
10
=50,000 x 1.7908 =Rs 89,542.38
For 3 monthly compounding: 50,000 x (1 +0.03)
20
=50,000 x 1.8061 =Rs 90,305.56


Example 2-2: Finding Annuity Values
If you were to receive Rs 1,00,000 every year for next 10 years what worth would it be
today if current rate of return is 8%?

Solution:
The present value of the sum of Rs 1 lac for 10 years at 8% is given by:
=Rs 1 lac x PV of Annuity (8%, 10 yrs) =1.0 x 6.7101 =Rs 6.7101 lacs


Example 2-3: Finding EMI
AB Ltd. is borrowing Rs 1.50 lacs for a period of 5 years at interest rate of 11% repayable
in 5 equal annual instalments at the end of each year. Find out the instalment amount,
the interest paid each year and the total interest paid for the loan.

Solution:
We may find the amount of instalment using EXCEL function PMT (11%, 5,150000, 0, 0) or
use the annuity table. The value of annuity at 8% for 5 years is 3.6959. Therefore the
instalments would be 1,50,000/3.6959 =Rs 40,585.55.

The break-up of each instalment into interest and principal is given below:

Year
Principal
outstanding
at
beginning
Instalment
paid Interest
Principal
repayment
1 1,50,000.00 40,585.55 16,500.00 24,085.55
2 1,25,914.45 40,585.55 13,850.59 26,734.96
3 99,179.50 40,585.55 10,909.74 29,675.80
4 69,503.70 40,585.55 7,645.41 32,940.14
5 36,563.56 40,585.55 4,021.99 36,563.56
TotalInterest 52,927.73

2-15

KEY TERMS

Future Value

The value of money at a future date with the given interest
rate

Present value The worth of the money today that is receivable or payable
at a future date.

Compounding The process of application of interest over interest period
after period over a given sum at specified rate for specified
time to know the worth of the money at a future date.

Discounting The process of removal of interest over interest period after
period on the given money at a future date to find out its
worth in todays date.

Annuity A fixed and equal amount of money receivable or payable
at periodic intervals evenly spaced over time, usually a
year.

Equated
Monthly
Instalments
An equal amount of money payable or receivable at
periodic intervals of time usually a month that is equal to the
amount of loan principal and the interest thereon at a given
rate.

SUMMARY

Time value of money is the most important concepts in finance that forms the
basis of decision making in almost all areas of finance. The applications range
from personal finance areas to corporate finance like capital budgeting and
valuation and derivatives and risk management.

The time value of money means that besides the amount of money it is
important when is it received. The reason for the time value of money is that it
has capacity to increase in value even when it is not put to any use.

The value of money increases with time due to application of interest. It grows
at a higher rate when interest is applied on the interest. Application of interest
over interest is known as compounding. Similarly the value of the money
received or paid later is less than what it is today by the amount of interest for
the time. The process of reduction in value eliminating the interest that could
have accrued is known as discounting.

Annuities refer to the equal amounts of cash flows spaced uniformly over time,
normally a year. The value of equal amount of receivable or payable at evenly
spaced intervals of time at a given rate of interest is called future value of
annuity. Similarly for a sum receivable or payable at a future date can be
equated with the equal amounts evenly spaced over time at a known rate of
interest.

2-16
Present values and future values of a single cash flows or recurring equal cash
flows are normally available in the Tables for computational use because of
very frequent applications of these values in finance.

One prominent application of the time value of money that is very widely used
in the field of finance is the determination of equated monthly instalments for
recovery of loans in specified time period and at a given rate of interest.

SELF ASSESSSMENT QUESTIONS

1. What is meant by time value of money?

2. What are the possible reasons that the money has time value?

3. Would you consider the reward for the risk undertaken in an investment
while calculating the time value of money? Explain.

4. What do you understand by a) future value and b) present value of
money c) annuities?

5. What principle is used in determining the Equated Monthly Instalment?

6. For how long should one invest to get double the amount a) at 10% b) at
8%?

7. Suppose you have Rs. 12,000 today and need to preserve it for next 8
years when you are required to pay fee for your son estimated to be Rs.
40,000.
a) At what rate should you invest this money so as to have the required
sum at the end of 8 years?
b) If you needed Rs 40,000 after 8 years and could invest at 12% only

8. AB Ltd. is borrowing Rs 50 lacs for a period of 4 years at interest rate of
15% repayable in equal instalments at the end of each year. Find out the
instalment amount, the interest paid each year and the total interest
paid for the loan.

FURTHER READINGS

1. Srivastava & Misra (2008), Financial Management, Oxford University Press,
Chapter 4
2. Prasanna Chandra (2009), Investment Analysis and Portfolio
Management: Theory and Practice, Tata McGraw Hill, Chapter 5

3-1
UNIT 3

INTRODUCTION TO RISK AND RETURN

3.0 OBJECTIVE
The objective of this unit is to
a) Explain the meaning of return and risk
b) Discuss various measures of return
c) Draw distinction between arithmetic mean, geometric mean, IRR and
expected value
d) Discuss various measures of risk
e) Demonstrates the superiority of standard deviation as measure o frisk
f) Explain the use of historical financial data to find expected value and
standard deviation

3.1 INTRODUCTION
Risk and returns are the two sides of the same coin. They are inseparable and
are so intricately linked that understanding of one without the other becomes
difficult. It is common to hear phrases like the returns are attractive but the risk
attached with it is too high or it seems a safe investment but the returns are
indeed poor. All such statements are subjective and biased by personal
preferences and attitudes towards risk and return. What could be risky for one
may be too dangerous for another. Similarly, a 10% return on bank deposit
would attract old and retired people but may not induce a young executive of
a multinational firm. Risk and returns go hand in hand and need to be weighed
together.

Understanding of risk and return is vital for all. For an individual they become
important for making investment decisions for the purpose of investing the
savings and planning for retirement, while for firms they are critical dimensions
along which all growth oriented projects and decisions of capital budgeting
are taken. Irrespective of the motives for investment we need to find a way to
measure risk and return.

The purpose of this Unit is to render objectivity to the assessment of risk and
return while refraining from making subjective interpretation of it being bad or
good, adequate or inadequate, acceptable or unacceptable, high or low etc.
We shall be dealing with the quantification of return and risk by attaching a
number to them so as to enable comparison of different investment
opportunities available. It is of significance because each individual or firm has
a menu of investments to choose from. Even if all the investments may be
acceptable they need to be ranked in order for making preferences along the
parameters of risk and return amongst the alternatives available.

3.2 SOURCE OF DATA ON RETURN AND RISK
For measurement of returns one needs a) the amount of investment b) its
maturity value and c) period of investment. Since by convention returns are
specified in annual terms the period of investment is deemed to be one year.
Also initial investment if deemed to be Rs 100 the returns become annualised
3-2
percentage. This leaves only maturity value of investment to be determined for
an initial investment of Rs 100. Similarly, the risk associated with the investment
would be reflected in the returns offered. Here we assume a common sense
preposition that increased risk demands increased returns. Risk and return
would move in the same direction.

To project the future value of investment one usually resorts to financial markets.
The prices of the financial assets as reflected in the stock markets, currency
markets and derivatives markets are normally used as efficient substitutes and
best proxy for the investment of any kind. The returns offered by the financial
assets must reflect true returns for several reasons. The reasons include i) the
easy availability of price information of financial assets, ii) great reliability of
prices as financial assets are frequently traded, iii) financial markets and prices,
there reflect collective wisdom of the market independent of individual biases,
and iv) the prices are freely determined in a competitive market, and even
when markets are not competitive that is the closest to free markets we have.

Based on the premise that returns offered by the financial assets would
incorporate the risk associated in owning the financial asset the same
information can serve as guide to assess and measure the risk as well.

All we need to do to assess return and risk of an investment is to find a
comparable financial asset that is traded in the financial markets. If we
succeed in doing so our job of measuring returns and risk is greatly simplified
and half done. Further with ever maturing financial markets world over the
identification of comparable financial assets should pose no great threats to
the most situations that we are likely to face in the real world.

3.3 RETURN
Admitting that financial assets serve as ideal proxy for measurement of returns
lets us assume that we wish to examine the returns from investment in telecom
business. For such business the returns offered by investment in Bharti Telecom
should serve as an ideal proxy for measurement of returns in such business.
Similarly an investment in petro-chemical we can approximate the return to the
returns on the stocks of a similar firm listed on the stock exchanges.

Having appreciated the suitability of data of financial assets to serve as
appropriate measure of returns let us focus on methods of measurement. For
convenience assume that the investment horizon is one year. Assume that one
makes an investment at t = 0 at in a firm whose price is Rs 100 (P0). After a year
the stock price becomes Rs 110 (P1). During this period the firm also gives a
dividend of Rs 5. Ignoring the time value of money, the % return on the can also
be stated as
% 5 1 x100
100
100 - 115
x100
Invested Amount
Invested Amount - end at Value
Return %
= =
=

This return can be split in two components of dividend yield and capital gains.
The total return after a period of one year is Rs 15 on an investment of Rs 100. Of
this an amount of Rs 5 is earned as dividend and Rs 110 is the profit upon selling
of the asset after investment horizon of one year. It may be noted that whether
3-3
or not the divestment is done is immaterial to the computation of return. If
actually divested the investor would realise the capital gain, and if not divested
the capital gain would remain unrealised. Therefore,

Total Return = Dividend Earned + Capital Gain
= 5 + 10
= Rs 15

The percentage return can be expressed in mathematical terms assuming P0 as
the initial price, D1 is the dividend received in the period 1, and P1 is the price at
the end of period 1, as Equation 3.1 as follows:
1 - 3 ion .....Equat .......... ..........
P
P P
P
D
P
) P (P D
Investment Initial
Gain Capital Dividend
Return Percentage Total
0
0 1
0
1
0
0 1 1
-
-
+ =
+
=
+
=


In the above analysis we have ignored the time value of money, made no
adjustment for inflation and the returns calculated are in nominal terms, and iii)
not provided for taxes that may be payable on dividend and capital gains that
are taxed at different rates.

3.4 EXPECTED RETURN
The computation shown in the preceding section assumed that prices at the
time of investment as well as divestment are known. Normally only the initial
value of investment is known and the value of divestment remains unknown. In
such a case the returns need to be worked out on expected value of asset in
future. The returns so determined would be expected return.

There are several ways one can estimate the expected return. These can be

By Direct Questionnaire: One way of finding the expected return is to address a
direct question to sufficiently large investors as to what price or return is
expected by them, and use statistical methods to arrive at a consensus view
about the return expectations of the investing community as a whole. Such a
method is time consuming, cumbersome and costly.

Develop a Valuation Model: Another approach to assess the expected return is
to develop valuation model that determines the value of the asset at the
end of investment horizon. Such an approach requires thorough
understanding of the business and understanding of the critical value
determinants. For example internet companies may be valued on the basis
of number of hits or a real estate firm on the basis of land area owned etc.
Such method of valuation with specific characteristics is adopted by equity
research firms, investment advisors etc as deep understanding and
intelligence is required for such an approach.

Use Standard Model: Those who are unable to comprehend the business
intricacies normally adopt more conventional models. These models are
popular with large number users and include models such as CAPM (Capital
3-4
Asset Pricing Model), APT (Arbitrage Pricing Model), PE Ratio (Price Earnings
Ratio) etc. The approach is easy to implement as data requirements are
nominal and publicly available. One simply needs to plug in the publicly
available data in to the model to arrive at expected return.

Use Historical Data: Yet another effective and inexpensive way is to use the
past returns as reflector of the future returns. It is believed that for
conventional businesses the changes in the expected return changes too
gradually. As such the returns offered in the recent past must give sufficient
indication of the returns expected in near future. It is a time tested approach
that requires minimal calculations. With the advent of information
technology the process of computing past returns can be completed in
matter of minutes.

3.5 ARITHMETIC MEAN (AVERAGE)
From the historical price data of the financial assets it is easy to compute the
average over the past. Assume that we are finding the average return on the
stock whose prices have moved from Rs 100 to Rs 130 in 6 years. During these 5
years the firm has also paid dividend of Rs 12 every year in preceding 3 years
and Rs 10 every year prior to that. The computation of the average return can
be earnings by way of dividend of Rs 36 and Rs 20 in 5 years and Rs 30 as
capital gain at the end of 5
th
year. Thus the average annual return is 86/5 =
17.2%.

However, this is not the way returns are computed. In order to have better
estimate we need to have returns on annual basis for all the five years. For this
we need to have price of the stock at the end of each year. All the data is
presented in Table 3-1.

Table 3-1: Historical Data of Stock Price Figures in Rs
YEAR Share Price
Pt
Dividend
during the
year, Dt
Capital Gains
(Pt Pt1)/Pt1
Dividend Yield
Dt/Pt1
Rate of
Return
(%)
0 100 - - - -
1 110 10 10/100 10/100 20.00
2 120 10 10/110 10/110 18.18
3 100 12 20/120 12/120 6.66
4 90 12 10/100 12/100 2.00
5 130 12 40/90 12/90 57.78

The average rate of return is the simple arithmetic mean of the returns. The
arithmetic average
R
mathematically is represented by Equation 3-2,
2 3 Equation . .......... R
n
1
) R .. .......... R R (R
n
1
R Return; Arithmetic
n
1
n n 3 2 1
= + + + =



For the data in Table 3-1 the arithmetic mean of returns works out to 18.26% as
follows:
% 26 . 18
5
3 . 91
57.78) 2.00 6.66 - 18.18 (20.00
5
1
R Return; Arithmetic = = + + + =
Arithmetic mean represents that on an average the stock yielded the return of
18.26% based on the past price and dividend performance.
3-5

Note that while computing the average return with annual data we obtained a
different figure (18.26% vs 17.2%). It is due to the fact that average returns for
the period used the price data at the beginning and end of each year, and
therefore returns for the year were based on the price at the beginning of the
period. Instead if the returns each year were computed on the base price of Rs
100 i.e. the price in the beginning, the annual return would be 17.2%.

Also note that we ignored the time value of money in computing the arithmetic
mean.

3.6 GEOMETRIC MEAN
For the moment let us assume that there is no dividend on the stock. We can
recomputed the return based on arithmetic mean as 7.37% (Readers are
advised to verify the same as an exercise). If there were to be no dividend the
investor would earn Rs 30 as capital gain only from his investment spanning 5
years. If the annual return is assumed to be r then it may be computed using
following equation:

100 x (1 + r)
5
= 130 gives r = 0.05387 or 5.387%

The return computed above is based on geometric mean. The general
expression specifying geometric mean return is given by Equation 3-3:

Initial value x (1 + r)
t
= Final value .. Equation 3-3
where t = period of investment in years.

We can also calculate the return based on the geometric mean from annual
returns. The relationship between the annual return for the period n, Rn and the
geometric return, Rg for investment lasting n periods is given by Equation 3-4.

1 - ) R + ..(1 )......... R + )(1 R + )(1 R + )(1 R + (1 = R
) R 1 ..( )......... R 1 )( R 1 )( R 1 )( R 1 ( ) R 1 (
n
n 4 3 2 1 g
n 4 3 2 1
n
g
+ + + + + = +
.Equation 3-4
3.6.1 Arithmetic vs Geometric Mean
We discussed the returns based on arithmetic and geometric mean. Which one
of them is right is a big question. The answer is dependent upon the objective of
finding return. In general when the performance of the firm is to be evaluated
as compared to others, or where one wants to take a prospective decision to
invest or not it is appropriate to use return based on arithmetic mean.
Arithmetic mean keeps the investment period constant (usually a year) so as to
facilitate comparison period after period or among the several equally spaced
investment horizons. For all future decisions returns based on arithmetic average
provide true guidance of what can be expected in future.

On the other hand geometric mean provides the returns for the holding period.
These are the returns actually earned over the investment horizon. Obviously
these returns depend upon the prices at the time of entry and exit. Geometric
mean must be used only for computing the realised returns, and cannot be
taken as performance measure.
3-6
3.6.2 Reasons of Difference in Arithmetic and Geometric Mean
The difference in arithmetic and geometric mean may be visualised rather
easily with an exaggerated example.

Consider the price of the stock at Rs 100. A year later price falls by 50% to Rs 50.
However, in the second year the price rises back to Rs 100 providing the gain of
100%. Assuming that there were no dividends during these two years the returns
based on arithmetic mean would be 25% i.e. the average of -50% and 100%.
However, realised returns would be none since the values of investment at entry
and exit are same. Using Equation 3-3 the returns would be zero as can be seen
below:
100 x (1 + r)
2
= 100 gives 1 + r = 1 or r = 0

The reason for the differences in the arithmetic and geometric mean is due to
the differing investment value from period to period. Geometric mean assumes
that the investment is compounded from period to period i.e. gains or loss of
one period are re-invested in subsequent periods, and hence are included in
the effective return one earns.

In contrast arithmetic mean assumes that investment in each period remains
constant. One either withdraws or invests more at the end of each period so as
to keep the investment constant over time. Therefore the investment is
adjusted. By doing so, we eliminate the compounding effect.

Lets us consider the same price information as above. Assume that an investor
buys one share at Rs 100 at t = 0. At the end of first year the value of investment
falls to Rs 50. In order to bring investment back to Rs 100, one needs to buy one
more share. The investor invests for one more share at Rs 50 to keep the
investment constant for second year. At the end of second year with two
shares in hand the end value of the investment is 2 x 100 = Rs 200. Deducting
the value of investment of Rs 150 the gain is Rs 50 in two periods over constant
investment of Rs 100. It is equivalent to earning an annual return of 25%,
precisely equal to the returns given by arithmetic mean.

3.6.3 Relationship Between Arithmetic and Geometric Mean
Geometric mean is always less than the arithmetic mean. Since the geometric
mean takes into account the compounding while the arithmetic mean keeps
the investment constant the difference in the two means would be dependent
upon the variability of returns from period to period. The variability of the return
is measured by standard deviation (discussed in the remainder chapter).
Without getting into the mathematical proof the relationship between the
geometric mean and arithmetic mean is approximated by Equation 3-5 where
Rg is geometric mean and Ra is the arithmetic mean, and is the standard
deviation of the returns.

2
2
1
a g
R R o ~ .Equation 3-5

The above relationship of the geometric mean and arithmetic mean is exact
when returns follow normal distribution.
3-7
3.7 INTERNAL RATE OF RETURN (IRR)
While computing returns based on arithmetic or geometric mean we ignored
the time value of money. All the inflows and outflows were aggregated to find
the return irrespective of the time of occurrence of the cash flows. Under the
circumstances where cash flows are spread over several periods and vary in
each period, the best way to find the realised returns is to use the discounted
cash flow approach.

The procedure is quite simple. We need to feed the successive cash flows in
successive rows (or columns) and compute internal rate of return in the last row
(or column) using the formula IRR (range of cash flows). Using EXCEL for the
data in Table 3-1 the computation of IRR is shown in Figure 3-1.

Figure 3-1: Computation of IRR using EXCEL


The computation shows that the holding period return i.e. return over 5 years on
the investment is 15.44% after taking into account the timings of the dividends
as also the disinvestment. Note that price data for the stock in the interim is not
required as we compute the holding period return.

Again the question arises as to which of the two, i.e., IRR and Average Rate of
Return, provides the correct answer. The difference between the two again lies
in the constancy of amount of the investment. While computing IRR the use of
actual cash flows implies that the investment in each period gets moderated
with the value. While computing arithmetic mean we assume constancy of
investment in each period. Therefore while making decisions about investing in
future use of neither the geometric mean nor IRR is appropriate. It would be
appropriate to make investment decisions on the basis of arithmetic mean as it
provides a judicious basis. The geometric mean will distort the opinion
depending upon the timings of investment and disinvestment, and IRR is subject
to change if the investment amount is changing in each period.

3.8 RISK
Besides return the other important dimension to investment decision is risk.
Broadly, the risk can be defined as the divergence of the actual outcome from
the expected outcome. Since we live in an uncertain world the expectations
seldom come out to be true. For investment decisions one expects a return of
say 20%. Even though this expectation of return is very realistic the actual return
in most cases would be somewhat different than 20%. This variability of return is
termed as risk. Hence we say that by making an investment while expecting
3-8
some return one has also assumed some risk. Therefore risk is inherent in
investment decisions.

The risk can be measured in several ways. Here we shall deal with the ways in
which the risk can be measured, their advantages and disadvantages.

3.8.1 The Expected Value: Probability Distribution
Before we discuss the ways of measuring risk, lets us understand what is meant
by expected return. In the preceding section we stated that arithmetic mean
provides a judicious basis of expected return. We defined the average return as
the sum of observations divided by the number of observations. Arithmetic
mean as basis for expected return
1. We implicitly assumed that past performance would be repeated in
future too,
2. We also presupposed that the reliable past data about the return is
available, and
3. We assumed that all observations were equally likely while it served as
benchmark for future.

All the three assumptions though seem reasonable yet may not represent true
expectations of future returns. Past performance may or may not be repeated,
and there could be several reasons for being so. Enough, reliable and
authentic past data may not be readily available. And lastly all the returns on
the assets are not equally likely. Some values of returns occur more often, while
some values occur fewer times when some extraordinary events happen.

In such situations the returns are not evenly distributed. There is a greater
chance that some values will occur more often than others. This estimation of
how likely each return is can be arrived in many ways including the past data.
A graphical plot of the values of the return on the horizontal axis and the
frequency of occurrence on the vertical axis is referred as frequency
distribution.

An example would illustrate the point. Consider the data of returns for 300
observations of returns as given in Table 3-2.

Table 3-2: Frequency Distribution of Return
Frequency of occurrence 15 25 30 45 60 50 35 25 15
Returns (%) 5.0 8.0 10.0 12.0 15.0 18.0 20.0 25.0 30.0
Probability x Return 0.25 0.67 1.00 1.80 3.00 3.00 2.33 2.08 1.50
Expected Return, %
15.63

In a scenario as depicted in Table 3-2 where the frequency of occurrence is not
same, the average will not represent the expected value because arithmetic
mean considers all values equally likely. One has to take into account the
likelihood of occurrence of each value. Instead the expected value can be
calculated as:

Expected Value = Sum of Product of Probabilities and Values

3-9
These values are shown in the last row of Table 3-2 and the expected value is
the sum of all the values and comes to 15.63%. The expected value can be
represented as Equation 3-6.
outcomes possibe of nos. n
outcome i the for Return R
outcome i of occurrence of y Probabilit p
Where
6 - 3 Equation .. .......... .......... .......... .......... .......... R p = E(R)
th
i
th
i
n
1 = i
i i
=
=
=

The frequency distribution of returns is plotted in Figure 3-2 for the data in Table
3-2. The visual presentation leads to better appreciation of the likely returns.

Figure 3-2: Frequency Distribution of Returns

3.9 MEASURES OF RISK
Different people have different connotations about risk. Some people associate
risk with the maximum loss that one can incur in an investment. Some others
would talk of the chances of not making the desired gains. Yet another set of
people would associate risk with the extreme values the investment may take.
Hence different people perceive risk differently. Also we must appreciate the
fact that what is termed as risky by someone may be perceived safe by
another. Therefore risk becomes a matter of attitude one has.

Without challenging the different perceptions of risk of being right or wrong our
attempt in this section is to find a suitable measure for assessing risk. We shall be
refraining from subjective interpretations such as being safe or risky, acceptable
or unacceptable, high or low. These interpretations are dependent upon the
profile of the investor and reflect the state of mind.

In order to be so there is a need to have a measurement of risk that is objective
and unambiguously states the fact but leaves the judgement of it being
acceptable or otherwise to the individuals. We now discuss several measures of
risk.
3-10

3.9.1 Range
Range is one measure that can give an idea about the magnitude of risk. The
difference between the maximum and minimum values of the return may be
defined as a range. Mathematically it can be stated as:

Range = Maximum Value Minimum Value ...Equation 3-7

The measurement of risk by range emphasises the possible extreme values that
an investment may take. For example, consider investment A at a price of Rs
200. Best estimates of future price reveals that it can go as high as Rs 400 if
good conditions prevail and while under depressed conditions the price fall to
as low as Rs 50. For another investment B, the estimated maximum and
minimum values are Rs 300 and Rs 75 respectively. On the basis of the
difference in the extreme values investment A may be regarded as more risky
having a larger possible variation of Rs 350 (400 50) as compared to Rs 225
(300 75) for investment B.

While range seems a simple measure of risk it ignores the likelihood of such
extreme events happening. If in the above case the likelihood of price of
investment A falling to Rs 50 is 10%, while for investment B the probability of
price falling to Rs 75 is only 50% the perception of risk would change. To have a
clear view of risk one has to not only consider the range of values that the
price/return can take but also the probabilities of the different values. Hence,
the range cannot be regarded as an appropriate measure of risk. Even if the
probabilities are same for extreme values the merit of judging risk on such
remote values is doubtful.

3.9.2 Average Deviation
Rather than evaluating risk on the basis of extreme values of an investment it
would be more appropriate to assess risk on some average. This indeed should
give better idea about the risk. This befits more our definition of risk, which is
deviation from the expected value. Hence we find out the deviation of returns
from a reference value such as an expected return. For the data given in Table
3-2 and depicted in Figure 3-2 we find that the expected value of return is
15.63%. Table 3-3 gives the deviations for each return (row 2). The average of
the aggregate of such deviations is 0.26%.

Table 3-3: Computation of Average Deviation %
Returns, % 5.00 8.00 10.00 12.00 15.00 18.00 20.00 25.00 30.00
Deviation, % -10.63 -7.63 -5.63 -3.63 -0.63 2.37 4.37 9.37 14.37
Average Deviation, % 0.26

Note that deviations exclude the probability. If probability is included in
deviations then the average deviation would become zero. This happens
because the positive deviations cancel out the negative deviations. This is a
major drawback with the measuring risk with average deviations, and hence it
cannot serve as an appropriate measure of risk.
3-11
3.9.3 Variance and Standard Deviation
From the discussions in preceding two sections we can conclude that the
appropriate measure of risk must include a) all values rather than few extreme
values, b) must include the probability of occurrence of each outcome, and c)
negative and positive deviations must not cancel out each other, but instead
be aggregated. The way of including all such properties is as follows:
a) Compute the expected value as discussed in Section 3.8.1,
b) Find deviations from expected value for each outcome,
c) Square the deviations so that positive and negative deviations do not
cancel out each other,
d) Multiply the squared deviations with respective probabilities, and
e) Add the weighted squared deviations.

The sum of squared deviation multiplied by probabilities is known as variance.
The measurement of risk through variance will have the unit of per cent
squared. In order to be consistent with the unit of measurement of expected
return, one can take the square root of the variance, called standard
deviation, as a measure of risk. Table 3-4 shows the computation of variance
and standard deviation for the distribution of returns on the investment as
shown in Figure 3-1.

Table 3-4: Computing Variance and Standard Deviation
Probability 0.05 0.08 0.10 0.15 0.20 0.17 0.12 0.08 0.05
Returns, % 5.0 8.0 10.0 12.0 15.0 18.0 20.0 25.0 30.0
Probability x Return 0.25 0.67 1.00 1.80 3.00 3.00 2.33 2.08 1.50
p x Deviation
2
5.65 4.86 3.17 1.98 0.08 0.93 2.22 7.31 10.32
Variance, %
2
36.53
Standard Deviation, % 6.04

The risk of the investment as given by standard deviation denoted by is 6.04%.

Mathematically, variance, and standard deviation are given by Equations 3-8
and 3-9 respectively, stated below:
returns of values possible of Number n
return of value Expected E(R)
return i of Value R
return of value i of y Probabilit p Where
9 - 3 on ....Equati .......... E(R)} - {(R * p = deviation; standard and
8 - 3 quation .........E .......... .......... E(R)} - {(R * p = Variance;
th
i
th
i
n
1
2
i i
n
1
2
i i
2
=
=
=
=

3.9.4 Semi Variance
Measurement of risk with variance or standard deviation seems to overcome all
the deficiencies that were there with other measures discussed. However, one
observation with variance and standard deviation is that their computations
include all the outcomes; both positive and negative deviations. According to
some the positive deviations should not form part of risk as they are in fact
3-12
desirable outcomes. For example if expected return is 15% then from the
perspective of risk the outcomes that provide return lesser than 15% should only
be included. The outcomes that provide returns in excess of 15% are desirable
and therefore must be excluded while measuring risk.

In case we ignore the negative deviations from the variance we would get
semi-variance. The computation of semi-variance for the data in Table 3-4 is
shown below:

Table 3-5: Computing Semi Variance
Probability 0.05 0.08 0.10 0.15 0.20 0.17 0.12 0.08 0.05
Returns, % 5.00 8.00 10.00 12.00 15.00 18.00 20.00 25.00 30.00
Probability x Return 0.25 0.67 1.00 1.80 3.00 3.00 2.33 2.08 1.50
p x Deviation
2
5.65 4.86 3.17 1.98 0.08 - - - -
Semi Variance, %
2
15.74

Though it would be a rather correct to have semi-variance but financial
analysts are unanimous on using variance or standard deviation as measure of
risk. It has been observed that returns on investment are distributed normally. A
normal distribution is a symmetrical distribution i.e. right hand side is the mirror
image of the left hand side. For symmetrical distribution the semi-variance
would be half of variance. Therefore making decisions based on variance or
semi-variance as measure of risk would lead to same conclusion. Since
variance/standard deviation is well tabulated it would be more convenient to
use variance as measure of risk.

The semi variance of the returns comes to 15.74 as shown in Table 3-5 while the
variance is 36.53. In this case semi-variance is not exactly half of the variance. It
is because the distribution of returns is not symmetrical from its central point as
can be readily visualised from Figure 3-2 that the distribution is slightly skewed
towards right i.e. positive deviations. It may be stated here that when the
returns are not symmetrical variance or standard deviation would not provide
complete insight into the risk. In addition to variance one needs to consider the
skewness of the distribution for true assessment of risk.

3.9.5 Coefficient of Variation
Standard deviation or variance is an absolute measure of risk. Sometimes we
are keen to find out a relative measure. For example, stock returns for
investments A and B may exhibit the standard deviation of 20% each. However,
the expected returns of the two may be 15% and 20%. Although in absolute
terms both the investments carry the same risk, in relative terms the risk of
investment B would be lower than that of investment A because its expected
return is higher.

The standard deviation when compared with the expected return is known as
the coefficient of variation. It is defined as the ratio of standard deviation to the
expected value and is given by computed in Equation 3-10.
E(R)

=
Value Expected
Deviation Standard
= Variation of t Coefficien Equation 3-10

3-13
The coefficient of variation must be used cautiously as a measure of risk. For an
expected value of zero it would always be infinite, which is a value difficult to
interpret. For lower values of mean the coefficient of variation tends to
overstate risk, while for higher expected values, the risk tends to be
understated.

3.10 MEASURING RETURNS AND RISK IN PRACTICE
We discussed measures of return and risk. In practice arithmetic mean is taken
as expected return and variance/standard deviation is considered as
appropriate measure of risk. In practice normally historical data is used to
compute the mean and variance.

The price information is obtained at regular and equal intervals of time and
returns are computed for each period. These periods can be daily, weekly,
monthly etc. Returns are computed as follows:

period the during dividend with 100 x
P
P P
P
D
period the in dividend no with x100
P
P P
r
n; period for return %
1 n
1 n n
1 n
1 n
1 n n
n
(

+ =

The mean value is calculated by taking arithmetic mean of returns.
n
R
= R = Return Average
9
1
i
.. Equation 3-11

Risk as measured by standard deviation is calculated by dividing the sum of
squared deviation by (n 1). Using the formula as given below the standard
deviation of the mean is 1.96%.

n
1
2
i
2
) R - (R
1 - n
1
= Variance, ..Equation 3-12
Variance = Deviation, Standard ..Equation 3-13

Consider the information regarding dividends and prices for a share for last 10
years as given in Columns 2 and 3 of Table 3-6:

The return for each year is found by dividing the capital gain/loss and dividend
by the previous price as shown for the year 2006.
% 33 . 33 100 x
240
80
100 x
240
240 - 310
+
240
10
= r 1997; period for return %
100 x
P
P - P
+
P
D
= r n; period for return %
n
1 - n
1 - n n
1 - n
n
= =
(

The average of the 9 observations is the expected return at 13.05%.

The variance is found by taking the sum of the squared deviations of the return
from the average. The squared deviation for the year 1997 is 2377.47 [(62.08
3-14
13.32)
2
]. From the following equation we find variance of the share as 0.0224,
leading to the standard deviation of 0.1497 or 14.97%.

n
1
2
i
2
0.0224 = ) R - (R
1 - n
1
= Variance,
14.97% = 0.0224 = Variance = Deviation, Standard


Table 3-6: Finding Returns & Risk from Historical Data
Year Dividend
(Rs)
Closing
Price (Rs)
Return
%
1999 5.00 200.00
2000 7.00 218.00 12.50%
2001 7.00 245.00 15.60%
2002 8.00 235.00 -0.82%
2003 8.00 275.00 20.43%
2004 9.00 320.00 19.64%
2005 9.00 240.00 -22.19%
2006 10.00 310.00 33.33%
2007 10.00 345.00 14.52%
2008 12.00 395.00 17.97%
2009 12.00 460.00 19.49%
Average Return 13.05%
Variance 0.0224
Standard Deviation 14.97%

SOLVED PROBLEMS

Example 3-1: Calculating Dividend Yield and Capital Gains
The current market price of a share is Rs 300. An investor buys 100 shares. After
one year he sells these shares at a price of Rs 360 and also receives the
dividend of Rs 15 per share. Find out his total return, per cent return, dividend
yield and capital gains.

Solution:
Initial Investment = 300 100 = Rs 30,000
Dividend Earned = 15 100 = Rs 1,500
Capital Gains = (360 300) 100 = Rs 6,000
Total Return = 1,500 + 6,000 = Rs 7,500
Total Percent Return = [(1,500 + 6,000)/30,000] 100 = 25%
Dividend Yield = 15/300 = 0.05 (5%)
Capital Gains = 60/300 = 0.20 (20%)

Example 3-2: Calculating Average Return
An investor has bought shares of six companies and invested equally in each of
them. The returns offered by the six companies in the last one year have been
21%, 24%, 25%, 18%, 120%, and 16%. Find the average return of the investor in
the last year.

Solution:
3-15
The average return =
) R .. .......... + R + R + (R
n
1
= R
n 3 2 1

% 29 = 16) + 120 + 18 + 25 - 24 + (21
6
1
= R


Example 3-3: Using Forecast to Estimate Return and Risk
An investor is considering buying a share for which he has made a forecast of
returns based on expected economic conditions. The states of economic
conditions are described as excellent, good, fair, poor, and bad. The chances
of each economic conditions and the forecast of returns are given below:

Scenario
Probability
p
Return
R
% %
Excellent 15.00 40.00
Good 25.00 20.00
Fair 35.00 10.00
Poor 15.00 10.00
Bad 10.00 20.00

Find out the expected return on the share and the standard deviation.

Solution:
The expected return and standard deviation are found using equations 5.3 and
5.4 as shown below:
% 11 = 0.10x20 - 0.15x10 - 0.35x10 + 0.25x20 + 0.15x40 = R p = E(R)
n
1 = i
i i

% 53 . 8 = 72.78 = E(R)} - {(R * p = deviation; standard and
78 . 72 =
31 - 0.10x + 21 - 0.15x + 1 - 0.35x + 0.25x9 + 0.15x29 = E(R)} - {(R * p = Variance;
n
1
2
i i
2 2 2 2 2
n
1
2
i i
2

Scenario Probability
p
Return
R
p R Squared
Deviation p
% % %
Excellent 15.00 40.00 6.00 3.75
Good 25.00 20.00 5.00 9.00
Fair 35.00 10.00 3.50 19.69
Poor 15.00 10.00 1.50 23.44
Bad 10.00 20.00 2.00 16.90
Expected Return % 11.00
Variance 72.78
Standard Deviation % 8.53

3-16

KEY TERMS

Dividend yield The amount of dividend as per cent of a current price is
called dividend yield.

Capital gains Profit measured by the difference of opening and closing
prices as % of opening price is capital gains.

Arithmetic
mean
Arithmetic mean is the average of observations.

Geometric
mean

Geometric mean is the compounded return over holding
period. It is found by n
th
root of the ratio of the prices at
beginning and end of holding period less 1, where n is the
number of periods.

Internal rate
of return

Internal rate of return is that rate of return which equates
future cash flows to the initial investment.

Probability
distribution

Probability distribution is a graphic representation that
specifies the values with the frequency of occurrence.

Range

Range is the difference of maximum and minimum
price/return.

Deviation Deviation is the difference between expected value and
the actual value.

Variance Variance is a measure of risk found by adding the squares
of deviations from mean multiplied by probability.

Standard
deviation

Standard deviation is a measure of risk and is the square
root of variance.

Coefficient of
variation

Coefficient of variation is a relative measure of risk and is
the ratio of standard deviation to expected value.

SUMMARY

Any investment decision is characterised by two parameters called the return
and risk. Both return and risk are so interrelated that they perhaps cannot be
studied in isolation. Since it is difficult to arrive at the measurement of return and
risk for each investment decision directly, financial experts resort to study of
return and risk of financial securities because these are traded and provide a
reliable data base. Further they reflect the collective wisdom of investors and
hence cannot be challenged.

Return of financial assets comprise of dividend yield and capital gains. Dividend
yield is the reward of ownership that accrues due to holding of the asset while
capital gains arise when the asset is disowned. Though there are several ways
3-17
that the expected return may be arrived at but more often than not historical
financial data is used to have a reasonable estimate of expected return.
Expected returns may be calculated by historical price data of the financial
asset.

Arithmetic mean and geometric mean are the two very common measures of
return. While arithmetic mean is the simple average geometric mean,
computed by the nth root of the returns over holding period the geometric
mean tells the holding periods return, for the purpose of decision making for an
investment arithmetic mean is an appropriate measure. The internal rate of
return (IRR) too is a measure of realized return over holding period that is based
on cash flows.

Risk is defined as realising lesser than expected returns. Its measures are range,
deviation, variance, and standard deviation, and coefficient of variation. Of all
the measures standard deviation is regarded as the best measure of risk and is
the unanimous choice of all financial analysts and managers alike.

One of the very popular methods of estimating the expected returns and the
risk associated is through historical data. With past price, data returns and risk
can be estimated by finding average and the standard deviation respectively.

For most financial assets the returns are deemed to resemble a bell-shaped
curve called normal distribution that is completely defined by the parameters
of average and standard deviation. The area under the curve of normal
distribution at a point gives the probability of finding returns lesser that point.
Standard normal distribution is a special case of normal distribution with a mean
equal to zero and standard deviation of one. The values of standard normal
distribution are tabulated or can be easily found using EXCEL. It is a very handy
tool of analysis because any normal distribution with given mean and standard
deviation can be converted to standard normal distribution.

SELF ASSESSSMENT QUESTIONS

1. What do you understand by return and risk?

2. What are different measures of return? Compare them.

3. Under what circumstances would you use arithmetic mean and geometric
mean as measures of return?

4. How do you define risk and what are the different measures of risk?

5. Why do you think standard deviation is an appropriate measure of risk?

6. An investor buys a share at its current market price of Rs 600. After a year he
sells them at a price of Rs 648 and also receives the dividend of Rs 12 per
share. Find out total return, % return, dividend yield and capital gains.

7. An investor is considering buying a share for which he has made a forecast
of returns based on expected economic conditions. The states of
3-18
economic conditions are described as excellent, good, fair, poor,
and bad. The chances of each economic conditions and the forecast of
returns are
Scenario Probability Return
P R
% %
Excellent 25 50
Good 30 25
Fair 20 15
Poor 15 10
Bad 10 20
Find expected return and standard deviation.

FURTHER READINGS

1. Srivastava & Misra (2008), Financial Management, Oxford University Press,
Chapter 5
2. Prasanna Chandra (2009), Financial Management: Theory and Practice,
Tata McGraw Hill, Chapter 8

APPENDIX 3-1: NORMAL DISTRIBUTION

Normal distribution is a probability distribution that is symmetrical around its
mean and is bell-shaped. This is the most frequently occurring probability
distribution and it is assumed that the returns on the stocks exhibit
characteristics similar to normal distribution.

The probability of occurrence of any value, x is given by p(x, , ), called
normal density function for a distribution that has mean of and standard
deviation of is given by Equation A3-1.
deviation standard = value, mean = where
e
2
1
= ) , p(x,
2
2
2
) - (x
-
..Equation A3-1

Probability of occurrence of a value can be found by Equation A3-1. For a
stock with expected returns of 20% and standard deviation of 5% the probability
that the stock return would be 22% can be found by putting x = 22% = 20%,
and = 5%. It is 7.36%.

The other value that is most often required while analysing risk and return is the
probability of stock return assuming a value less than or greater than a
particular figure. For example, we may be more interested in knowing the
probability of return less than 22% or more than 22% rather that finding
probability of returns being exactly 22%. The area under the normal distribution
curve gives the probability of value falling below x. It is known as cumulative
normal distribution.

Values of probability density function and cumulative density function for any
value of return, x can be found using EXCEL given the expected value and
standard deviation. For value of x = 22% with the expected value of 20% and a
3-19
standard deviation of 5% the density function and cumulative density function
are shown in Figures A3-1(a) and A3-1(b), respectively. The path is Insert
Function NORMDIST where x represent the chosen stock return.

For the density function (the probability that the value would exactly equal to x)
to choose false under cumulative, and for cumulative density (the probability
that the value would be less than x) to choose true under cumulative.

Figure 3-1(a); Using EXCEL to find Normal Density


Figure 3-1(b): Using Excel to find normal cumulative density


The probability that the return would be exactly equal to 22% is 7.36% and the
probability that the returns would be less than 22% is 65.54%. It also implies that
the probability that the returns would exceed 22% is 34.46% .

3-20
Normal distribution is completely defined with two parameters, i.e., mean,
and standard deviation, . The vertical axis gives the probability of occurrence
of particular value of return represented on the horizontal axis. The area under
the curve provides the probability of return falling within the specified range.
Standard Normal Distribution
For a mean value, of zero and standard deviation, of one the distribution is
called standard normal distribution. Any normal distribution is converted into
standard normal distribution and the corresponding value of x becomes z equal
to as given by Equation A3-2.

- x
= z .. Equation A3-2

It is always better to use the standard normal distribution because we can
convert all normal distributions with any value of mean or standard deviation
into an equivalent standard normal distribution. The areas can be found using
EXCEL exactly in the same manner as described for normal distribution except
that one has to choose NORMSDIST function instead of NORMDIST. This is shown
in Figure A3-2.

Figure A3-2: Using Excel to find cumulative density function with standard
normal distribution



4-1
UNIT 4

BASICS OF CAPITAL BUDGETING

4.0 OBJECTIVE
The objective of this unit is to
a) Explain the meaning of capital budgeting and kinds of proposal
b) Discuss various techniques of appraising projects
c) Demonstrate how to compute payback period, net present value and
internal rate of returns.
d) Discuss relative advantages and disadvantages of NPV and IRR
methods.
e) Explain how to project the cash flows of the project and treatment of
sunk costs, side effects, opportunity cost and working capital.
f) Explain what is meant by the concepts of incremental and relevant
cash flows, separating financing cash flows and matching of cash flows
with the discount rate.

4.1 INTRODUCTION
Capital budgeting decision relates to acquisition of assets that have long term
implications of the capacity of the enterprise for production, revenue and
profits. It refers to the desirability of acceptance or rejection of a project based
on systematic evaluation of project parameters that are translated in financial
terms. Capital budgeting is considered strategic in nature affecting the
competitive position of the firm. Lack of capital budgeting proposals in any
enterprise signals a bleak future of the firm because the existing projects would
have some limited life as new products and competitors emerge.

Since the business opportunities available in the environment are always huge
as compared to the resources, financial or otherwise, available with the firm,
capital budgeting decision becomes fairly intricate as it impacts other areas of
corporate finance like capital structure, dividends and cost of capital. Capital
budgeting decision is often referred to as investment decision of the firm where
allocation of capital among the different projects is decided.

4.2 FEATURES OF CAPITAL BUDGETING DECISION
Some of the features of capital budgeting decision have to be borne in mind
while evaluating the proposals. These features have implication on the process
as well as decision making.

Large Outlays: Capital budgeting decisions normally involve higher outlays.
Larger the investment greater the precaution one must take to appraise the
project. Business risk is too large. Further larger outlays may necessitate
borrowing and as such capital structure of the firm is also affected. This adds to
the financial risk. Business risk coupled with financial risk may add to the
complexities in appraisal

Non-reversibility: The capital budgeting decisions are normally non-reversible.
For example having taken a decision to set up a steel plant one cannot reverse
4-2
it if the future conditions become difficult for the survival of the project and do
not permit the desired income to accrue. The project as such cannot be
abandoned. Firms would have to live with the situation once the decision is
taken. Related issue with the non-reversibility is the inflexibility. The cost of the
project is considered as given and there is little that the management may do
to control the outlay.

Experience: Most investment decisions relate to the areas where the firm do not
have much experience. If the project is a diversification or a capacity
enhancement proposal, the management may draw upon the past
experience. But in case the project is in unrelated areas the capital budgeting
exercise becomes too risky as the assumptions of the appraisal may not hold in
real situations.

Strategic nature and uncertainties with the capital budgeting proposals call for
tremendous amount of planning, care and systematic evaluation. It becomes a
time consuming process since knowledge gaps are to be fulfilled.

4.3 TYPES OF PROJECTS
From the perspective of evaluation these projects may be classified in different
ways that have impact on the process of capital budgeting.

4.3.1 Related and Unrelated Projects
The normal process of growth of enterprises involves expansion of capacities,
followed by backward/forward integration. In such situation the firm gathers
experience and makes a conscious effort to increase revenues and profit. The
other process of growth involves diversification of activities into an unrelated
area. For example an IT company flush with funds may decide to start banking
operations. For related diversification the element of risk is considerably less as
compared to unrelated diversification.

In terms of the process of evaluation expansion and new projects are make
significantly different. The ease and speed with which a firm can collect reliable
and accurate information for related project is not same for unrelated projects.
It takes much longer and costs more to gather relevant information for new
projects. Also the level of confidence in the relevant information for new
project is also lesser.

4.3.2 Independent and Mutually Exclusive projects
Another way the projects can be classified is on the basis their dependence on
one another. Few projects are independent i.e. the acceptance of one does
not have bearing on another. For example two projects of manufacture of
washing detergent and bathing soaps are independent of each other. In
contrast replacement of machine from two alternate suppliers is not
independent of each other because buying from one automatically implies
rejecting the other supplier. Such projects are called mutually exclusive.
Mutually exclusive projects are have either-or situation. Acceptance of one
project implies rejection of another.

The implication of independent and mutually exclusive project is on the
appraisal process. In mutually exclusive project one has to choose between the
4-3
projects while independent projects can be accepted or rejected. Hence
decision making is more flexible in case of independent projects.

4.4 TECHNIQUES OF EVALUATION
There are many techniques of evaluation of capital budgeting proposal. These
techniques help decide whether to accept or reject a proposal, based on
some evaluation criteria.

These techniques of appraisal of projects can broadly be categorised in two
the discounted cash flow techniques (DCF) and non cash flow discounting
(Non DCF) techniques. DCF techniques would involve using of the concept of
discounting of cash flows (already discussed in Unit 2 on Time Value of Money.
while non DCF techniques would not use the concept of discounting. We shall
discuss two methods under each as depicted in Figure 4-1 (Note that these are
not the only methods available. There can be some more that are not
discussed in this unit).



4.5 ACCOUNTING RATE OF RETURN
Amongst the non DCF techniques we have two methods the accounting rate
of return and payback period. We discuss both of them here. The Accounting
Rate of Return (ARR) is defined as average rate of return over the initial
investment as given by Equation 4-1.

Investment Average
Profit Average
= Return of Rate Accounting . Equation 4-1

ARR id based on profits as derived from accounting. This is a natural ways of
deciding whether or not a venture should be undertaken. If the ARR exceeds
the desired rate of return we accept the project else we reject it.

All business ventures are required to prepare statement of profit and loss on
periodic basis, usually a year. In case of new project it shall be a projected
profit and loss account. These projected profits serve as basis of decision
making whether or not the firm undertakes the capital expenditure now. An
example would help explain the method. These profits are measured against a
benchmark for deciding acceptance/rejection of the project.

As an illustration let us consider a rather simple situation of a firm wanting to buy
a machine costing Rs 5 crore which is capable of producing 10,000 pairs of
shoes every month. The firm has a 10-year agreement with a marketing firm that
has undertaken to lift 80,000 pairs every month at price of Rs 300. The raw
Figure 4-1: Techniques of Evaluation of Capital Budgeting Proposal

Project

Non DCF Techniques DCF Techniques

Accounting Payback Net Present Internal
of Return Period Value (NPV) Rate of Return (IRR)
4-4
material and other variable cost of producing shoes is Rs 210 per pair. The firm
has prepared following statement of accounts on an annual basis;

Table 4-1: Profit and Loss Account for Producing Shoes
Particulars Basis/Assumption Annual (Rs in lacs)
Nos of pairs of shoes
produced
@ 10,000 pairs per month or
1,20,000 pairs per annum

Revenue @ Rs 400 per pair 480.0
Raw Material cost @ Rs 210 per pair 252.0
Administrative
overheads
@ Rs 5 lacs per month 60.0
Depreciation @ 10% of the cost of machine on
straight line basis assuming life of
10 years
50.0
Total Cost 338.0
Profit before tax Revenue Total Cost 118.0
Taxes @ 40% of the profit 47.2
Profit after tax 70.8

Based on the above estimates of profit and loss account we can work out the
rate of return using Equation 4-1. We have assumed here that the profit of the
firm would remain same and repeated for 10 years i.e. for entire life of the
project, and hence the average profit for the life of the project would be same
as shown in Table 4-1. The initial investment of Rs 500 lacs was charged uniformly
to expense by way of depreciation over the life of the machine of 10 years.
Therefore the average investment was Rs 500/ 2 =Rs 250 lacs. Hence ARR by
Equation 4-1 is 28.32%.

% 32 . 28
00 . 250
80 . 70
Investment Average
Profit Average
= Return of Rate Accounting

In most likely cases the profit would vary in each of the year and the returns on
investment for each year will be different because in a new project the
revenues pick up gradually over a period of time. To make judgment on the
basis of first year income and its replication for all remaining years would be
erroneous. In order to have an overall view of the earnings it will be prudent to
average out the income. Hence one needs to project the profit for the life of
the project separately for each year.

4.5.1 The Decision-making Criteria:
Mere calculation of the accounting rate of return is not much of help. It is
merely a number, which reflects the worthiness of the project in absolute terms.
To enable the firm make a conscious decision whether to accept or reject a
proposal, it needs to be compared with some benchmark. Therefore
management must set before hand a target rate of return for acceptance of
the project. If the accounting rate of return exceeds the target rate of return
the firm accepts the proposal else it is rejected. For example if required rate of
return for the project is 30% the proposal is rejected and if the required return is
25% the proposal is accepted.
4-5
4.5.2 Merit and Demits of ARR Method
The major and perhaps the only advantage of the method is its simplicity of
calculation because accounting information is easily available and easy to
interpret. It is easily comprehendible. However there are several limitations of
the method.

Subjective Approach: The decision-making rule lacks justification. The
benchmark decided by the firm is ad-hoc and ignores objectivity for the
sake of simplicity. A financial decision like capital budgeting having lasting
impact on the standing and competitiveness of the firm cannot be decided
on subjective basis.

Non Cash Flow Approach: The second serious objection to the method is that it
assumes that accounting profit is the true profit. We all know that accounting
profit is subject to the polices of depreciation, inventory valuation, revenue
recognition etc which may not represent the true value of the profit but are
mere adjustments for compliance of accounting policies and the
accounting standards. Seldom do these accounting figures reflect the true
values of assets and income that are consistent with the market-determined
values. Acceptance and rejection of the project must be based on the
market values rather than book values since market values truly reflect the
worth of the firm.

Ignores Time Value of Money: Even if accounting profit is deemed to be
appropriate reflecting true value of the firm it would be erroneous to assign
same value to the profits generated in different periods. Clearly Rs 100 today
is more important than the Rs 100 in the tenth year. We need to provide for
the time value of money. Accounting rate of return does not provide for the
time value of money.

Inconsistent Definition: Lastly another issue with the ARR is its inconsistent
definition. While measuring accounting rate of returns the post-tax profits are
compared with the average investment on the assumption that both profits
and the investment made belong entirely to the equity holders. Other
sources of funding and their expectations of returns are ignored.

4.6 PAYBACK PERIOD METHOD
Second method under non DCF techniques is payback period method. This
method focuses on how long would it take to recover the investment made.
Capital budgeting proposal typically involve one large capital outflow followed
by small periodic cash inflows. These small periodic inflows are rewards for the
investment made. How soon the rewards outweigh the cost is the question that
is answered by the payback period method.
Table 4-2: Payback Period: Cash Flows of a Project
Rs.
Initial cash outflow 10,00,000
Cash inflows 1
st
Year 2,00,000
2
nd
Year 5,00,000
3
rd
Year 3,00,000
4
th
Year 4,00,000
5
th
Year 5,00,000
4-6
As a simple example to understand the application of payback method, let us
consider the cash flows of a project as given in Table 4-2. Of the initial
investment of Rs 10 lacs, the project provides cash inflows of Rs 2 lacs, 5 lacs, 3
lacs, 4 lacs, and 5 lacs from year 1 to 5 respectively. Now we can see it takes to
3 years to get back the initial investment. It returns Rs 8 lacs in the first three
years.
4.6.2 Decision Making Criterion
To make a decision for acceptance or rejection of the project this payback
period is compared with the predetermined time frame, n years for the project
and following rule applied:
If payback period is <n; Accept the project
If payback period is >n; Reject the project

In the above case if the decision-making criterion is set as cut-off payback
period of 4 years, the project will be accepted. On the other hand if
management has prescribed 3 years as limit for acceptance the project will be
rejected.

4.6.3 Merits and Demerits of Payback Period Method
Like ARR payback method is also a simple method. But unlike ARR this method is
based on cash flows. Some of the advantages and situations that make this
method popular are:

Emphasis on Liquidity: All firms normally face constraints of funds and it is always
a concern that how soon the capital invested is regained so that it is
available for next project in waiting. Liquidity is of prime importance. In fact
the desired or cut-off payback period would be governed by the
investment opportunities that the management foresees in immediate
future. More the number and larger the fund requirement shorter would be
the payback period desired.

Efficient Use of Capital: With emphasis on liquidity we may say that the concern
is for efficient use of capital. Faster payback reflects more efficient use of
capital. The productivity of capital would be another parameter that would
enable decide the cut-off payback period.

Risk Orientation: Payback period method indirectly covers the risk
management. As we know that future is uncertain. Nearer cash flows have
greater chance of fructifying than the distant cash flows. Uncertainties of
the cash flows increase with time. As distant cash flows have more inherent
risk an emphasis on early payback is reducing the risk associated with the
project. Prescribing a smaller cut-off payback period in a way a simple tool
of managing risk and reflects the managements appetite for risk.

The disadvantages of the payback rule are similar to that of accounting rate of
return rule.

Arbitrary Selection of Cut-off: Like ARR the determination of cut-off payback
period is largely subjective. The managerial discretion is not supported by
objective data. The arbitrarily chosen cut-off payback period may reject
some of the projects that may ultimately result in enhancement of
4-7
shareholders wealth. The focus of the method is on liquidity rather than
profitability.

Ignores Time Value of Money: Again like ARR the payback method ignores time
value of money. A project with cash flows as in Table 4-2 giving a payback
period of 3 years would be ranked inferior to a project of same size with no
cash flows in first two years and entire Rs 10 lacs accruing in 3
rd
year. All cash
flows prior to payback are treated equally irrespective of time they occur.
This objection can easily be taken off by discounting the cash flows and
compute payback period based on discounted cash flow.

Treatment of Cash Flows after Payback Period: Not only all the cash flows are
treated with equal importance prior to the payback period, the method
altogether ignores the importance of the cash flows after the payback
period. Cash flows occurring after payback do have value albeit lesser than
the earlier cash flows. Consideration of the post payback period cash flows
may alter the preferences of the projects given by payback rule.

Despite its disadvantages the payback period remains a popular evaluation
criterion because of its applicability in certain situations. For industries where
technological obsolescence is high such as electronics and software, the
desirability of early recovery of initial investment is extremely vital and important
and may precede any other criteria. Here it may be fair to treat cash flows
beyond payback period as bonus. This may be a simple and effective way of
treating the uncertainty without adopting complicated models of risk analysis.

4.7 NETPRESENTVALUE METHOD
DCF techniques of project evaluation attempt to overcome the major
objection in non DCF techniques of valuing the cash flow depending upon the
time they occur. Net Present Value (NPV) method involves following steps:
a. Estimate the cash flows for each period for the life of the project,
b. Discount these cash flows at an appropriate discount rate to arrive at
present values of the cash inflows,
c. Subtract the initial investment from b) above to arrive at net present
value,

It requires three important inputs a) cash flows for the life of the project b) the
discount rate (This would be discussed in Unit 4) and c) the initial investment.

Mathematically NPV of the project is given by Equation 4-2.
0
n
1
t
t
CF -
r) + (1
CF
= NPV Value, Present Net

.. Equation 4-2
where CF0 =Cash outflow now (Initial Investment)
CFt =Cash inflow for Period t (Normally 1 period =1year)
t =Period t
n =Life of the project in number of periods
r =Discount Rate

Again let us consider a small example demonstrating the use of NPV technique.
Consider a project with initial outflow of Rs 10 lacs and cash inflows for its life of
4-8
three years as Rs 5 lacs, 6 lacs and 7 lacs respectively as shown in Table 4-3.
Assuming the discount rate at 12%, we find the present value of cash inflows as
Rs 14,22,990. Subtracting the initial cash outlay of Rs 10 lacs, the net present
value of the project is Rs 4,22,990 as shown below and in Table 4-3.

lacs 4.23 Rs 10.00 -
12 . 1
00 . 7
12 . 1
00 . 6
1.12
5.00
= NPV Value, Present Net
3 2


Table 4-3: Illustration: Net Present Value: Discount Rate 12% (Figures in Rs.)
Now 1
st
Year 2
nd
Year 3
rd
Year
Cash Flow -10,00,000 5,00,000 6,00,000 7,00,000
Present values of
cash in flows
-10,00,000 5,00,000/ 1.12
=4,46,428
6,00,000/ 1.12
2
=4,78,316
7,00,000/ 1.12
3
=4,98,246
Net Present Value 14,22,990 10,00,000 = 4,22,990

4.7.1 The Decision Rule
Under NPV method all the cash flows are brought to the same point of time, i.e.
at t = 0, when the initial investment is undertaken. Hence the cash flows
become comparable. The rationale of decision is clear that if present value of
cash inflows exceeds the present value of the cash out flows the project is
worth considering as it adds value. If NPV is negative the project destroys value.

The positive NPV accrues to the shareholders. Hence it is consistent with the
objective of the firm which is to maximise the shareholders wealth. By
accepting the positive NPV project the additional wealth created for the
shareholders is equal to the NPV of the project.

The decision making rule for the acceptance/rejection of the projects is as
below:
NPV >0 ACCEPT
NPV <0 REJ ECT

In the extremely unlikely situation of NPV = 0 the acceptance or rejection of
project neither adds nor destroys the wealth of the shareholders. In such a
situation the project is more likely to be rejected as implementing the project is
not worth the efforts by the management.

In case of multiple projects being available the priorities of the selection of
projects would be in the order of NPV. The project with largest NPV is preferred
over all others.

4.7.3 Merits and Demerits of NPV Method
All the shortcomings of the ARR method and payback period method are
overcome in NPV method. These are listed below:
1. The most appealing aspect of NPV method is the recognition of time
value of money. NPV method compares the cash flows only when they
are converted to occur at the same point of time.
2. It considers all the cash flows of the project for its entire life.
3. It also accounts for the risk in projects by providing flexibility to adjust the
discount rate according to the riskiness of the cash flows.
4-9
4. The decision making rule is extremely clear and is consistent with the
objective of the firm of increasing shareholders wealth. It enables
quantification of shareholders wealth.
5. Additive Property of NPV:
The most remarkable advantage of the NPV method emanates from the
additive property of NPV. The value of the firm can be said to be equal
to the sum of net present value of all the projects it is having. In case the
firm accepts two projects with NPV of Rs 5 crore and Rs 3 crore then it
can be said that the increase in the value of the firm would be equal to
the sum of the NPVs of the projects being accepted. The value of the
firm therefore would rise by Rs 8 crore.

4.8 INTERNAL RATE OF RETURN (IRR) METHOD
Internal Rate of Return (IRR) method is also a DCF method of project appraisal
with identical data requirement as that of NPV method. The method evaluates
the project in slightly different manner. Rather than computing the NPV at a
given discount rate the IRR method calculates that discount rate which makes
NPV equal to zero. This discount rate that makes NPV zero is called internal rate
of return of the project. Mathematically, this may be represented as Equation
4-3 as follows:
0 = CF -
r) + (1
CF
= NPV Value, Present Net
0
n
1
t
t
.. Equation 4-3

With cash flows known we need to compute NPV with progressively increasing
the discount rate till the NPV becomes zero. To understand this let us examine
the same cash flows of the project as given in Table 4-3.

We calculated the net present value of the cash outflows Rs 10 lacs in Year 0
and cash inflows of Rs 5, 6 and 7 lacs respectively from Year 1 3 at Rs 4.23 lacs
using the discount rate of 12%. A look at the Equation 4-2 would reveal that by
increasing the discount rate the NPV would fall. To determine internal rate of
return we keep increasing the discount rate till NPV becomes zero. This discount
rate would be the IRR, as defined. This exercise is shown in Table 4-4 from
discount rate starting from 12% to 40% in steps of 4%.

Table 4-4: NPV and Discount Rate
Cash Flow
Year 0 1 2 3 NPV
Discount Rate (% p.a.) -10.00 5.00 6.00 7.00 Rs lacs
12% 4.23
16% 3.25
20% 2.38
24% 1.61
28% 0.91
32% 0.27
36% -0.30
40% -0.82
44% -1.29

As can be noticed from Table 4-4 the NPV turns from positive Rs 0.27 lacs at
discount rate of 32% to negative Rs 0.30 lacs at discount rate of 36%. This implies
4-10
that in IRR must lie in between these two discount rates of 32% and 36%. Using
linear extrapolation as 4% increase in discount rate leads to a decline of NPV by
Rs 0.57 lacs, we can find approximate IRR as 33.89%.

% 33.89 1.89% 32% 100 0.27x x
(-0.30) - 0.27
32 - 36
32% = IRR e Approximat

The inverse relationship of NPV with discount rate is shown in Figure 4-2. Where
the NPV crosses the horizontal axis is the IRR of the cash flow.

Figure 4-2: Net Present Value and Discount Rate


From the illustration of the calculation of IRR the complexity of its computation is
evident. The iterative process of finding the IRR may be time consuming and
cumbersome. However with Excel we can find the IRR of the cash flows within
minutes. The cash flow data can be entered in successive rows/columns for
different years with cash out flow with negative sign and in flows as positive
sign. In the last row/column the formula for IRR may be given specifying the
range of cells containing the cash flow information. The syntax is =irr(range of
cell). This is shown in Figure 4-3 which contains the data in cells B4 to E7. Cell F7
contains the IRR formula. Alternatively one may use formula using the main
menu and choosing IRR. The dialog box of the Excel would guide the
application as shown in Figure 4-3. The exact IRR is 33.87%.

4.8.1 The Decision Rule
The IRR tells us the rate of return generated by the cash flows of the project. It
will be profitable to invest in the project if the rate of return exceeds the cost of
capital because then the project would be able to service the capital and
leave some surplus. On the other hand if IRR is less than the cost of capital it
would imply that cash flows are not enough to meet the expectations of
suppliers of capital. In such a case it will not be desirable to pursue the project.
The decision rule can simply be put as follows

If IRR >Cost of Capital; Accept
<Cost of Capital; Reject
4-11
This cost of capital is often referred as hurdle rate that must be met by the
project for its acceptance. This hurdle rate is used as discount rate for the cash
flows while computing the net present value.

Figure 4-3: Computing IRR with Excel


4.8.3 Merits and Demerits of IRR Method
IRR is akin to NPV rule. It is a representation of a project in a single parameter
that provides a decision making rule for acceptance or rejection of a project.
The mechanics of the IRR are similar to NPV rule. The merits and demerits of IRR
method are same as NPV method and therefore require no further elaboration,
except that unlike NPV, IRRs are not additive.

4.9 Comparing NPV and IRR
For understanding of the relative advantages and disadvantages of the IRR
and NPV method let us have a deeper look in some specific situations. These
situations are of a) non-conventional cash flows, b) mutually exclusive projects.

Non Conventional Cash Flows: Conventional cash flows of a capital budgeting
proposal normally have large net cash outflows initially followed by regular and
small cash inflows for later periods. Non-conventional cash flows of a project
imply that there are multiple periods of net cash outflows in the intervening
periods which also have some positive cash flows. One such typical situation
can be that a firm starts a pilot project by investing a sum and waits for some
time for the cash inflows to become steady. After some periods the firm may
decide to go for full-blown project needing another cash outflow that is
followed by another set of cash inflows in subsequent periods. Finding IRR of
such cash flows poses a problem. Without stating a proof such a cash flow
would have more than one IRRs. There would be as many IRRs as the number of
sign changes. Hence which of the IRR is correct would require managerial
discretion. Under such circumstances NPV would provide a decision
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unambiguously. IRR rule can only be applied to the projects with conventional
cash flows.

Mutually Exclusive Projects: The second situation that merits attention is
selection of one project out of mutually exclusive projects. Mutually exclusive
projects are those where acceptance of one automatically implies rejection of
another. For example replacing a machine with technology A or technology B
would be mutually exclusive, as acceptance of one technology means
rejection of the other.

In case of mutually exclusive projects the IRR rule and NPV rule may give
divergent views. Let us consider two mutually exclusive projects A and B with
cash flows of the two as below:

Year 0 1 2 3 4 5
Cash Flow A -15.00 5.00 6.00 6.00 3.00 6.00
Cash Flow B -19.00 6.00 7.00 6.00 5.00 9.00

The IRR of the two projects and their NPVs at discount rates ranging from 14% to
23% are calculated in Table 4-5.

Table 4-5: Comparing NPV and IRR - Mutually Exclusive Projects
Year 0 1 2 3 4 5 NPV IRR
Cash Flow A -15.00 5.00 6.00 6.00 3.00 6.00
22.03%
Discount Rate PROJECTA
14% -15.00 4.39 4.62 4.05 1.78 3.12 2.95
15% -15.00 4.35 4.54 3.95 1.72 2.98 2.53
16% -15.00 4.31 4.46 3.84 1.66 2.86 2.13
17% -15.00 4.27 4.38 3.75 1.60 2.74 1.74
18% -15.00 4.24 4.31 3.65 1.55 2.62 1.37
19% -15.00 4.20 4.24 3.56 1.50 2.51 1.01
20% -15.00 4.17 4.17 3.47 1.45 2.41 0.66
21% -15.00 4.13 4.10 3.39 1.40 2.31 0.33
22% -15.00 4.10 4.03 3.30 1.35 2.22 0.01
23% -15.00 4.07 3.97 3.22 1.31 2.13 -0.30
Cash Flow B -19.00 6.00 7.00 6.00 5.00 9.00
20.83%
Discount Rate PROJECTB
14% -19.00 5.26 5.39 4.05 2.96 4.67 3.33
15% -19.00 5.22 5.29 3.95 2.86 4.47 2.79
16% -19.00 5.17 5.20 3.84 2.76 4.29 2.26
17% -19.00 5.13 5.11 3.75 2.67 4.11 1.76
18% -19.00 5.08 5.03 3.65 2.58 3.93 1.28
19% -19.00 5.04 4.94 3.56 2.49 3.77 0.81
20% -19.00 5.00 4.86 3.47 2.41 3.62 0.36
21% -19.00 4.96 4.78 3.39 2.33 3.47 -0.07
22% -19.00 4.92 4.70 3.30 2.26 3.33 -0.49
23% -19.00 4.88 4.63 3.22 2.18 3.20 -0.89
Differential Cash
Flow (B - A) -4 1 1 0 2 3 17.18%
4-13

The IRR of project A is 22.03 % and that of project B 20.83is %. Hence according
to IRR rule project A is preferred as its IRR is higher than the project B.

The net present values of the projects A and B are dependent on the discount
rate used. Ranging from discount rate of 14% to 23% the values of NPV for
projects A and B are computed above and depicted in Figure 4-4. We notice
that if the discount rate used is say 20% the project B has higher NPV that
project A. Therefore with 20% discount rate project B should be preferred over
project A. This is in conflict with the outcome given by IRR rule. However, if the
discount rate used is say 14% the project A is preferable than project B as it has
higher NPV. For this discount rate the outcome of NPV rule is consistent with IRR
rule. This may be seen rather easily from Figure 4-4.

Figure 4-4: Net Present Value and Internal Rate of Return


Should we rely on IRR rule or on NPV rule is the question. While NPV is
dependent upon the discount rate chosen, IRR isnt. Therefore while the IRR rule
will always provide the same order of choice in selection of projects, the
ranking by NPV rule may change with the chosen discount rate. However, this
need not lead to the conclusion that IRR, being always consistent is a superior
method than NPV. In fact it is the opposite that is true.

The objective of the firm is to create value for the shareholders. We must
therefore prefer project that creates larger value to the shareholder. It is the
NPV that talks about the absolute value creation. IRR tells value creation in
relative terms only. Shareholders are interested in knowing what value is added
to their wealth. Further since the decline in NPV of project B is steeper than the
decline in project A the discount rate used becomes important. A decision
without consideration to the discount rate that would represent the cost of
capital would not be sound enough.
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4.9.1 Point of Indifference
As can be seen from the Figure 4-4 the rate of decline of NPV with increasing
discount rate is different for project A and project B. Starting with discount rate
of 14% both for project A and B we find that the NPV of project B is higher than
that of project A. However decline in NPV of project B is also higher. Hence with
increasing discount rate the faster decline in NPV of project B would close the
gap of NPVs. As we increase the discount rate further the NPV of project B
would fall below that of project B. Prior to that there would come a discount
rate when the NPVs of the projects would become equal. The discount rate at
which this happens is called the point of indifference, i.e. the firm would be
indifferent whether it chooses project A or project B.

The point of indifference by definition is where the two NPVs are equal, or

NPVA =NPVB
Or NPVA NPVB =0 =NPVB NPVA

One way of knowing the point of indifference is to calculate the NPVs of the
projects at different discount rates and keep comparing them till the NPVs
match. An alternative and simpler method is to find out the IRR for the
differential cash flow. Since both the NPVs are equal there differential would be
zero. By definition the discount rate which makes NPV zero is the IRR. Hence IRR
of the differential cash flows would be the discount rate. This is illustrated for the
project A and project B in the last row of Table 4-6. The IRR of differential cash
flow is 17.18%.

How does IRR of the differential cash flow help? It helps us in reconciling the
conflict in acceptance of two mutually exclusive projects. It becomes a
benchmark for making further judgement. If the cost of capital is greater than
the IRR of the differential cash flow no conflict is seen between the two
methods. However, if the cost of capital is less than IRR of the differential cash
flow NPV and IRR methods would give contradictory results as condensed
below:

Table 4-6: Comparing NPV and IRR - Mutually Exclusive Projects
NPV Rule IRR Rule Result
If Cost of Capital < 17.18%
NPVB >NPVA
Accept B; Reject A
IRRA >IRRB
Accept A; Reject B
Conflict
If Cost of Capital > 17.18%
NPVA >NPVB
Accept A; Reject B
IRRA >IRRB
Accept A; Reject B
No conflict

4.10 ADVANTAGES OF NPV METHOD
As stated earlier, for most cases of independent projects and no capital
constraint NPV and IRR methods give identical results for capital budgeting
decisions. However, to avoid any misleading interpretations analysts
recommend applying NPV rule rather than IRR rule for its ability to handle
special situations like non conventional cash flows and mutually exclusive
projects: Besides the NPV method also has following advantages:

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4.10.1 Relative Simplicity of NPV: The mathematical computation of NPV is easier
that IRR. In the absence of computer/financial calculator the IRR would
have to be calculated by hit and trial approach, which is an iterative
process consuming more time.

4.10.2 Use of Conservative Re-investment Rate: Both IRR and NPV methods are
based on discounted cash flow technique. The cash flows are being
discounted at a specific rate in both the methods. It is implicit in the
method. While computing NPV it is implied that the interim cash flows are re-
invested at the discount rate used. For IRR the discount rate is derived so as
to make NPV equal to zero. The implied assumption is that the interim cash
flows are being re-invested at IRR itself. For example if IRR of a stream of
cash flow is 30% and the cost of capital is 20%, then under NPV method all
the interim cash flows are assumed to be re-invested at 20%. Under IRR
method the same cash flows the assumed re-invested rate is 30%. Since for
the projects that are being accepted the IRR will be higher than the cost of
capital, the re-investment rate in NPV method is on the conservative side.
NPV method is therefore preferable because of conservative re-investment
rate.

4.10.3 Flexibility of Discount Rate in Different Periods: NPV method provides
flexibility of using different discount rates for cash flows of different periods.
This does not exist in IRR method. Normally the discount rate in NPV method
is constant for the life of the project. It seems a reasonable assumption for
projects whose life is short during which the discount rate is assumed
constant. In case the project extends for long periods, one may believe that
the discount rate is liable to change with time. Under such circumstances
the NPV method can be adapted to incorporate the changed discount
rate Under IRR method no change is possible and it is assumed that IRR
would continue to remain valid for all the entire life irrespective of how
long/short the project life is. IRR method breaks down as it assumes the
common re-investment rate for all the cash flows.

4.10.4 Quantifying Wealth Creation: Managers and shareholders alike are normally
interested in knowing how much richer would they be if the project is
accepted. NPV directly tells how much accretion to the wealth of the
shareholders would take place upon acceptance of the project. IRR
method fails to provide that answer as it merely compares IRR with the cost
of capital. Further in case of multiple projects being undertaken the total
accretion to the wealth of the shareholders can be measured by direct
addition of the net present values of each project because of additive
property of NPV. Such additive principle cannot be applied to the IRR
method.

4.10.5 Ranking of Projects in Capital Rationing Situation: Firms normally have
several projects for which enough funds are not available. In such situations
the firm needs to know the priority amongst the identified projects, and
therefore may have to rank them in order of preference. Because of the
ability of the NPV method to provide the amount of wealth creation the
projects can be ranked in order of wealth creation. Such an approach
4-16
would be unfailing. The IRR method may not be suitable because of i) its
inability to measure wealth creation and ii) use of higher re-investment rate.

4.11 ADVANTAGES OF IRR METHOD
Despite its inability to handle all situations the evaluation criteria of IRR remains
a popular method of appraisal because of following possible reasons.

4.11.1 Easier Comprehension: Most people are comfortable in measuring benefits
in relative percent terms even though it is complex to compute IRR. An IRR
of say 15% as against discount rate of 10% would clearly communicate that
it is safe to accept the project. The figure of NPV in isolation is not easily
comprehensible as compared to IRR.

4.11.2 Lesser Input Data Requirement: Another advantage with IRR is the fact that
one can compute IRR simply from the cash flows without knowing the
discount rate. Though for a complete decision the cost of capital is required
but for comparisons of various independent and conventional projects
knowledge of cost of capital is not important. The cost of capital as discount
rate is essential input in computation of NPV. Under IRR all one needs to
know the IRRs of different projects being compared.

4.11.3 Priority for Early Cash Flows: IRR for the project giving early cash flows would
be higher but the same is not true for NPV method. Since IRR favours
projects with early cash inflows firms may prefer IRR method as earlier cash
inflows mean easier funding for other projects and better liquidity. Risk is
supposed to compound with time and hence earlier cash inflows mean
lesser of risk because they are more certain than the distant cash inflows.
Higher IRR in a way takes care of the aspect of risk indirectly.

PROJ ECTING CASH FLOWS

4.12 CASH FLOWS
The exercise of capital budgeting requires two inputs the cash flows for the life
of the project and discount rate. The discount rate would be discussed in next
unit, while we elaborate on the principles of projecting cash flows for the life of
the project in forthcoming paragraphs.

The projection of future cash flow is a more challenging part of the capital
budgeting exercise than computing NPV or IRR. As long as firms use discounted
cash flow technique the requirement of cash flow cannot be dispensed with. It
is a challenging area that possibly needs maximum managerial discretion
because projection of cash flows for the project is a much cumbersome
exercise. We shall discuss what needs to be included and what needs to be
excluded in projection of cash flows.

The cash flows of the project can be classified into three phases:

1. Initial investment: Projection of initial cash flow; the initial outlay or
investment and often referred as project cost is done on rather firm basis
includes the cost of equipment, working capital etc.
4-17
2. Cash flow for the life: Cash flow for the life of the project; most often
recurring every year. Though there is no such compulsion to have annual
cash flow but more often than not one projects cash flows on annual
basis presumably because of convenient practice of preparing annual
performances, reviewing them and to even out the seasonality.
3. Terminal cash flow: At the end of the useful life the project is deemed
closed even though in practice it may not happen. Projecting the cash
flow in the end is another exercise requiring distinct set of information
and managerial discretion.

4.13 PRINCIPLES OF CASH FLOW PROJ ECTION
Irrespective of the category of the cash flow there are certain well established
principles that need to be observed for the capital budgeting exercise. They
are discussed below:

4.13.1 Include Only the Relevant and Incremental Cash Flows
As a foremost principle of projecting cash flows we need to consider only the
relevant and incremental cash flow. For example if the proposal is to replace
an existing machine with higher capacity technically superior machine we
should consider the differential cash flows rather than absolute cash flows of
the new machine. If the new proposed machine can product 12 lac pieces of
the quality saleable at Rs 20 as against the existing machine with output of 8 lac
pieces at a price of Rs 12 the incremental cash flow would be Rs 144 lacs (12 x
20 8 x 12). The absolute cash flow would be Rs 240 lacs (12 x 20). It is the
incremental cash flows that are relevant cash flows for the purpose of
evaluating whether or not the new machine should be purchased.

Similarly, if the new machine is costing Rs 40 lacs but the old machine could be
sold for Rs 3 lacs net of taxes the initial investment would not be Rs 40 lacs but
instead is 37 lacs (40 -3).

Acceptance or rejection of projects impacts the cash flows of the firm on
differential basis. It is the additional revenue and additional cost that are
important. The evaluation is being done for what happens to the firm with or
without the new investment. If the project is to be accepted the present cash
flows are foregone to acquire the new cash flows. The net gain would be the
difference of the two cash flows.

For a new firm such an exercise is extremely simple because all the cash flows in
the absence of the project are zero and all the cash flows of the projects are
the incremental as well as aggregate for the firm. However for an existing firm
evaluation of projects like capacity expansion, product development,
replacement of capital items etc. poses problems in projection of differential or
incremental cash flows. One has to take care in identifying the relevant items of
revenue and expense while estimating the incremental cash flows. The
concept of incremental cash flows is central to the capital budgeting process.

a) Include Side Effects
Including side effects of the projects is direct consequence of the principle of
incremental cash flows. Consider for example the launch of a brand of soap
by a firm that already owns a brand. Launching of another brand would
4-18
create new customers. However, some of the customers using the existing
brand would switch to using the new brand. While introducing new brand
would create new sources of revenue the existing source of revenue may be
adversely affected. More often than not managers tend to forget the
impact the acceptance of the project is going to make on the existing
operations of the firm. In most cases inclusion of the project in the business
activities of the firm has an impact on the existing operations, because firms
normally diversify gradually into related activities.

b) Ignore Sunk Cost
Sunk cost is the cost that has been incurred and does not have bearing on
the decision making for the capital budgeting process. We need to exclude
such cost from the decision making process as it is neither relevant nor
incremental cash flow. For example consider that the preliminary expenses
include the cost of Rs 25 lacs incurred for market survey. Should that cost be
included in the decision making process? The answer would be provided by
examining whether acceptance or rejection of project would make any
difference to the cash flow. Clearly, here the answer is no. If so the inclusion
of such sunk cost is irrelevant to decision making. Whether project is
accepted or rejected the market survey cost has been incurred. On the
contrary many managers may feel that exclusion of the sunk cost would lead
to underestimation of the cost of the project. However they are wrong
because this cost is irrelevant to acceptance or rejection of the project.

c) Include Opportunity Costs
The exercise of projecting cash flows starts from the items of expenditure and
revenues that are visible. However, there can be certain cost/benefits that
may not be visible. We need to include them into our analysis even though
the cash flows they actually do not occur. The rationale for including these
notional cash flows is to account for the value of opportunity foregone.

Consider for example a project that requires use of land but it was
purchased long time back. Should the use of land be considered a sunk cost
and be excluded from the cash flows? Though it seems a sunk cost but in
reality if the project does not use this land it would have to find an alternative
site. If so the cost would reflect the cash outflow either by purchase of the
land or as rental on periodic basis. Therefore to implement the project the
cost would have to be incurred and must be included in the differential cash
flow. Use of any existing assets for implementation of the project, the
opportunity cost must be included. In our example if the firm decided to use
the existing land, its current market value should be included in the cost of
the project.

Similarly, the usage of the existing facilities is the issue of allocation of
overhead cost to the project. Normally costs of common facilities and other
overhead cost which are not attributable to a specific project directly are
allocated to different projects on some rational basis depending upon
managements perception. Consistent with the principle of incremental cash
flow the extra cost in using the existing facilities should form the part of the
cash flows of the project.

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d) Include Working Capital Changes
Capital budgeting decisions invariably involve investment in capital assets,
which are easy to visualise. Besides capital assets the project also requires
working capital in the form of inventory, receivables, advances and cash.
Though part of this is financed by suppliers of material and loans the
remaining part of it must be financed by long term capital of equity. This
needs to be included in the initial outlay.
As the project progresses with time increased revenue and profit also
demand infusion of working capital on periodic basis as higher levels of
inventory, receivables etc are required to maintain enhanced operations.
Increased working capital must be included in the periodic cash flows over
the life of the project. In most cases it would be cash outflow. The changes in
the working capital are calculated as below:
Cash outflow =Increase in current assets Increase in current liabilities

Finally at the end of the life of the project the working capital is deemed
released in the cash flow of the terminal year. It must be taken as cash inflow
in the terminal year.

4.13.2 Separate Financing Cash Flows
Another principle of capital budgeting relates to the treatment of cash flows
related to financing. The suppliers of capital need to be serviced from the cash
flows generated by the project. The debt would carry the interest burden as
well as cash outgo on account of principal on periodic basis. Similarly equity
suppliers expect dividend on the capital provided by them, if enough cash
flows are generated. Should we adjust these cash out flows towards interest,
principal repayments and dividends?

The principle of capital budgeting requires that the cash flows that need to be
examined are those generated by the asset and not what combination of
capital created them. An asset of Rs 100 financed by all by equity would have
same capacity of generate cash flow as it would if it were financed by equally
be debt and equity. Acquisition of asset is an investment decision and how it is
funded is a financing decision. Sharing of the cash flows amongst the capital
suppliers should not distort the ability of the asset to generate cash. It is a
different stream of cash flow that must be separated from the stream of cash
flows of the investment decision.

Having recognised that the streams of cash flows from investing activity and
financing activity are separate, the next question that arises is how to establish
a relationship between the two. Without a relationship between the investment
and financing decision the exercise will be incomplete. The answer is fairly
simple. The objective of the exercise of capital budgeting is to compare the
adequacy of cash flows of the project to meet the requirements or
expectations of capital suppliers. Whether or not the expectations of capital
suppliers are met by the project is examined by the discount rate we choose to
arrive at the net present value of the cash flows of the project.

Since debt carries interest burden which is not considered in the cash flows this
is also referred as interest exclusion principle.

4-20
4.13.3 Only After Tax Cash Flows Are Relevant
Taxes are mandatory if the firm has made profit (not positive cash flow). Except
for the interest on loans the suppliers of capital can only be serviced after
paying taxes. The desirability of project needs to be examined from the point of
view of shareholders (suppliers of capital). Hence the cash flows after paying
taxes are relevant. The priority of tax claim over suppliers of capital demands
some extra caution in dealing with certain items of expenditure that have
features of tax implications. There are three important issues in treatment of
taxes. We examine them below:

Tax rate: The first issue is which tax rate must be used. Since tax structure usually
has slab structure varying rates are available. It may be noted that the tax
rate to be used for the computation of cash flows is the marginal tax rate. If
the project under consideration makes a loss and other projects make
greater profit the firm would be taxed though the project may not have any
cash outflow on account of taxes. Another issue is that taxes are applied to
the firm and not to the project. However, there may be some project specific
tax rebates available. In the capital budgeting exercise we have been
treating the cash flows on differential and incremental basis that invariably
means that how cash flows of the firm would be affected in aggregate. Only
project specific tax incentive must be accounted for separately.

Interest: As stated earlier under the interest exclusion principle that interest on
debt is excluded from the cash flows. The interest on debt is tax deductible
i.e. it is an admissible expense for tax purposes. It is normally referred as tax
shield of debt as effective interest cost of debt comes down by the amount
of tax saved. Generally as a matter of convenience we exclude taxes by
directly deducting the amount of taxes from the earnings before interest and
taxes (EBIT). This would tax the entire earnings. After doing so we would adjust
the tax effects of interest in the cost of debt included in the discount rate.
This convenient way of taxing the entire earnings would be equivalent to
providing for the tax shield the debt enjoys, as can be seen from the
following:

Cash Flow =Earnings Before Interest & Tax (EBIT) x (1 Tax Rate, T)
=Profit Before Tax x (1 T) +Interest x (1 T)
=Profit After Tax + Interest x (1 T)

Depreciation and Amortisation: Another item that has tax implication is
depreciation on assets. It is a permissible expense that is allowed to
recognise that an asset needs to be replaced once its useful life is over. From
the point of view of cash flow, depreciation is a non-cash expense. Similarly
amortisation refers to evening out of the expense and hence profit over
several years rather than in single period. In cash flow terms it has taken
place once and not over several years. Yet depreciation and amortisation
appear in the projections of cash flows because they influence the
accounting profit and the tax amount. Hence we need to add the
depreciation and amortisation back to the cash flows after tax as it is
available as cash. Typically it corroborates the principle that cash flows are
real benefit and not the accounting profit. There are other items of debtors
4-21
written off or creditors written back that impact the profit and taxes but not
the cash flows.

4.13.4 Cash Flow Terminal Year
Though the principles of projecting cash flows are enumerated well but the
cash flows for terminal year need special mention. All the principles stated
above apply to the cash flow of any year including the terminal year. Terminal
year is however is characterised by some special cash flows other than
operational. At the end of its life the project is deemed abandoned in capital
budgeting decision even though in practice the project may continue.
Therefore we need to address a) disposal of asset, b) net working capital, and
c) effects of taxes.

Mostly at the end of the useful life of the project the assets are deemed to be
surplus and available for sale. Therefore we need to have the realisable value
of the asset as inflow in the terminal year in addition to the regular cash flow for
the year. The realisable value would have tax implication too.

The aspect of disposal of assets has tax implication. Further complexities are
added due to complicated tax treatment of sale of capital assets. Depending
upon the tax laws there could be tax savings or tax incidence on disposal of
fixed asset. When realisable value is higher than the salvage value, tax would
be payable on the capital gains and when less tax would be saved. If tax is
saved it is treated as cash inflow else it is an outflow. The net realised salvage
value would be adjusted for taxes.

Similarly the working capital deployed in the project needs to be added back
on the presumption that the project comes to an end and hence the working
capital is released. Since working capital infusion did not have any tax
implication while infused, it would have no tax implication when released.
Therefore the initial working capital and its subsequent increases due to
increased operations would stand released when the project is deemed over.

Terminal year cash flows therefore would be
Operational cash flow
+ Release of Net working Capital
+ Salvage value of the asset realised
Tax saved/paid

4.14 MATCHING CASH FLOWS AND DISCOUNTRATE
An important issue in evaluation of capital budgeting proposals is the
consistency in the cash flows and the discount rate. The discount rate besides
reflecting the cost of capital of the firm must also reflect the riskiness of the cash
flows of the project. Risky projects demand higher discount rate. Stable cash
flows may be discounted at more conservative rate. Using a lower rate of
discount than desired for a particular set of cash flows would overestimate the
net present value while a higher than desired rate would underestimate the net
present value.

The second aspect of matching of cash flows and the discount rate relates to
for whom the project is being evaluated. The capital budgeting decision is
usually viewed from following two perspectives - All suppliers of capital i.e.
4-22
equity and debt capital or for suppliers of equity capital. The cash flows that
are discounted will have to be consistent with the stakeholders being
considered.

If cash flow belonging to all the stakeholders is considered then the relevant
discount rate will be Weighted Average Cost of Capital (WACC) unless the risk
profile of the new project demands modification of the discount rate. The
method is referred as WACC method.

If the analysis is being done from the perspective of equity shareholders then
the relevant cash flows will be those belonging to shareholders alone and the
relevant discount rate will be cost of equity. This method is known as equity
residual approach.

Whether we adopt WACC approach or equity residual approach the net
present value would be identical.

Lastly one has to see if the cash flows being examined are nominal or real. If
nominal the discount rate too must be nominal and if the cash flows are real
the discount rate too must be real. The principle of consistency in capital
budgeting demands that nominal cash flows are discounted at nominal
discount rate while real cash flows are discounted at real discount rate.
The relationship between real rates and nominal rates is given as:
(1 + Nominal Rate) =(1 + Real Rate) x (1 + Inflation Rate)
or (1+r ) =(1+a) x (1+I)
where a =real rate and I =inflation rate

Irrespective of method the net present value would be identical as long as we
observe the principle of matching the cash flows with the discount rate.

4.15 CONCLUDING REMARKS
Despite extremely scientific approach to capital budgeting there are few other
aspects that need attention. Firms need to engage themselves in continuous
exploration of ideas and look for opportunities. Some of the ideas are simply
experimented to gather experience and develop a feel of the environment
and gauge the potential of business opportunities. Such cases are not ripe for
extensive capital budgeting exercise. The acceptance or rejection of each of
the project is deemed to have no bearing on the subsequent courses of action
that a firm may have. It is rarely the case. Invariably, what a firm does in the
past either opens up further avenues of investment or constrains the future
courses of action. Different projects executed at different points of time during
the life of the firm cannot be treated as isolated decisions. New projects were
the possibly the consequences of the old history. In the capital budgeting
exercise we have not accounted for such opportunities that could be made
available.

Management of the firms often have decisions in their hand to correct the
action during the mid course. These choices are include an option to delay i.e.
the proposal rather than being implemented today may be deferred for some
time when the uncertainties would reduce. The management of project also
have a choice to commence operations at lower scale and then expand later
4-23
as it develops more confidence in the project. Further the management also
has a choice to abandon the project any time prior to maturity. In capital
budgeting exercise the situation assumed today must last for the life of the
project with no flexibility to management to adopt a mid course correction.
These flexibilities remain but are not valued.

It is often said that capital budgeting exercise is an art rather than a
mathematical equation. The approach described here is best suited to routine
conventional projects. Some alternative approaches would have to be
examined if the projects of non conventional nature need to be evaluated.

SOLVED PROBLEMS

Example 3-1: Payback Period & Discounted Payback Period
Project is under consideration for selection. Its initial cash outlay is Rs. 1,800 and life of 5
years. The cost of capital of the firm is 12%.
Years
Project 0 1 2 3 4 5
Project Cash Flow -1,800.00 300.00 600.00 800.00 1,200.00 1,100.00

a) What is the payback period of the project?
b) If the cut off payback period is 3 years should the project be accepted?
c) What is the cut off period on discounted cash flow basis?

Solution
a) The cash flows indicate that the capital investment of Rs 1800 can be recovered in
slightly more than 3 years with cash inflows of Rs. 1,700 in first three years. By
extrapolation we may compute the exact payback period.

Recovery up to Year 3 =1,700
Balance to be recovered =1,800 1,700 =100
Approximate time required to recover the balance assuming uniform cash inflow
during the years
=100/1200 x 12 =1 month
Therefore payback period is 3 years and 1 month.

b) With cut off payback period of 3 years the project may be accepted.

c) Using 12% cost of capital the discounted cash flow and its cumulative values are
computed below:

Project 0 1 2 3 4 5
Project Cash Flow -1,800.00 300.00 600.00 800.00 1,000.00 1,100.00
Present Value -1,800.00 267.86 487.32 569.42 635.52 624.17
Cumulative PV 267.86 755.18 1,324.60 1,960.12 2,584.29

Based on discounted cash flow the recovery is made after third year but before
fourth year. The exact calculations are

Recovery up to Year 3 =1,324.60
Balance to be recovered =1,800 1,324.60 =475.40
Approximate time required to recover the balance assuming uniform cash inflow
during the years
=475.40/1,960.12 x 12 =2.91 months
4-24
Therefore payback period on discounted cash flow basis is 3 years and 3 months.

Example 4-2: NPV and IRR Methods
A firm is considering two mutually exclusive projects Project A and Project B with
initial capital outlays of Rs 3,000 and Rs 2,400 with life of 5 years. The cash flows
for 5 years for both the projects are given below:

Years
Project 0 1 2 3 4 5

Cash Flow - A -3000.00 800.00 1000.00 1200.00 1200.00 1800.00
Cash Flow - B -2400.00 800.00 700.00 900.00 1000.00 1400.00

a) Find out NPV of each project assuming cost of capital at 20%.
b) Find out IRR of each project.
c) Which of the project would you choose and why?

Solution:
The NPVs at 20% discount rate and IRRs of each project are calculated below:

Discount Rate 20%
Years
Project 0 1 2 3 4 5

Cash Flow - A -3000.00 800.00 1000.00 1200.00 1200.00 1800.00
Present Value -3000.00 666.67 694.44 694.44 578.70 723.38
NPV 357.64
IRR 24.65%

Cash Flow - B -2400.00 800.00 700.00 900.00 1000.00 1400.00
Present Value -2400.00 666.67 486.11 520.83 482.25 562.63
NPV 318.49
IRR 25.31%

Based on IRRs of the projects Project B is preferred having IRR of 25.31% as
against 24.65% for Project A. However, the NPV of Project A is higher at Rs
357.64as against Rs 318.49 for Project B. According to NPV rule Project A is
preferred.

We would choose Project B because its present value is higher at Rs 918.49
consisting of Rs 318.49 from the project and Rs 600 saved on the initial
investment.

Example 4-3: IRR and NPV
Refer to Example 4-2. If the cost of capital changes to 24% compute the NPVs
of the projects. Does IRR change? Would your decision change? Why or why
not?

4-25
Solution
The NPVs at 24% are computed below:

Discount Rate 24%
Years
Project 0 1 2 3 4 5

Project A - Cash Flow -3000.00 800.00 1000.00 1200.00 1200.00 1800.00
Present Value -3000.00 645.16 650.36 629.38 507.57 613.99
NPV 46.47

Project B - Cash Flow -2400.00 800.00 700.00 900.00 1000.00 1400.00
Present Value -2400.00 645.16 455.25 472.04 422.97 477.55
NPV 72.98

The IRR would not change as the cash flows have remained same. IRR is
independent of discount rate. The decision to choose Project B over Project A
remains unchanged. Both IRR and NPV of Project B are higher.

Example 4-4: Point of Indifference
Refer to Examples 4-2 and 4-3. Find out the point of indifference. What does it
communicate?

Solution
We find the point of indifference i.e. the discount rate at which NPVs of the two
projects are equal by finding the IRR of the differential of the cash flows of the
two projects.

Years
IRR
0 1 2 3 4 5
Differential Cash
Flow -600.00 0.00 300.00 300.00 200.00 400.00 22.31%

The IRR of the differential cash flow is 22.31%. At this discount rate the NPVs of
the two projects would be equal and there would be identical increase in
wealth. If the cost of capital is higher than 22.31% the IRR and NPV rule would
be consistent with each other and give same order of preference. However if
the cost of capital is less than 22.31% the NPV and IRR rules with give conflicting
outcomes.

KEY TERMS

Independent
Projects
Independent projects are those where acceptance of one
does not impact the acceptance/rejection of another.

Mutually
Exclusive
Projects

Mutually exclusive projects are those where acceptance of
one implies rejection of another.
Accounting Accounting rate of return is average profit as % of average
4-26
Rate of Return investment over the life of the project.

Payback
Period
Payback period is the amount of time required to recover
the original investment back.

Present Value Present value is the value of the cash flow now at a specific
discount rate that occurs at a future date.

Discount Rate Discount rate is the rate at which we compute the present
value of the future cash flow. This established the
relationship between future and present cash flows.

Net Present
value
Net present value is the present value of cash inflows less
present value of the cash out flows.

Internal Rate
of Return
Internal rate of return is that discount rate at which the net
present value equals zero.

Point of
Indifference
Point of indifference is the IRR of the differential cash flows
of two projects. At this discount rate the NPVs of the two
projects are equal.

Reinvestment
rate
Reinvestment rate is that rate at which the interim cash
flows are reinvested.

Sunk Costs Sunk costs are those items of cash flows that have occurred
in the past and do not have an impact on the current
decision-making.

Opportunity
Cost
Opportunity cost refers to the value foregone or opportunity
lost while putting a resource to use.

SUMMARY

Capital budgeting decisions are very vital and crucial to the survival and
growth of the enterprise. These decisions relating to the acceptance or
rejection of the projects have long-term implications and are strategic in
nature. The features of capital budgeting proposals include 1) their non-
reversibility 2) information gaps in data collection 3) inherent risks in the projects
and 4) inflexibilities and 5) inability to incorporate changes depending upon the
experiences gathered later.

There are various tools to examine the acceptability of the projects. They can
be segregated into DCF based techniques and non-DCF based techniques.
Non-DCF techniques include methods of Accounting Rate of Return and
Payback period. These methods do not place any importance to time value of
money. All cash flows are treated with the same value. Payback period is
concerned about the time period it would take to recover the original
investment. The payback period is compared with the cut-off. Payback period
computation is important for industries with high degree of technological
obsolescence.
4-27

Net present value, a DCF technique is the present value of the cash inflows
discounted at a rate less initial investment. If the NPV of the project is positive it
is accepted else we reject it. NPV states the contribution a project makes to the
value of the firm. Acceptance of project increases the value of the firm by the
amount of its NPV.

Internal rate of return method, another DCF technique computes IRR. It is that
rate of return, which makes the net present value of the project as zero. As
discount rate increases the NPV of the project falls and ultimately turns
negative. Internal rate of return is the maximum discount rate that is supported
by cash flows of the project. If the cost of capital is less than IRR, we accept the
project otherwise we reject it.

Generally NPV method and IRR method are consistent with each other. Few
circumstances that may lead to contradictions in NPV method and IRR method
are 1) non-conventional cash flows of the project 2) mutually exclusive projects.
The source of contradiction is attributed to implicit assumptions about the
reinvestment rate of the interim cash flows of the project. Under NPV method
the reinvestment rate for the interim cash flows is assumed to be the discount
rate used while in IRR method reinvestment is implied at the IRR itself.

While projecting the cash flows of the project it is usually convenient to split
them into three; i.e. 1) Initial cash outlay 2) Regular cash flows over the life and
3) cash flows for the terminal year. All the cash flows are made on incremental
basis. This implies inclusion of cash flows due to side effects, ignoring sunk cost
and inclusion of opportunity costs. Infusion of working capital at the
commencement of the project, further changes in the subsequent operational
years and its ultimate release in the terminal year too must be considered in the
incremental cash flow.

In any capital budgeting exercise it is important to have discount rate and cash
flow matching. The discount rate must be a) consistent with the risk of the cash
flow, b) must represent the cost of the suppliers of capital whose cash flows are
being considered and c) nominal for nominal cash flows and real for real cash
flows.

SELF ASSESSSMENT QUESTIONS

1. What do you understand by capital budgeting? How do you classify
different kinds of projects?

2. What is payback period? How do you appraise projects on the basis of
payback period and what are the limitations? Under what circumstance
would you like to use payback period?

3. What do you understand by discounted cash flow techniques of capital
budgeting? What is Net Present Value and how do you assess the
desirability of any project based on Net Present Value method?

4-28
4. What does Internal Rate of Return signify? How do you accept or reject
the projects based on IRR method of evaluation?

5. What are limitations of IRR method as compared to NPV method?

6. Discuss three different types of costs that deserve special attention due
to incremental principle while projecting cash flows of a project.

7. What do you understand by matching cash flow and discount rate?

8. A project has initial outlay of Rs 20 crore with uniform inflow of Rs 5 crore
for its entire life of 8 years. What is the NPV of the project at a) 15% and
b) 20%?

9. Find out the IRR of the project cash flows as given in Problem 8.

FURTHER READINGS

1. Srivastava & Misra (2008), Financial Management, Oxford University Press,
Chapter 10.
2. Prasanna Chandra (2009), Financial Management: Theory and Practice,
Tata McGraw Hill, Chapter 11 and Chapter 12.
3. Brealey and Myers (2002), Principles of Corporate Finance 6
th
Edition,
Tata McGraw Hill, Chapter 5 and Chapter 6.

5-1
UNIT 5

INTRODUCTION TO COST OF CAPITAL

5.0 OBJECTIVE
The objective of this unit is to
a) Explain the meaning of opportunity cost
b) Discuss weighted average cost of capital (WACC)
c) How to find cost of various financing instruments like debt, preference
capital and equity
d) Discuss various model of measuring cost of equity and their relative
advantages and disadvantages.
e) Discuss various ways that the weights of different sources of financing
can be used in determining WACC
f) Explain what is meant by marginal cost of capital
g) Make aware of the pitfalls in using WACC as discount rate

5.1 INTRODUCTION
In the last unit on capital budgeting we elaborated that the cash flows of the
project need to be discounted at an appropriate rate. This appropriate rate of
discount is also referred as hurdle rate; a rate that the project cash flows must
exceed for it to be accepted. Environment continuously offers business
opportunities that need to be examined whether or not these must be
exploited by the business enterprises. The discount rate serves as a benchmark
against which all the projects must be evaluated.

This appropriate rate of discount or hurdle rate must account for a) time value
of money b) expectations of suppliers of capital and c) the riskiness of the cash
flows of the project. In most cases this hurdle rate happens to be cost of
capital, the subject matter of this unit.

The cost of capital hinges around the concept of opportunity cost i.e. the return
of the next best alternative foregone. The opportunity cost is manifested in
expectations of investors financing of the projects. The project cash flows
should be able to service the expectations of the investors. Since the
expectations of diverse investors are diverse, the only way the aspirations of the
all the suppliers of capital can be incorporated is on aggregate basis. The
aspirations of the investors regarding return on an aggregate basis are
reflected in different markets that exist for different securities. Hence markets
rate of return would form the basis of computation of the cost of capital. The
aspirations of the investors would also include time value of money, and hence
it need not be considered separately.

Besides market oriented returns the hurdle rate must also account for the risk
associated with the investment. In order to include the risk characteristics the
opportunity cost must compare investment of same risk class. We cannot use
the opportunity cost of a bank fixed deposit, an extremely safe option while
evaluating the investment in stock market, an inherently risky investment. If
aspirations of investors are incorporated on aggregate basis we segment the
5-2
markets on the basis of risk class and then take its return as the opportunity cost
for that class o frisk. Different market returns account for the risk differentials in
different markets.

From the perspective of risk the discount rate must incorporate the following:

The business risk: The benchmark must incorporate the risk of the project. Higher
the risk of the project higher must be the discount rate. Riskiness of the
project is manifested in the variability of the cash flows. More often than not
managers tend to offset the risk of cash flows by raising the qualifying bar i.e.
to revise upwards the discount rate appropriately and consistent with the
uncertainty of the cash flows.

The financial risk: The variability of the cash flows pertains to the business risk
where the market environment and related factor cause uncertainty of cash
flows. The other factor affecting the discount rate relates to capital structure.
The expectations of the returns for the capital providers change with
changing capital structure. The risk faced by equity capital suppliers
increases as firm borrows more and more. This is called financial risk. The
discount rate appropriately must reflect the element of financial risk the
equity capital suppliers are exposed to with increasing debt.

5.2 WEIGHTED AVERAGE COST OF CAPITAL (WACC)
Firms access different markets for mobilising capital. If so not only the
expectations of different market would constitute the cost of the capital but
also the proportions in which capital is raised from different markets.

The three broad kinds of suppliers of capital to a firm are
a) Debt holders are those who lend funds and expect a fixed return
irrespective of success or failure of project. Such form of capital is called
debt and its suppliers are called debt holders.
b) Equity shareholders are those who are willing to merge their fortunes with
the performance of the project, expecting high returns if profits permit
and sacrifice returns if project does not succeed. Such capital is called
as equity capital and its suppliers are known as equity holders or
shareholders.
c) Preference shareholders are those who do not want to take extreme
position of either shareholders or debt holders, but want a fixed return
subject to adequate cash flows. Their claim is prior to that of
shareholders but is junior to debt holders. This capital is called preference
capital and its suppliers are preference shareholders.

Weighted Average Cost of Capital, WACC will be one single number that will
take in to account the expectations of all suppliers of capital. This may be used
as a hurdle rate that must be overcome if the project is to be accepted.
Crossing of this hurdle rate will imply that all types/classes of capital suppliers
are satisfied with by the cash flows of the project.

In order to develop a single number, we need to consider the cost of suppliers
of all kinds of capital individually and separately. Then depending upon the
5-3
proportions of each kind of capital a weighted average may be found.
Mathematically this can be represented as

WACC = we x re + wp x rp + wd x rd. Equation 5-1
where
we = Proportions of equity re = Cost of equity
wp = Proportion of preference capital rp = Cost of preference capital
wd = Proportion of debt rd = Cost of debt

We now examine the cost of individual components of the capital.

5.3 COST OF DEBT
The cost of borrowed funds is easiest to determine. The lenders of funds specify
their expectations in the terms and conditions. The cost of debt is normally the
coupon rate that is payable by the firm to the holders of the debt instruments. If
a firm raises funds from public through an issue of debenture at 12% at par
(Issue price equal to face value on which interest is payable) the cost of debt
would be 12% at the time of issue of debt.

While at the time of raising debt the coupon rate would reflect the true cost of
funds, it would not remain so for the entire tenure of the debt. If the debt is not
traded the true and current cost of debt would be equal to the current rate of
interest on which the loans are available. This is on the presumption as if the
present borrowings were to be liquidated by raising another loan/debt.
However, if the debenture were traded in the market, its price would reflect the
true and latest trends of the expectations of the interest rates in the market. As
market price changes the cost of debt too would change.

Market price in excess of issue price would imply decline in the interest rate
scenario, while market price of the instrument lesser than the issue price would
indicate rise in the interest rate since the time of the issue. Using 12% as cost of
debt will be erroneous if the market price of the debenture is different than the
issue price/face value.

5.3.1 Cost of Redeemable Debt:
Normally debt is issued with definite/certain terms of repayment of debt. The
debt is repayable either as bullet payment upon the completion of period or is
payable in instalments over periodic intervals. Irrespective of how the debt is
repaid the cost of debt is found by equating the price of debt to the present
value of cash out flows discounted. The rate that equates the two is the cost of
debt.

Following Equation 5-2 would accurately and appropriately determine the cost
of debt denoted by rd, that pays a fixed sum, C in each period and is
repayable at the end of tenure of debt.

N
1 t
N
d
t
d
t
o
) r (1
R
) r (1
C
P
.Equation 5-2
where; P0 = Current market price of the debt normally called debenture
Ct = Coupon payments (Interest) at time period t
N = Number of periods left for maturity of the debenture
R = Repayment of principal as bullet
5-4
rd = Cost of debt

Solution for the Equation 5-2 can be obtained by the process of trial and error
to match the price of the debt with that of the present value of the cash out
flows of coupon payments and the repayment of principal. The rate at which
the cash out flows match the price is the cost of debt.

Alternatively we can very quickly find the value of discount rate by using IRR
function in the EXCEL. The IRR of the cash flow would be the cost of debt.

5.3.2 Cost of Perpetual Debt:
When a debt is never repaid it becomes perpetual debt. The entire cash flow of
such debt would consist of interest payment forever as given by Equation 5-3.

1 t
t
d
t
o
) r (1
C
P
.. Equation 5-3

Fortunately Equation 5-3 is easier to solve than Equation 5-2 (the equation for
redeemable debt). Equation 5-3 is a simple case of a geometric progression
which may be solved without hit-and-trial method or using Excel. Equation 5-3
simplifies to
o
t
d
d
t
o
P
C
= r or
r
C
= P
Equation 5-4
Therefore the cost of perpetual debt, rd is simply equal to the coupon payments
divided by price of debt/debenture.

One may have a lingering doubt about the availability and sanctity of finding
cost of perpetual debt, when no lender would provide such debt. We discuss
this in the perspective of long term debt and capital structure of the firm. A 30-
year debt is issued by many infrastructure or utility companies as they need to
raise fund on a long term basis. Though these debts are repayable the tenure
indeed is long which may be equivalent to a situation of perennial debt.

Another situation of perennial debt is when the firm decides to have fixed
amount/proportion of loan in its capital structure. If the debt from one source is
repayable one can generate equal debt from another source to maintain the
desired capital structure. In such case though the debt is repayable for the
lender but from borrowers perspective the debt is perennial.

5.3.3 Post Tax Cost of Debt:
Equations 5-3 and 5-4 state the cost of debt from the perspective of lenders.
However from the perspective of the firm viewed from its owners point of view
i.e. the shareholders would the cost be same as the return that the lenders earn.
From the perspective of the shareholders of the firm the interest paid to the
lenders is not borne entirely by the shareholders. A big part of this cost is borne
by government as payment of interest is recognised as an expense and firm
saves the tax on such interest outgo.

The effect on the earnings that are available to shareholders would not reduce
by the amount of interest, but by a smaller amount; the difference being the
amount of tax. If a firm pays 40% tax and has an interest outgo of Rs 100 the
5-5
effective outgo on interest payment would only be Rs. 60 since the firm will now
have to pay Rs 40 less of tax. This is due to the fact that the interest payment
would be admissible as a business expense. The funds available to the
shareholders would therefore reduce by Rs 60 and not by the amount of
interest i.e. Rs 100.

Since we analyse situations from the perspective of the shareholders being the
owners of post tax residual income only, the effective cost of debt would
therefore be as per Equation 5-5.

Post Tax cost of Debt = rd (1-T).. Equation 5-5
Where T = Corporate Tax Rate

5.3.4 Floatation Cost
Mobilising debt from banks or from the capital markets the firms are required to
incur some costs such as processing fee in case of loan from banks and
expenses for due-diligence, road shows, advertising, printing of application
forms, brokerage, underwriting etc in case of access to capital markets. All
these costs are front end and referred as floatation costs, and are normally
expressed as % of the value of funds being mobilised. Naturally such floatation
cost would increase the cost of debts because one realises lesser amount than
face value and pays coupon on face value. The cost of debt net of floatation
would be rd/(1-f) where f is floatation cost

5.3.5 Issue at Discount/Premium:
Also in order to be consistent with conditions prevailing in the capital market
the debt may be issued at premium or at discount to the face value of the
bonds. Further the redemption of the bond may be at premium or discount to
the face value, depending upon the market conditions and as an inducement
for investors to subscribe to the issue.

The floatation cost and premium or discount at the time of issue or at
redemption impact the cash flow and the best way to find the cost of the debt
would be to calculate the IRR of the cash flows. Equation 5-6 provides
approximate cost of debt.

2 / ) R + P (
N / ) d / p p / d f ( + ) T 1 ( C
= r
0
m m
d
Equation 5-6
where f is floatation cost,
d /p are the discount or premium over face value at the time of issue
pm/dm is premium/discount on the redemption, and
N is the tenure of the instrument.
5.4 COST OF PREFERENCE CAPITAL
The preference capital raised by the firm is more in the nature of debt rather
than equity capital from the viewpoint of its cost. Preference shareholders are
promised a fixed amount of dividend, no more no less, with the stipulations that
unless the commitment to preference shareholders is met, no dividend to equity
shareholders can be paid.

5-6
Just like debenture holders and loan providers have prior claims on the cash
flows of the firm, the preference shareholders also enjoy the same rights.
However, there is a difference in the treatment of the dividend payable to the
preference shareholders from the interest payable to debt providers.

While interest is a tax deductible expense dividend is not. Therefore, the cost of
the preference capital is higher compared to debt for the same amount of
interest or dividend promised. To keep same cash flow to equity capital
suppliers, a firm will have to earn higher if it has to pay same rate of dividend on
preference capital as the interest rate on the debt.

Simply stated the cost of preference capital is the amount of dividend payable.
If the preference capital is traded or redeemable after a specified time, the
cost of preference capital can be found form the following Equation 5-7, similar
to the one used for finding cost of debt.

N
1 t
N
p
t
p
t
o
) r (1
R
) r (1
D
P ....Equation 5-7
where: P0 = Current market price of preference share
Dt = Dividend payments at time period t
N = Number of periods left for maturity of the preference share
R = Redemption value of the preference share
rp= Cost of preference share capital

Also since the dividend to preference shareholders is payable only out of
income arrived at after tax there is no difference in the pre-tax or post-tax cost
of preference capital. They are identical unlike the cost of debt where the pre-
tax and post-tax cost differs by the amount of tax saved.

5.5 COST OF EQUITY
Unlike debt or preference share there in no stated or mandated return
promised to the providers of equity capital. In the absence of any firm
commitment on part of the issuer it becomes extremely difficult to estimate the
cost of capital for equity holders. It is so because equity shareholders are
owners of residual profits. The entire residual that is left after meeting all
commitments including those of suppliers, workers, government besides other
suppliers of capital, belong to the shareholders. Hence the returns become risky

The only way one can incorporate the cost of equity is by finding the
expectations of shareholders. The complexity is compounded because there
are no directly observable phenomena that can reflect accurately the
expectations as well as the risk of the equity shareholders. Hence we rely on
analytical models driven by fundamentals and market conditions.

5.5.1 Internal Vs External Equity
Before we discuss models of finding the cost of equity we must distinguish
between two forms of equity. Equity capital is normally classified in two ways; 1)
the profits that are not distributed but used by the firm in funding the growth,
called retained earnings and referred as internal equity and 2) equity capital
raised afresh to fund the projects and growth, called external/fresh equity

5-7
The cost of equity by issuing fresh stock is more than the cost of internal equity
due to operational differences though theoretically both should be same. The
practical considerations that have cost implications are:
1. Existence of floatation cost
2. Under utilisation of external equity
3. Under pricing of fresh capital

First, the issuance of fresh equity involves some floatation cost. These costs
include fees to merchant bankers, underwriting commission, administrative cost
etc. Sometimes these costs related to floatation are as high as 10% depending
upon the amount mobilised. If floatation costs are f expressed as % of price of
equity the cost would be:
f) - (1
equity internal of Cost
= equity external for r
e

If floatation cost is 5% of the issue price and cost of internal equity is 16% then
the cost of fresh equity shall be 16.84% (16/0.95).

Second, fresh issues of capital are made in chunks where the entire funds
mobilised are not used instantaneously. Large projects do have considerable
gestation period and unless the project is executed fully, the use of funds will be
partial only. This time lag between mobilisation of funds and its use has a cost.
The funds are idle for some time and firms normally deploy these funds in short-
term risk free securities to earn some income. Such a situation is less likely with
the retained funds since surpluses are generated periodically and deployed
accordingly. For most growing firms retained funds can be assumed used
instantaneously.

The last issue which possibly has the greatest impact is the issue of pricing the
fresh capital. If a firm has to mobilise capital afresh it would have to price the
new issue somewhat less than the current market, in order to induce investors to
subscribe to the capital. Therefore the firm would have to issue larger number of
shares.

There are basically two approaches to arrive at cost of equity capital

1. Dividend Capitalisation Approach and
2. Capital Asset Pricing Model Approach.

Both these models are driven by market conditions and measure the cost of
equity in an indirect manner. We discuss both these models now.

5.6 DIVIDEND CAPITALISATION MODEL
Dividend capitalisation model (to be discussed in detail under Unit 7 on
Valuation of Shares) assumes that the price of the firm reflects the expectations
of shareholders. The return is manifested in the prices. Shareholders provide
capital to firm to earn an income, which comes from two sources. One is a
recurring income in the form of dividend an investor receives by holding to the
share. This is known as dividend yield. The other is appreciation in the price
expected over a period of time. This appreciation in price is naturally governed
by the expected growth in the income and therefore the dividend.

5-8
If equity shares are traded in the market at a price of P0 and if it is expected
that the firm will pay a dividend of D1 in the next year, it may be reasonable to
assume that one is willing to buy the stock at P0 to earn the dividend of D1. This
would imply that the return expected is the dividend yield given by re = D1/P0.

This can be derived my making extremely simplistic assumption that the current
price of the equity share is nothing but the discounted cash flow of the
dividend expected from the share. Mathematically this is put as
8 - 5 uation ........Eq .......... Yield Dividend
P
D
r equity, of Cost
or ;
r
D
P Then
D ...... D D D . i.e constant is dividend if
......... ..........
) r (1
D
) r (1
D
) r (1
D
) r (1
D
P
0
e
e
0
3 2 1
4
e
4
3
e
3
2
e
2
e
1
0

If a firm pays dividend of Rs 20 and the stock is selling at Rs 100 the returns to the
shareholder would be 20%. If the price remains constant one can assume that
investors in equity are satisfied with the return. If they aspire for greater return
the price would fall down and if the returns are in excess of expectations the
price would go up till the return expectations are matched.

A variant on the dividend capitalisation model is often used where we assume
that the dividend would grow from period to period. In such a case the price of
the stock would be higher than what it would be without dividend growth. If we
assume a constant growth of g in dividend from one period to another in the
above model the cost of equity capital can be arrived at as below:
9 - 5 ion .....Equat .......... .......... .......... g......... +
P
D
= r equity, of Cost
or ;
g - r
D
= P then
......... ..........
) r + (1
g) + (1 D
+
) r + (1
g) + (1 D
+
) r + (1
g) + (1 D
+
) r + (1
D
= P
0
1
e
e
0
4
e
3
1
3
e
2
1
2
e
1
e
1
0

This can give far realistic estimate of the cost of equity capital than with the
assumption of constant dividend. If we continue to assume as before, that the
dividend expected in the next period would be 20% of the current price but the
market believes that the dividend will grow at a constant rate of say 10% the
cost of equity becomes 30%.

Major limitations of Dividend Capitalisation Model include
It assumes that all earnings are distributed
It cannot be applied to firms that do not pay dividend at all or the
payout is not proportional to the growth in earnings.
Dividend Growth Model assumes that dividends will grow at a constant
rate of g indefinitely into the future. This clearly is impossible.
The model does not consider the risk of the project and assumes that the
risk is manifested in price of the stock.

5-7 CAPITAL ASSET PRICING MODEL
Another approach to determine the cost of equity is a market based approach
that directly addresses the question of what returns can be expected from
5-9
investment in the assets. Reverting to our discussion of risk in UNIT 3 we stated
that the true measure of risk is standard deviation. Before we describe the
capital asset pricing model (CAPM) a word about kinds of risk needs to be
mentioned.

The aggregate risk of the returns on the stock can be bifurcated into
systematic risk and unsystematic risk. There are many causes that affect the
returns on the stock. These factors are divisible in two broad categories. One
category of factors affect prices (and hence returns) of all stocks traded in the
market. These factors include broad economic parameters like inflation rate,
interest rates, budget, GDP growth, fiscal policies, monetary policies, rainfall
etc. Any change in these factors impacts prices of all securities rather than a
few to change, albeit the change in the prices would not be identical for all
the securities. Rather the changes would be in different proportions for different
securities. These factors are market wide factors.

Another set of factors that causes the prices of the securities to change are
specific to the firm. The returns and the prices of the stock is also dependent
upon the company specific events such as expansion, product development,
capital expenditure programme, competitive position, marketing policies, cost
control, management change etc. These factors affect the price of the security
concerned and not the market as a whole. These factors are unique to the
security concerned.

The risk in the returns of the securities can be consisting of market wide factors;
the systematic risk and the unique risk; the unsystematic factors. Capital asset
pricing model makes following assumptions:

In case of the portfolio of stocks the unique factors of different securities
are said to be nullifying. At a time one firm does well while another
passes through bad times and at other times the opposite happens.
The investors are concerned with the aggregate returns of the portfolio
rather than returns on the individual securities.
Most investors invest in number of securities rather than single security.
Therefore the returns on the portfolio would be governed by market wide
factors and not unique factors, as it can be diversified away by including
more and more securities to the portfolio.
Under perfect market conditions the returns of the particular securities
would be governed by its sensitivity to market wide factors.

Systematic risk refers to the variability in returns of the stocks attributed to
market wide factors. We define this risk as beta and assign specific meaning
to the values of 0 and 1. The value of zero is assigned to for ventures that have
no systematic risk at all. The value of 1 is assigned as a standard for the project
that offers risk equivalent to that of the market. Since investors have a choice to
invest in the market and the risk of returns provided by the market is presumed
to be standard it is assigned a value of 1. The projects having greater risk than
the market will have a of greater than 1, while those with lesser risk than the
market will have a of less than 1.

Capital Asset Pricing Model provides for the direct adjustment of the risk in the
expected returns. A highly simplistic mathematical presentation would state
5-10
that expected returns from a project are directly proportional to the risk of the
project. Higher the risk higher is the expectation of returns and vice versa.
Recognising the linear relationship of expected return and risk we need to
quantify risk and develop a measure. Conforming to the above characteristics
following equation will correctly define the expected cost of equity re for a risky
venture:
re = rf + x (rm rf) Equation 5-10

where; rf = Expected return on risk free securities,
rm = Expected return on the market, and
= Expected risk of the project.



CAPM is depicted in Figure 5-1. It states that the returns on the equity are
linearly related to the systematic risk of the project. There are three inputs
required to compute the cost of equity the risk free rate of return, the market
return, and the sensitivity of the stock to the systematic factors.

Risk free returns can be assumed to be the returns offered by government
securities like T bills and bonds. Market return can be found by changes in the
value of the index. Both the values of rf the risk free returns and rm the return on
the market are available for immediate past. Since economic conditions
change only gradually over time, it will be reasonable to assume that trends
depicted in the recent past would continue to be reflected in not-so-distant
future.

The problem of measurement of the risk of the project is rather complex. It is
not a directly observable phenomenon like the risk free rate and market return.
It has to be derived from relevant observable parameters. is the relationship
of the returns of the firm with the returns of the market in the same period. One
way to find out this relationship is through regression of past data of returns of
the firm with the returns of market. Returns of the security with that of market in
the recent past are observed and compared. A of 1 will indicate that if
market moves by 1% the returns on the security will also move by 1%. A of 0.5
implies 0.5% change in return with 1% change in returns on the market.

Figure 5-1: Cost of Equity CAPM based

Cost of Equity
re

rm

Risk Premium
(rm-rf)

rf

= 1 Risk,
5-11
Once risk free rate, market returns, and are available the cost of equity can
be calculated by Equation 5-10. For risk free returns of 5%, market returns of 15%
and with security of 1.8 the cost of equity for the firm is 23% as shown below:

re = rf + x (rm rf) = 5 + 1.8 x (15 - 5) = 23%

5-8 COMPARISON - DIVIDEND CAPITALISATION AND CAPM APPROACHES
We discussed two different and distinct approaches to find the cost of equity
the Dividend Capitalisation Model and Capital Asset Pricing Model. Both are
based on sound fundamentals that are difficult to defy. However they would
have their relative advantages and disadvantages.

As one would observe the computation of cost of equity capital through CAPM
based approach has the advantage of
i) Incorporating the risk of the project,
ii) Relates the cost of equity to the current market conditions as the
unrealistic returns are not admissible,
iii) Elimination of need to know the policies on dividend and hence the
earnings.

The disadvantages would emanate from the assumption that past is
appropriate guide to the risk of the project as is based on past data. If does
not remain constant the cost of equity may not be true. The model fails when
the assumption of investors holding diversified portfolio of securities doesnt hold
good. Under such situations ignoring project related unique risk would be
fallacious. Sometimes unique risk may assume greater dimension than the
systematic risk.

As against this the dividend capitalisation approach can be defended with its
i) Consideration of the growth potential of the project - the project specific
parameter,
ii) incorporating the risk in the current price of the asset, which includes
both systematic and unsystematic risk, and
iii) paying due emphasis to the earning potential of the project

Dividend capitalisation approach does not consider risk of the dividend. Further
the assumptions of dividend capitalisation approach include constant payout
ratio, which makes its application difficult for firms. It is normally observed that
firm keep dividend stable while the earnings fluctuate. The volatility of earnings
is not transferred to the dividend. CAPM based approach does not require any
such assumption regarding dividend and instead derives cost of equity on the
market based information. However, it requires assumptions of investors holding
diversified portfolio which too is difficult to defend.

Realising the different sources of deriving the cost of equity in the two models
discussed above it is more likely both models will give different values of cost of
equity. Both the models stand on sound financial logic that is difficult to
dislodge. Using the two approaches one is likely to find two different estimates
of cost of equity. Only by coincidence they may give identical figures. Since
both the models have some limitations and stand on sound financial logic it
would be better to calculate the cost of equity by both the methods and
5-12
average them out, as a managerial decision though theorist may continue to
argue for superiority of one method over the other.

5.9 RELATIVE VALUATION - Cost of Equity for Non-Traded Firms
Both the dividend capitalisation approach and CAPM based approach to
determine cost of equity are based on firms market information and apply to
firms that are traded in the market. How do we compute cost of equity for
privately held firms? There are many possible ways of getting this answer One
may use comparative pricing and use the data of a firm that is listed and
traded and is engaged in the same activity. The cost of equity for the firm in the
same line can serve as a useful guide and starting point. Of course adjustment
on account of size of the firm, capital structure etc would need to be made.
This is known as comparative valuation where we look for similar asset that is
traded in the market and value the non-traded asset according to the traded
asset.
5.10 ASSIGNING WEIGHTS
Having studied the cost of capital from different sources, the next question to
be answered is the proportion of capital from each of the source. The firms
cost of capital that must be used as discount rate is the weighted average of
each of the sources used as given by Equation 5-1.

There are three ways the proportion of capital from each source can be
determined. These are
1. Marginal proportions
2. Book value proportions
3. Market value proportions

5.10.1 Marginal Proportions:
Using marginal proportions means using the proportions of each source that
have been used to raise the incremental capital for the project under
consideration. Proportions based on actual amounts raised from each source
to fund the new project are used to determine the WACC.

Some managers believe that it is the cost of specific sources of funding the
project that is relevant for capital budgeting decision. The rationale is that if the
project is able to generate adequate cash flows to meet the obligations
undertaken to execute the same, the project must be accepted. However this
notion is fallacious as we can see from the following.

Suppose a firm has two projects A and B with equal outlay of Rs 50 crore each.
The IRR of the projects is 12% and 15% respectively. The cost of debt is 10% while
the cost of equity is 18%. If firm decides to fund the project A with debt and
project B with equity it would end up accepting the former and rejecting the
latter. However if the order of financing is changed the decision would be
reversed. The outcomes with marginal cost as basis of decision making are
condensed in Table 5-1.
5-13

Table 5-1: Decision Making With Marginal Cost of Capital
Project IRR Nature and cost of
incremental
funding
Outcome Nature and cost of
incremental funding
Outcome
A 12% 100% Debt at 10% Accept 100% Equity at 18% Reject
B 15% 100% Equity at 18% Reject 100% Debt at 10% Accept

Therefore we may say that proportions of specific sources of funding to arrive at
cost of capital are irrelevant and would distort the capital budgeting process.

The situation just described does not take into account either the past record or
the future requirements. It does not consider the fact that the firm decided to
have 100% debt funding for project A only because the capital structure
permitted such debt. Possibly, the firm was already having high proportion of
equity and had the borrowing capacity available then. More and more
projects would find acceptance at such low cost of capital being used as
discount rate, which would be a wrong decision. Similarly the firm had to resort
to equity funding for project B later because it had exhausted the debt
capacity and ended up rejecting a more profitable project. If only the firm had
considered the past and future it was possible to avoid the mistake.

Hence past and current capital structure cannot be ignored while considering
cost of capital. Todays incremental cost of capital in fact gets benefits of
yesterday and affects the tomorrows cost of capital. Using todays marginal
cost as discount rate would be erroneous.

Therefore, while deciding about the cost of capital and hence the discount
rate for the capital budgeting decision we need to consider the target capital
structure of the firm. It is a different matter that at any point of time the actual
capital structure may not conform to the target capital structure. Therefore the
appropriate weights to be used in determination of WACC are the weights of
target capital structure.

However some may argue that the proportions of existing capital structure be
used. Such would be a correct position if every time firm needs additional
capital it raises the same in the same proportions as existing today.

5.10.2 Book Value Vs. Market Value Proportions:
Having accepted that the proportions that must be used in determination of
WACC are the proportions of target capital structure a question as to how
these weights must be valued arises. There are two ways the target capital
structure may be looked at; 1) on the basis of book values and 2) on the basis
of market values

Assume that a firm has total funds of Rs. 100 crore in the form of equity and
debt and they are reflected in the books as follows:
Nature of Funding Amount (Rs. crore) Proportion Post Tax Cost
Equity including reserves 50.00 50% 20%
Debt 50.00 50% 8%
Total 100.00 100%

5-14
Assuming cost of equity at 20% and post tax cost of debt at 8% the Weighted
Average Cost of Capital, WACC based on the book value weights would be

WACC (Book Value) = 0.50 x 20% + 0.50 x 8% = 14.00%

The liabilities of a firm are represented in the financial statements at book value,
i.e. the costs at which they were actually raised in the past and they are used in
determining the proportion in the computation of WACC.

If equity and debt were traded in the market, the market values of each will be
different than what is reflected in the financial statements. Consider the same
firm with size of Rs. 100 crore represented by equity and debt debt of Rs 50
crore each. Assume that both equity and debt are traded. The value of equity
shares and debt in the market are Rs 150 crore and Rs 50 crore respectively at
current market price. Based on market value the proportion of each in the
capital structure would be as shown below:

Nature of Funding Market Value (Rs crore) Proportion Post Tax Cost
Equity 150.00 75% 20%
Debt 50.00 25% 8%
Total 200.00 100%

Using same cost of equity and debt as before, the Weighted Average Cost of
Capital, WACC based on the market value weights would then be

WACC (Market Value) = 0.75 x 20% + 0.25 x 8% = 17.00%

What are the proportions of debt and equity in the capital structure? Is it 1:1
based on book value proportions or is it 1:3 based on market value proportions.

From the viewpoint of mobilisation of fresh capital it is argued that new capital
can be raised only at market values of equity and debt and therefore the
proportions of debt and equity must be based on market values and not book
values.

However there are many merits in using the book value weights. The merits of
using book value proportions are 1) its simplicity, and ready availability leading
to operational ease 2) book values are free from vagaries of market, which
cause market values to change on a day-to-day basis 3) book value
information published in public documents is readily available to all, and 4)
most financial analysis by banks, financial institutions is based on book values.

Due to dynamic conditions of the market it will be hard to find consistency and
unanimity in the proportions if they are based on market values. Use of book
value proportions will not be controversial.

It is widely accepted that use of proportions based on market value is most
appropriate while computing cost of capital of the firm. The market values are
true indicators of expectations of the investors, and firm is supposed to fulfil
these expectations if it plans to raise new funds from them. From this viewpoint
using market value proportions scores over book value proportions and is a
5-15
good reason that overwhelms all advantage so using book value weights.
Despite the convenience in using the book values one must use the market
value weights in the target capital structure, which ultimately determines
WACC and the appropriate discount rate for capital budgeting decisions. .

Using the cost of specific sources used to finance a project is fallacious for
many reasons. Firstly, suppliers of specific capital consider interalia the existing
as well as final capital structure while deciding upon the quantum of capital
and its cost. Due consideration is given to the historical capital structure and
industry norms. Secondly, capital is fungible. Among many projects that a
company may undertake it is difficult to assign specific source of capital to any
project. The firm as a single entity uses all sources of capital for all its activities.
Finally, firms normally strive to raise funds in such a manner so as not to distort its
existing capital structure in the long run, minor short term deviation
notwithstanding. They continue to strive for a target capital structure, although
it is achieved over a very long period of time.
5.11 WACC AS DISCOUNT RATE AND RISK
Earlier we discussed that the discount rate must take into account the riskiness
of the cash flow besides incorporating the aspirations of investors. The riskiness
of the cash flows of the project would depend upon the kind of expansion the
firm is undertaking.

WACC includes the expectations of the investors. The investors take into
account the nature of business the firm is in and accordingly modify their
aspirations of return. These returns are incorporating the risk of the firm on an
aggregate basis considering the business risk and the financial risk. The business
risk represents the sensitivity of the cash flow due to changing business
environment and financial risk pertains to the proportions of debt used. As long
as business risk and financial risk of the firm remain unaltered WACC (based on
target capital structure using market value proportions) would serve as an ideal
discount rate for evaluation of the projects.

Most capital budgeting projects a firm undertakes are a) normally small as
compared to the total size of the firm b) in the same line of business and c) do
not distort the capital structure substantially. Such project would be expansion
of existing line of business, improving features and quality of existing products,
advertising campaigns, cost reductions, replacement of machines etc. All
these projects neither alter the business risk or the financial risk of the firm. The
cash flows of these projects bear the same business risk as the existing
operations do. For evaluation of such projects the use of WACC as discount
rate is appropriate.

However, blind use of WACC as discount rate for all projects is erroneous. While
it can serve as guiding tool, WACC is not the universal discount rate. Not all
projects the firm undertakes bear same business and financial risk as existing
today. For example large acquisitions even in the same line of business may
keep the business risk same but may alter the financial risk due to large debt
that may be resorted to acquire the new business distorting the existing capital
structure. Similarly diversification in unrelated line of business would alter the
5-16
business risk of the firm. A firm in the oil and petroleum sector wanting to
expand in telecom sector would be one such example.

Use of WACC under such circumstances may lead to two kinds of errors.
Suppose WACC for firm is 12%. It is considering a low risk project that demands
a discount rate of 10%. This conventional project has positive NPV at 10% but
turns to negative NPV at 12%. If evaluated with WACC as discount rate the
project would be wrongfully rejected. Similarly if there is some unconventional
project that demands discount rate of 15% and has a negative NPV. However,
if discounted at WACC of 12% the project has positive NPV. It would be
accepted again wrongfully. Managers have to guard against such errors and
blind use of WACC as discount rate for all projects is not recommended. These
errors are presented in Figure 5-2.



5.12 FACTORS AFFECTING COST OF CAPITAL
Foregoing discussion on the cost of capital would reveal that there are host of
factors that impact the cost of capital of the firm. Cost of different components
of the capital is market determined. Following are general factors and
influence the cost of all firms:

Prevailing yields in debt and capital markets: They alter the opportunity cost of
the suppliers of capital and hence influence the WACC.

Tax rate: would alter the expectations of debt suppliers. Because of the tax
deductibility of the interest the cost of debt is also influenced by the tax rate.
Higher the tax rate greater is the tax shield on the debt and lesser is the cost
of debt.

Investment policy, dividend policy and capital structure decisions: Besides
market oriented factors that affect cost of capital in general for all the firms
there are few critical firm specific factors that influence the cost of capital of
the firm. Investment policy, dividend policy and capital structure decisions
Figure 5-2: WACC as Discount Rate
and Possible Errors
Discount Rate


Risk Adjusted cost of capital

A
Error Type I


B WACC
Error Type II





Risk of the project

Error Type I: Accepting
Project A using WACC as
discount rate that
otherwise should have
been rejected as the risk
of the project demanded
use of higher discount rate
than the WACC of the
firm.


Error Type II: Rejecting
Project B using WACC as
discount rate that
otherwise should have
been accepted rejected
as the risk of the project
demanded use of lower
discount rate than the
WACC of the firm.

5-17
are closely linked and each of them affects the cost of capital. We have
worked out the cost of capital under implied assumptions of 1) the firm
follows dividend policy of constant pay-out and 2) a target capital structure
using market valued weights. In case of change in any of these the WACC
would undergo a change.

General economic conditions and company specific policies play a dominant
role in the determining the market returns. Since all these factors keep
changing with time the cost of capital cannot be said to be static in nature. It
has to be constantly reviewed since not only the cost of individual components
would change with time but also the weights of each components being
market determined too would change.

SOLVED PROBLEMS

Example 5-1: Computing Cost of Perpetual Debt
Ispat Limited has issued two bonds in the past as detailed below:
Face value of the Bond Coupon Rate (Annual)
Bond A: Rs. 20 crore 12%
Bond B: Rs. 40 crore 11%

Assume that each bond has face value of Rs 100 and market values of Bond A
and B are Rs 110 and Rs 105 respectively. The firm keeps amount of debt
constant and pays tax at 30%. Find out the pre-tax and post tax cost of debt for
the firm.

Solution:
The cost of debt has to be calculated using Equation 5-4. With coupon rate
and market price given one can solve for rd.

The cost of Bond A = 12/110 = 10.91%
The cost of Bond B = 11/105 = 10.48%
The pre tax cost of debt = 10.91 x (20/60) + 10.48 x (40/60) = 3.64 + 6.99 = 10.63%
The post tax cost of debt = (1 T) rd = 0.70 x 10.63 = 7.44%

Example 5-2: Cost of Redeemable Debt
Ispat Limited wants to raise another debt for a short term with a bond of face
value of Rs 100 to be issued at Rs 98 with coupon rate of 9% payable annually
redeemable at a premium of 2% at the end of 3 years.

Solution:
Using Equation 5-2 we can find out the cost of bonds as follows:
3
d
3
d
2
d
d
) r 1 (
102
) r 1 (
7 . 0 x 9
) r 1 (
7 . 0 x 9
r 1
7 . 0 x 9
98

N
1 t
N
d
t
d
t
o
) r (1
R
) r (1
C
P

Solving the above equation using IRR function in Excel we get post-tax cost of
debt rd = 7.69%

5-18
Example 5-3: Cost of Equity Capital using Dividend Discount Model
Ispat Limited stocks are currently trading at Rs. 120. The most recent dividend by
the firm was Rs. 10 per share. Historically, the dividend has been growing at 10%
but some anticipated growth is 12%. Find out the cost of equity from the
perspective of a) historical management b) future.

Solution:
a) The cost of equity re is given by historical growth rate
% 17 . 19 = 1917 . 0 = 10 . 0 +
120
10 . 1 x 10
= g +
P
) g + 1 ( D
= g +
P
D
= r
0
0
0
1
e

b) The cost of equity re based on anticipated growth
% 33 . 21 = 2133 . 0 = 12 . 0 +
120
12 . 1 x 10
= g +
P
) g + 1 ( D
= g +
P
D
= r
0
0
0
1
e


Example 5-4: Cost of Equity using CAPM
Ispat Limited is a listed at stock exchange and the current price of its share is Rs
120. The estimated beta of the firm is 1.20. Currently the market returns are 14%
and the returns in the government securities are prevailing at 6%. Find out the
cost of equity using Capital Asset Pricing Model.

Solution:
As per Capital Asset Pricing Model (CAPM) the cost of equity is
re = rf + x (rm rf) = 6 + 1.2 x (14 - 6) = 15.60%

Example 5-5: Weighted Average Cost of Capital
Flag Precision Limited (FPL) has been maintaining a capital structure of 40:60 for
debt and equity capital which it believes is optimal. The 10% debt of FPL is
selling at discount of 20% to the face value. FPL has paid the dividend of Rs. 4
per share in the immediate past is growing at 15%. The market value is Rs 60 for
a share with face value of Rs 10. Flag Products Limited has reserves of Rs 25 per
share. The corporate tax payable by the firm is 40%. What is the WACC for FPL
based on book value and market value weights?

Solution:
.67% 22 0.2267 = 0.15 +
60
4x1.15
= g +
P
g) + (1 D
= g +
P
D
= r Equity; of Cost
% 50 . 7
80 . 0
) 4 . 0 1 ( 10
= r Debt; of Cost Tax Post
0
0
0
1
e
d

Computation of WACC
Source Cost
(%)
Market Value Weights Book Value Weights
Market
Value
Weight Weighted
Cost
Book
Value
Weight Weighted
Cost
Debt 7.50 40 0.400 3.00 50
#
0.588 4.41
Equity
Capital
22.67 60 0.600 13.60 35
*
0.412 9.34
WACC (%) 16.60 13.75
# Debt sells at 20% discount. Therefore the face value of debt is 40/0.8 = 50,
which is the book value too
* With the face value of Rs 10 the firm has reserves of Rs 25 giving a book value
of Rs 35 against market price of Rs 60.
5-19
KEY TERMS

Opportunity
Cost
The returns foregone in the next best investment option is
called opportunity cost.

Weighted
Average Cost
of Capital
WACC is the composite cost of capital with cost of each
component of capital multiplied by its proportion in the
capital structure.

Dividend
Capitalisation
Model

Dividend capitalisation model states that the price of the
share is equal to the present value of dividends of the firm.
Capital Asset
Pricing Model
Capital asset pricing model relates the returns on the
security with the systematic risk of the asset.

Beta Beta denotes the sensitivity of the stock returns with the 1%
change in the market returns.

Marginal
Proportions
The proportions of different sources of capital in raising the
incremental finances are marginal proportions.

Book Value
Weights
The proportions of different sources of cost of capital based
on the value as recorded in the books of the firm are book
value weights.

Market Value
Weights
The proportions of different sources of cost of capital based
on their market value are market value weights.

SUMMARY

Cost of capital is an extremely important input for capital budgeting decision
providing the hurdle rate that the projects cash flow must surpass. Cost of
capital serves as a benchmark for evaluation.

The basic determinant of cost of capital is the expectations of the suppliers of
capital. The expectations of the suppliers of capital are dependent upon the
returns that could be available to them by investing in the alternatives. The
returns provided by the next best alternative investment is called opportunity
cost of capital.

Weighted average cost of capital, WACC is a composite figure reflecting cost
of each component of cost of capital multiplied by it proportion in the capital
structure.

Cost of debt and cost of preferred debt are explicitly stated in the instruments
and hence are easy to determine. They have to be viewed from the
perspective of shareholders. Tax deductibility of interest provides the tax shield.
This accrues to the shareholders and hence the cost of debt falls by the
amount of tax saved. Preferred capital is like debt but has no tax shield. Hence
its cost remains at what is stated on the instrument.
5-20

Cost of equity capital is most difficult to determine because there is no legal
binding to pay any compensation and no explicit mention of charges to be
paid on such capital. Cost of equity capital is determined either by dividend
capitalisation approach or CAPM based approach. The price to be used in any
of the model is the market determined. is the primary determinant of risk that
governs the cost of equity.

After cost of each component is determined they need to be multiplied by the
respective proportions to arrive at WACC. The weights based on the target
capital structure are most appropriate though the current capital structure may
not conform. These weights can either be based on book values or the market
values. Though book value weights are easy and more practical the use of
market value based weights is technically superior.

SELF ASSESSSMENT QUESTIONS

1. What do you understand by opportunity cost and how is it relevant
for determination of cost of capital?

2. What is the significance of weighted average cost of capital?

3. Why the cost of debt is adjusted for taxes while cost of preference is
not?

4. Despite no legal binding to pay dividend the cost of equity is not zero
but is highest. Explain.

5. Compare dividend capitalisation and capital asset pricing model
approach to the determination of cost of equity. Do you think the
CAPM based approach is superior to dividend capitalisation
approach?

6. What is marginal cost of capital? How is it different from WACC? Can
WACC ever exceed marginal cost of capital?

7. Why should one use market value based in computation of WACC?

8. A firm has issued debt at 10% with face value of Rs 100 aggregating
Rs 50 crores. The debt is selling at 10% premium to the face value. The
book value of equity is Rs 50 crore but the market capitalisation is Rs
110 crore. The firm pays tax at the rate of 35%. Find a) pre tax and
post tax cost of debt b) WACC based on book value and market
values.

FURTHER READINGS

1. Srivastava & Misra (2008), Financial Management, Oxford University Press,
Chapter 13.
2. M Y Khan and P K Jain (2006), Financial Management: Text, Problems
and Cases, Tata McGraw Hill, Chapter 12
6-1
UNIT 6

VALUATION OF BONDS

6.0 OBJECTIVE
The objective of this unit is to
a) Understand role and features of bonds
b) Distinguish between various types of bonds
c) Identify the cash flow patterns of bonds and their relevance in
determining the value of bonds
d) Value a bond at different points of time
e) Understand the relevance of yield and its relationship with price
f) How to value a deep discount bond
g) How to fix the call price of callable bonds

6.1 INTRODUCTION
Bonds are one of the prominent financial instruments of capital markets world
over. These bonds are issued by government, public sector, municipal
corporations and various firms in the private sector.

The importance of bonds especially those by government is that the returns
offered by bonds act as a benchmark in arriving at the expected returns on
other instruments of ownership/borrowing. The yields offered by securities issued
by government are the best surrogates for risk free interest rates in an economy.
The bonds issued by private sector firm offer a greater return because there
exist a small risk of default which is absent in government securities.

Bonds are instruments of borrowing by the governments and firms. Issue of
bonds is actually a loan where the issuer borrows and subscribers lend money
for a specified period of time for a return. These bonds promise a fixed rate of
return till the date of maturity and the pay back of the principal sum in a
phased manner or at maturity, as per the terms of the bond.
6.2 FEATURES OF THE BOND
Features of the bond relate to the terms and conditions on which bonds are
issued. These conditions are decided at the time of issue of the bonds and
more often than not are not changed subsequently. These terms are contained
in a document commonly called as indenture. The decision of the subscribers
to invest or not to invest in a given issue depends on these features.

Over the period of time with changing needs of the issuers as well as the
subscribers of the bonds many modifications in the features of the bonds have
taken place and as the result different variants of bonds have evolved. These
species of genre bond vary from one another in terms of their risk, cash flow
patterns, tradability, etc. Standard features and terminology used in the bonds
are described below. The five features that are crucial to the valuation of
bonds are:
1. Face Value 2. Coupon Rate 3. Periodicity of Coupon
4. Maturity, and 5. Redemption Value
6-2
6.2.1 Face Value
Face value, also referred as par value, is the amount of money that is stated on
the face of the bond. The principal sum borrowed is normally repaid at
maturity. Face value is the amount of money on which the issuer pays interest
to the subscriber. Most bonds are issued with the face value of Rs 100 or Rs
1,000.

Issues at Premium or Discount: The issue price of the bond, the money that the
subscriber pays to the issuer while subscribing, can be different from the face
value. More often than not bonds are issued at par. When bonds are issued
at price higher than the face value it is said to be issued at premium and
when issued at a price lower than the face value then it is said to be issued
at discount.
6.2.2 Coupon Rate
The borrowing made by the issuer is on the promise that subscribers would be
paid interest. The rate of interest payable by the issuer to the subscriber of the
bond is called the coupon rate. The rate of interest offered is governed by
several factors, which predominantly include
a) Current economic conditions,
b) Yields prevailing in the market,
c) Issue price of the bond i.e. issue at par, premium or discount,
d) Redemption value of the bond i.e. redeemed at par, premium or discount,
e) Risk associated with the bond,
f) Quality as judged by the rating of the issuer,
g) Tenure of Bonds etc.

At the time of the issue of the bonds the coupon rate is often set equal to the
yield prevailing in the market especially when issued at par.
6.2.3 Periodicity of Coupon Payments
The coupon rate of the bond is specified as annual interest payment. However
the issuer may decide to pay the interest at regular intervals other than annual.
Since timing of the cash flow is important, as elaborated in the concept of time
value of money, the periodicity of payment becomes an important
determinant of the value. The returns offered by bond with coupon payments
on quarterly basis would be higher than the bond with the same coupon but
making interest payment on semi-annual basis. Coupon payments are normally
evenly spaced over time and are more often than not semi-annual.
6.2.4 Maturity
The principal sum borrowed through the issue of bonds is to be returned to the
subscriber. When all principal is paid, the liability of the issuer ends. The maturity
of the bond refers to when the entire principal would be paid back. The
duration from the date of issue until the bond is redeemed is called maturity
period of the bond. It can be as long as 30, 50 or 100 years or as short as 1-5
years.
6.2.5 Redemption Value
At the end of maturity the sum borrowed must be refunded. The amount of
money paid at the time of maturity is called redemption value. Normally bonds
6-3
are redeemed at par value represented by words redeemable at par.
Sometimes bonds are redeemed at premium or discount to the par value too.
6.2.6 Tax Benefits
Another important characteristic determining the returns and valuation of bond
are the benefits attached with the bond. Bonds are often used in financing of
long term projects and subscribers buy these bonds to lock-in the returns for
long time. These returns become more attractive when some tax advantages
are given to the subscribers. This increases the attractiveness of bonds widening
the market and increasing liquidity. Tax benefits also benefit the issuers because
larger investor base is available to them and hence helps better pricing. While
the cost of raising finance is reduced the returns to subscribers are not
sacrificed.
6.3 TYPES OF BONDS
Bonds can be classified in many ways. Some of the classifications are explained
below:

Based on Issuer: Sovereign or Corporate
One classification may be based on the nature of the issuer. The bonds
issued by governments are called sovereign debts. The bonds issued by firms
are called corporate bonds. There are not many variants in case of
government bonds but corporate bonds keep adding or modifying features
of the bonds with changing times.

Based on Nature of Coupon Rate: Fixed or Floating Rate
Another way the bonds may be classified is on how the coupon rate is
specified. The coupon rate is normally fixed. The advantage of fixed coupon
is that the liability of the issuer as well as the receivable amount for the
subscriber is known for the entire tenure of the loan.

However, bond can also be issued on floating rate basis where the coupon
rate is not fixed but instead is linked to some benchmark. Here the amount of
coupon varies from period to period. LIBOR (an acronym for London Inter Bank
Offer Rate) or MIBOR (an acronym for Mumbai Inter Bank Offer Rate) are the
most common benchmarks used for international and domestic bonds
respectively. The coupon payment is based on the most recent benchmark
rate. Here the coupon rate if specified as MIBOR + 100 basis points and MIBOR
happens to be 7% then coupon of 8% would be payable for the period. As
MIBOR changes coupon rate too changes.

The advantage of such floating rate bonds is that they provide hedge against
the changing interest rates and always pay return equal to the prevailing yields
in the market. Issuer and subscriber link their return according to the prevailing
market yields.

6.3.1 Indexed bonds
Indexed bonds are like floating rate bond where the coupon payments are
based on inflation rate rather than benchmark yields. Such bonds are called
indexed bonds as they pay coupon based on some price index used for
measuring inflation.
6-4

As bonds are investment for a longer period with relatively smaller coupon rate
as compared to the returns in alternative investment, the subscribers are
uncertain as to how rich can they get with fixed and small coupon rates if
inflation exhibits wide movements. Issuance of index-linked bonds would assure
subscribers of some real return over inflation.

The advantage of these bonds is that they provide returns to subscribers on real
basis rather than on nominal basis to induce subscription.

6.3.2 Based on Time of Redemption: Callable / puttable bonds
Sometimes bond provide for early redemption though they specify normal
maturity. Though the bonds are issued with fixed maturity but an option for early
redemption can be built into the features of the bond by the issuer.

The issuer may reserve a right but is under no obligation, to call the bond prior
to its prescribed maturity. For example a bond issued for 10 years may be
redeemed at any time after 5 years. Such bonds granting an option to issuer to
redeem earlier than prescribed maturity are called callable bonds. While
calling the bond the issuer redeems at a price called call price.

Callable bonds are issued to safeguard against a situation of a substantial fall in
interest rates subsequent to the issue at a higher coupon. As the issuer is under
continued obligation to pay the promised coupon it may be advisable to call
the bond and re-issue at lower coupon.

Similarly when the option to redeem the bond prior to its maturity rests with the
subscriber they are called puttable bonds. When the interest rates are
comparatively higher than the coupon rate of the bond the subscribers may
want to reclaim the principal from the issuer to invest in more profitable
avenues. Puttable bonds provide the subscribers option for early exit to exploit
increased yields.

Time and Amount of Redemption
Another variation emanates from the manner of redemption of bonds. The
issuer may like to redeem the principal in instalments or in a lump sum at the
maturity, known as bullet payment. For example a 10-year bond may pay 11%
at the end of 10
th
year or may decide to redeem 25% each in 7
th
, 8
th
, 9
th
and
10
th
year.

The manner of redemption (lump sum or phased) is dependent upon the cash
flows that the firm expects to generate from the investments made out of the
borrowed money. Such repayments provide flexibility to the issuer to extinguish
liability according to cash generation capability.

6.3.3 Zero Coupon/ Deep Discount Bonds
Sometimes bonds are issued without coupon implying that no regular returns
would be paid to the subscribers. Bonds that pay no coupon are called zero
coupon bonds. These bonds have a face value that is redeemed at the end of
maturity.
6-5
In order to provide return to the subscribers these bonds are issued at
substantial discount to the face value, hence also referred as deep discount
bonds. For example a 25-year bond with face value of Rs 1,00,000 may be
issued at say Rs 10,000. The subscriber pays Rs. 10,000 now and receives Rs.
1,00,000 at maturity 25 years later. The entire returns are provided entirely at the
time of redemption rather than in the form of regular coupons.
6.3.4 Convertible Bonds
Convertible bonds almost offer a separate class of their own as against the
regular bonds. Convertible bonds are the instruments that remain as bond for
some time and become equity, partially or fully, after that.

Attractiveness of bonds is limited as they offer paltry returns, are relatively less
liquid, and lock-in investment for long periods of time. Therefore they are
difficult instruments to market.

To broaden the base of investors firms merge the features of equity with those
of bonds in a manner that a part value of the bond becomes convertible into a
predetermined number of equity shares at certain time interval from the date
of issue. Such bonds are known as convertible bonds.

Convertible bonds offer several advantages to issuer and subscribers alike.
Some of these advantages are:

a) New projects do not generate cash flows; therefore equity will be difficult
to sell and issue price will be lower.
b) Investors would be more inclined to subscribe to the fixed income
security.
c) Convertibles combine advantages of equity and debenture, offering
fixed income in the initial stages and sharing of profit (dividend) at a later
date. It provides regular fixed return during uncertain period initially and
while offers larger potential gains when cash flows are established.
d) Equity acts as sweetener and helps reduce coupon bringing down the
cost of financing.

Partially convertible bonds convert only part of bonds into equity. Firm stops
coupon payments on the portion converted into equity as on conversion,
investors start enjoying the privileges as the shareholders (owners). The
remaining portion, call non-convertible part continues to remain as bond
fetching the interest till the date of maturity.

Another useful feature of these bonds is that they can be used to convey
positive financial signals to the market about the firms expected performance.
For example, if an existing public company chooses to issue stock, the market
usually interprets this as a sign that the company's share price is somewhat
overvalued. To avoid this negative signal, the company may choose to issue
convertible bonds, which bondholders will likely convert to equity anyway
should the company continue to do well.
6-6
6.4 CASH FLOWS OF THE BOND
Features of the bond as described above decide the cash flow of the bond.
These cash flows are required to find the value of the bond. Cash flows of a
conventional bond consist of two parts;
a) Periodic coupon payments, and
b) Final redemption payment.

Consider as an example a 12% semi-annual bond with face value of Rs 100
redeemable at 5% premium at the end of 3 years. A 12% coupon would result
into a cash flow of Rs 6 (6% of Rs 100) every six months. The cash flows of the
bond from the perspective of the subscriber are as shown below.

Time (months from now) 0 6 12 18 24 30 36
Coupon received 0 6 6 6 6 6 6
Principal paid (-) and
redeemed (+)
-100 105
Total cash flow -100 6 6 6 6 6 111

Note that the inflow to the subscriber is an outflow to the issuer. Therefore the
cash flows of the issuer would be same but with opposite signs.
6.5 PRICING OF BOND
Pricing of the bond is based on the concept of time value of money. To value
the bond we require minimum of two sets of inputs:
a) The cash flows of the bond, and
b) The discount rate, at which to find the present values of the cash flows.

Value of the bond is the price one would pay now in exchange of the future
cash flows that accrues over the remaining life of the bond to its owner.
Therefore the value of what is being paid today must be equal to the present
value of the future cash flows at a specific rate of return called the discount
rate.

6.6 APPROPRIATE DISCOUNTRATE
The rate at which to discount the cash flows of the bond cannot be decided
arbitrarily. It must have following characteristics:

Risk associated with the cash flows: First and foremost, the risk characteristics of
the cash flow must be considered. We earlier stated that time value of
money should exclude the risk associated. But buyer of the bond is making
an investment, and therefore faces a risk whether or not the promised future
cash flows would fructify. Since the discount rate reflects the return the buyer
gets by investing, higher the risk of cash flows higher must be the discount
rate.

Since bonds offer rather certain cash flows the discount rate used in finding
the value of the bond is normally close to risk-free rate. We may add the risk
premium in the discount rate depending upon the risk profile of the issuer
who promises the cash flows.

6-7
Normally bonds are rated. Higher is the rating if expected cash flows are
more stable. Therefore bonds with higher rating would have lower discount
rate.

Expectations of the return of the investors: The expectation of return by buying
the bond is second important factor that needs to be considered. Higher the
expectation of return higher must be the discount rate.

Markets and economy: Market conditions and state of the economy greatly
affect the choice of discount rate. In developed economy the bonds usually
have lower yields because a) inflation rates are lower and stable and b)
markets are competitive. In developing countries the yields are generally
higher due to higher and unstable inflation rate and shallow markets. If high
interest rates and high inflation rates prevail in the market a higher discount
rate would be used. The host of economic factors determine what interest
rate and inflation rate are appropriate.

Timing of the cash flows: The last factor affecting the discount rate is the timing
of cash flows. Cash flows more distant in future must be discounted at a
higher rate simply because time adds to the uncertainty. The nearer the cash
flows in future the lesser the uncertainty and hence the risk associated with
cash flows. Such cash flows must be discounted at a lower rate.

The discount rate that takes into account the expectations, risk, economic
conditions, and the timing of the cash flow is used for discounting the cash
flows so as to find out their present values.

6.7 VALUING BOND ATTHE TIME OF ISSUE
The pricing of the bond at the time of the issue is complex. It is the value that
issuer gets and subscribers pay. The issuer must decide very carefully all the
features of the bond at the time of issue because they cannot be altered
subsequently. Among many things following are most important:
a) Face value,
b) Coupon rate,
c) Periodicity of coupon payment,
d) Tenure/Maturity of the bond, and
e) Redemption price

Generally the face value and redemption values are equal at Rs 100.
Periodicity of coupon payment is mostly semi-annual. However, coupon rate
must take into consideration the factors of expectations of subscribers, market
conditions, and risk characteristics. In most cases the coupon rate is set equal
(or probably slightly higher) to the prevailing yields in the market. Current yields
take into account the investors expectations. At the time of the issue the
coupon rate must be aligned to the current yields.

Since the coupon rate and the current yields are aligned the bonds can be
issued at par i.e. at face value. For reasons other than finance the issuer may
like to raise the coupon rate beyond current yields to attract and induce
investors to subscribe. If that be the case the market price of the bond would
be greater than the face value providing extra gains.
6-8

Let us value a bond paying 10% coupon on semi-annual basis. The bond is
issued at face value of Rs 100 and a life of three years (normally bond are
issued for longer maturity) at the end of which it would be redeemed at par.
The coupon rate of 10% is perhaps 1% above the current yields. At what price
the bond would trade in the market immediately after the issue.

To find the value of the bond we discount the cash flows of the bond at 9%; the
prevailing yield in the market.

The value of the bond would then be given by Equation 6-1.
1 - 6 Equation .......... .......... ..........
r) + (1
R
+
r) + (1
C
= P Price, = bond the of Value
n
t
n
1
t
t
0

where Ct =Cash flow (Coupon payment) at time t
Rt = Redemption value at maturity after n periods,
r =Discount rate and
n =Remaining life in number of periods.

The cash flows of the bond are depicted in Figure 6-1. To find the value we
need to discount each of the cash flow at 4.5% to get the present value. Using
Equation 6-1the value of the bond
1
is Rs 102.58 as worked out below.

102.58 Rs = 80.63 + 4.01 + 4.19 + 4.38 + 4.58 + 78 . 4
1.045
105
1.045
5
1.045
5
1.045
5
1.045
5
1.045
5
= P bond, the of Value
6 5 4 3 2
0

1
The value of the bond can also be found using PV tables. Since coupon payments
are equal and occur at regular intervals the value of the bond would be sum of
annuity of coupon payments at 4.5% for 6 periods and present value of redemption
amount at 4.5% after 6 periods. Using tables in Appendix A-3 and A-4 the value of
the bond is as below
Value of the bond =5 x PVA(4.5%,5) +105 x PV(4.5%,6)
=21.95 +80.63 =Rs 102.58
Figure 6-1: Value of a Bond
Figures in Rs
Time (months) 0 6 12 18 24 30 36
Cash flow 5.00 5.00 5.00 5.00 5.00 105.00
4.78
4.58
4.38
4.19
4.01
80.63
102.58 Present value of cash flows of bond
6-9
Note that the discount rate chosen is 4.5% (half of 9%) because payments are
made on semi-annual basis, and number of periods is 6 equal to six half-year
periods in 3 years. In this exercise we have assumed that each semi-annual
period is equal (in reality it would not be so).

What does the market price of Rs 102.58 means? It simply means that if an
investor buys the bond at this price he would be entitled to receive the cash
flows attached and the yield for the investor would be 4.5% semi-annual or 9%
p.a.

6.8 VALUE OF BOND AFTER COUPON PAYMENT
As the time progresses the issuer of the bond pays the coupon on scheduled
dates and the market value must decline by the proportional amount of the
coupons that have already been paid. The investor in the bond would only pay
for the remaining cash flows of the bond.

Let us value the same bond just after second coupon has been paid. Next
coupon payment is exactly 6 months away. Now the remaining life of the bond
is 24 months with 4 coupons and the principal. The remaining cash flows of the
bond would consist of

1. four coupons of Rs 5 each at the end of 6, 12, 18 and 24 months, and
2. principal payment of Rs 100 at the end of 24 months.

The value of the bond would be discounted value of the cash flows at Rs 101.79
as shown in Figure 6-2.

It was assumed that even after I year and payment of two coupons, the
discount rate remains same at 4.5% for six months equivalent to 9% per annum.
In case the discount rate has changed the value would change too.

6.9 VALUE OF BOND IN BETWEEN TWO COUPON PAYMENTS
Finding value at the time of the issue and immediately after coupon payment
was rather easy because whole number of period was present between the
now and the next coupon date. How do we value bond in the interim i.e. any
time between the two coupon dates or two successive cash flows?

Figure 6-2: Value of a Bond Immediately After Coupon Payment
Figures in Rs
Time (months) 0 6 12 18 24
Cash flow 5.00 5.00 5.00 105.00
4.78
4.58
4.38
88.05
101.79 Present value of cash flow of bond
6-10
To illustrate let us consider valuing the same bond 4 months after the second
coupon has been paid. Remaining life of the bond is now 20 months. Next four
coupon payments are 2, 8, 14, and 20 months away from now and the
principal would be paid after 20 months. We need to adjust the discount rate of
9% per annum for these periods for each of the cash flows to value the bond.
Adjusting the discount rate for rather inconvenient period would make the
calculation complex. We have following 2 options that are easier to execute:

1. Value the bond at a date when last coupon was paid, and
2. Then compound this value for the period elapsed since the last coupon
date

Alternatively, we can
1. Value the bond at next coupon date, and
2. Then further discount the value for the period remaining for next coupon
date.

I few have to value the bond after 4 months of the coupon date then a) we
can value the bond at t =-4 i.e. the last when the coupon was paid and then
compound for4 months (as depicted in Figure 6-3) or b) value the bond at the
next coupon date, add coupon amount and then discount further for 2
months.

We already have value the bond immediately after second coupon payment
at Rs 101.79. In order to value the bond 4 months after this date of payment of
coupon we need to compound the value for 4 month. At the annual rate of 9%
the rate of growth 4 months would be 3%. Therefore value of the bond after 4
months of coupon would be 1.03 x 101.79 =Rs 104.84.

6.10 VALUE OF THE BOND ATMATURITY
The value of the bond at maturity is independent of the discount rate. Since
there is no time left for maturity there would be no time value attached to the
cash flow. Cash flow at maturity of the bond is its redemption value. The bond
being discussed pays Rs 100 at redemption date and therefore, the value of
the bond would be Rs 100 on the maturity. The holder would not like to sell it for
less than Rs 100 and new buyer would not like to pay anything more than Rs
100.
Figure 6-3: Value of the Bond at Any Time

Last Coupon Now Next Coupon and
Payment Subsequent Cash Flows

Time (Months) 0 =- 4 4 6 . .. 12 18 . .. ..



Value of bond A
At last coupon date Discounted value of cash flows of bond, A

Value of bond now B =Compounded value A

6-11

6.11 VALUE OF THE BOND AND DISCOUNTRATE
When the value of the bond was fixed at the time of the issue the coupon rate
was aligned to the market yields prevailing then. Markets are dynamic and
hence the yields do not remain constant. They change almost continuously. Of
the two determinants of the value of the bond i.e. the cash flows and the
discount rate only the former remains fixed. The discount rate build in the
investors expectations and market conditions is subject to change.

As the discount rate changes the value of the bond also changes. However,
the principle of valuation remains same i.e. the value of the bond is the value of
its cash flows discounted at prevailing rate. There exists an inverse relationship
between the value of the bond and discount rate. As discount rate increases
the value falls.

The value of the 3-year semi-annual 10% bond redeemable at par is computed
for the discount rates of 4% to 16% in Table 6-1. This is graphically depicted in
Figure 6-4.

Table 6-1: Value of the Bond and Discount Rate
Figures in Rs
Period
Cash
flow
Discount Rate (% per annum)
4% 6% 8% 10% 12% 14% 16%
1 5 4.90 4.85 4.81 4.76 4.72 4.67 4.63
2 5 4.81 4.71 4.62 4.54 4.45 4.37 4.29
3 5 4.71 4.58 4.44 4.32 4.20 4.08 3.97
4 5 4.62 4.44 4.27 4.11 3.96 3.81 3.68
5 5 4.53 4.31 4.11 3.92 3.74 3.56 3.40
6 105 93.24 87.94 82.98 78.35 74.02 69.97 66.17
Value of the Bond 116.80 110.83 105.24 100.00 95.08 90.47 86.13


6-12
From the data in Table 6-1 and Figure 6-4 we note the following:
1. As discount rate increases the value falls and vice versa. Value falls from
Rs 116.80 at 4% to Rs 86.13 at 16%.
2. When the discount rate is above coupon rate (10%) the value of the
bond is less than its face value i.e. Rs 100.
3. When the discount rate is below coupon rate (10%) the value of the
bond is more than its face value i.e. Rs 100.
4. When the discount rate is equal to the coupon rate the value of the
bond is equal to its face value.

We may generalise the above observations as follows:
When discount rate, r >coupon rate, c: Price <Face Value
When discount rate, r <coupon rate, c: Price >Face Value
When discount rate, r =coupon rate, c: Price =Face Value

6.12 VALUE OF THE BOND AND RISK FREE RATE
Inverse relationship of the discount rate and the value of the bond raise an
ancillary question. To what extent the discount rate can fall or to what extent
the value of the
bond can rise?
Obviously the
decline in discount
rate cannot take it
below the risk free
rate. The discount
rate cannot fall
below the risk free
rate. This is shown as
Figure 3-5. In such a
case the discount
rate would include
only the time value
of money and would
not include the risk premium in it. Therefore the value of the bond cannot be
more than what is obtained by using risk free return as discount rate.

Discount rate can be seen as sum of the risk free rate and the premium for the
risk, for whatever risk the cash flows of the bond carry. It is indeed difficult to find
the risk free rate in an economy. But value of the bonds that are deemed to be
risk free can serve as a guide to find the risk free rate. Who can issue bonds that
carry no risk of cash flow fructifying? Worldwide it is believed that debts issued
by governments are risk free because of the unique ability of the central banks
to supply the money, if situation so warrants.

6.13 VALUE OF BOND AND MATURITY
How does the value of bond changes as it approaches maturity? As maturity
approaches the price approaches its redemption value because any price
other than redemption value would present an opportunity of arbitrage. At
maturity date no buyer would pay an amount in excess of the redemption
value, which he receives upon owning the bond, and nor would the counter-
party accept any amount lesser than the redemption value, which he receives
Figure 6-5: Bond Value and Risk Free Rate




Price




Risk Free Rate

Discount Rate
6-13
by continuing to hold. Another reason can be that the since time to maturity
has already come the
discounting would have
no effect on the value of
the bond. Extending the
logic we may state that
the spread between the
market price and the
redemption value
decreases, irrespective of
whether bond is trading at
premium or discount to
the face value. On
maturity date the spread
would reduce to zero and
value equal to redemption value. It may be seen from Table 6-2 where the
value of the same bond is computed with 3 years, 2 years, and 1 year
remaining for maturity, assuming that the market interest rates remain constant
over time. This is depicted graphically in Figure 6-6.

Table 6-2: Value of the Bond and Time
Figures in Rs
Period Cash flow
Discount Rate 8%
Now After 1 year After 2 years
1 5 4.81 - -
2 5 4.62 - -
3 5 4.44 4.81 -
4 5 4.27 4.62 -
5 5 4.11 4.44 4.81
6 105 82.98 89.75 97.08
Value of the Bond (Rs) 105.24 103.63 101.89

6.14 VALUE OF BOND REPAYABLE IN INSTALMENTS
In the earlier example we valued the bond with bullet repayment. For the
valuation of bonds that repay the principal in phased manner we continue to
use the same principle of discounting the cash flows. The value of a 3-year
bond with 10% coupon payable semi-annually with 3 year to maturity and
repayment of principal 30%, 30% and 40% at the end of 1, 2 and 3 years is
shown in Table 3-3 for different discount rates.

Note that for the first year the bond would pay Rs 5 as coupon (10% annual) on
the principal amount of Rs 100. When Rs 30% is paid back the coupon payment
would reduce to Rs 3.50 (10% annual on Rs 70). After another year the coupon
would further reduce to Rs 2.00 (10% annual on Rs 40). The cash flows of the
bond would be as per column 2 of Table 6-3.
Figure 6-6: Bond Price and Time

Price
Premium Bond

Par Value=Redemption Value



Discount Bond

Maturity
Time
6-14

Table 6-3: Value of Bond Redeemable in Instalments
Figures in Rs
Period
Cash
flow
Discount Rate (% per annum)
4% 6% 8% 10% 12% 14% 16%
1 5.00 4.90 4.85 4.81 4.76 4.72 4.67 4.63
2 35.00 33.64 32.99 32.36 31.75 31.15 30.57 30.01
3 3.50 3.30 3.20 3.11 3.02 2.94 2.86 2.78
4 33.50 30.95 29.76 28.64 27.56 26.54 25.56 24.62
5 2.00 1.81 1.73 1.64 1.57 1.49 1.43 1.36
6 42.00 37.29 35.17 33.19 31.34 29.61 27.99 26.47
Value of the Bond 111.90 107.71 103.75 100.00 96.44 93.07 89.87
6.15 YIELD ON THE BOND
Value of the bond is as given by Equation 6-1 with the known discount rate. In
the real world however, the situation is the other way round. Bonds are
compared with the yield that they offer rather than the price. Once the bond is
listed for trading the bond value keeps changing with time as market
expectations or return changes.

How do we relate the changes in bond value with return? There are number of
ways the return on bond is specified. We shall discuss three of them. They are

1. Current Yield,
2. Yield to Maturity (YTM), and
3. Realised Yield

6.15.1 Current Yield
Current yield of the bond is simplest estimate of the return the bond offers. It is
defined as annual coupon payment divided by the current market price of the
bond. If a bond pays 10% coupon on face value of Rs. 100 and is trading at Rs.
90 the current yield, or return is Rs. 10/90 =11.11%. Current Yield is as given by
Equation 6-2.

2 - 6 ion .....Equat x100......
P Price, Current
Value Face x Coupon%
= (%) Yield Current
0


Current yield considers only the regular part of the income that accrues to the
bondholder and ignores the return that would be generated as capital
gains/losses on maturity or upon selling prior to maturity. Current yield only
serves as an approximate measure of return that does not require much
information or computation.

6.15.2 Yield to Maturity (YTM)
Commonly referred as YTM, the Yield to Maturity is the return that an investor
would earn by buying the bond at prevailing price and then holding the bond
till its maturity.

6-15
The YTM of the bond is given by Equation 6-1 with discount rate r representing
YTM. With r replaced as YTM Equation 6-1 is reproduced below:
3 - 6 Equation ..........
YTM) + (1
R
+
YTM) + (1
C
= P Price, = bond the of Value
n
t
n
1
t
t
0


One price is equivalent to one yield and vice versa. With different discount rate
(YTM) used the prices would be different, and in no case we can get the same
price for two different discount rates. With a given price we can find the YTM
and with given YTM we can find the price.

With the given price how do we find the appropriate discount rate i.e. YTM? To
illustrate the computation of YTM consider an example of a Bond X with face
value of Rs 100 redeemable at par after 6 years from now. It carries a coupon
of 12% payable annually (assumed for simplicity of computation only) and is
currently traded at Rs. 90. We assume that the investor buys the bond and
holds it till maturity. The cash flows of the bond may be inserted in Equation 6-1
and solved for r as follows:
6 6 5 4 3 2
0
r) (1
100
r) (1
12
r) (1
12
r) (1
12
r) (1
12
r) (1
12
r) (1
12
= 00 . 90 P Price,

The solution to determine the YTM of the bond can be attempted through trial
and error method by taking an approximate value of r and checking if the right
hand side of the equation matches with the price. For approximate initial value
of the YTM we may estimate that the return must consist of a) the current yield
equal to Rs. 12/ 90 =13.33%, and b) the capital appreciation at maturity when
Rs. 100 is received against investment of Rs 90 spread over period of holding
approximately being equal to (100-90)/ 6=1.67%. The total yield therefore must
be approximately 13.33+1.67 =15.10%.
Approximate YTM
=Current Yield Annualised Capital Gain/Loss ..Equation 6-4

The actual exact yield would be lesser than what is given by Equation 6-4. It is
because in the approximation, we assumed all gains accruing now rather than
later, and ignored the time value of money that reduces the value on
discounting.

For accurate measure of the YTM we need to find the Internal Rate of Return
(IRR) of the stream of cash flows of the bond assuming negative cash flow of
buying the bond now at current price and treating coupons and redemption
value as cash inflows. This can easily be done in EXCEL. We feed the cash flows
in the successive rows and insert function IRR with the range of cells containing
the cash flows of bond in the last. This is demonstrated in Figure 6-7 for a bond
selling at Rs 90 that pays annual coupon on face value of Rs 100 and
redeemed at par.

The result of IRR of 7.71% as shown in Figure 6-7 implies that for an investor who
buys bond at Rs 120 and holds it till maturity would have the return of 7.71%.
YTM considers both a) the capital loss/gain upon maturity, and b) coupons,
with their time values. Current yield considers neither.

6-16

6.15.3 Realised Yield
Realised yield as the name suggest is the yield the buyer realises when divested
of bond. YTM tells the yield that would be realised if bond is held until maturity.
However, the investors can sell the bond prior to its maturity. Would the yield be
still equal to YTM? Certainly not.

We may compute the realised yield on an approximate basis using Equation 3-
4. Suppose the investor of the bond at Rs 90 decides to sell the bond after 4
years at the then prevailing price of say Rs 95. His return now would consist of Rs
12 per annum and the capital gain of Rs 5 (Rs 95 Rs 90) averaged as Rs 1.25
for 4 years. Therefore the approximate realised yield would be (12+ 1.25)/ 90 =
14.72%. For accurate measurement we can use the EXCEL. Readers may verify
that he exact yield realised would be 14.45%.

6.16 VALUE OF DEEP DISCOUNT/ZERO COUPON BONDS
The bonds that do coupons are called as zero coupon bonds. The only way
they can provide the returns to investor is by way of capital gains i.e. issuing the
bond at much lower price than the face value at which they are redeemed.
Since these bonds are issued at substantial discount to the face value they are
also referred as deep discount bonds.

It is easier to value a deep discount bond because with regular coupon absent
it consists of only two cash flows i.e. one cash outflow at the time of buying and
the other cash inflow at the time of redemption. Bonds normally provide returns
to investors in two forms, one the periodic coupon payments, and two, the
capital gains from the difference between the selling/redemption value and
issue/purchase value. In contrast zero coupon bonds provide all the returns as
capital gains. Typical examples of zero coupon instruments are the 91-day or
364-day Treasury Bills (T-Bills) issued by government. However, deep discount
bonds are of much longer tenure.

6-17
Value of a zero coupon bond is specified in terms of yield it offers. For a bond
with time T until maturity it is given by Equation 6-5.

5 - 6 uation ...Eq .......... ..........
r) + (1
Value Face
= Bond Coupon of Zero Value
T


For example the value of the zero coupon bond of face value of Rs 1,000 with
10 years to maturity that offers 12% yield is 1,000/ 1.12
10
=Rs 321.97. The current
price and the returns of a zero coupon bond with time T remaining for maturity
are related by Equation 6-6.

Current Price x (1 + r
)T
=Face Value Equation 6-6

The price of the zero coupon bond would increase so as to reach its
redemption/face value on maturity. If the price of the bond moves to Rs 380
after a year then the yield on the bond would be 11.35%.

230 x (1+r)
9
=1,000 give r =11.35%

6.17 VALUE OF CALLABLE BOND FIXING THE CALL PRICE
Callable bonds are issued to enable issuer reduce cost of funds by providing an
opportunity to extinguish the high cost liability. If at the time of issue of the bond
the yields are high the issue price of the bond would be less. If subsequent to
the issue the yields start declining the price of the bond increases. Referring to
Figure 6-4 we note that the price of the bond rises if market interest rates fall.
The issuer would like to call back the bond and re-issue at lower coupons by
redeeming the existing bond even at higher price. Lower coupon in future
would compensate more than the higher price paid for redeeming the bond.

The decision relates to a) for how long the issuer should wait before calling the
bond and b) at what level of yield should it call the bond. The decision to
waiting for the earliest redemption time must consider the fact that subscribers
of the bond must be guaranteed the existing coupon for some minimum time.
The decision to determine at price to call back is determined on to what extent
the issuer is prepared to wait for the yields to fall.
Table 6-4: Valuing Callable Bond: Fixing Call Price
Period Cash flow Present Value at 7% p. a.
1 5.00 4.83
2 5.00 4.67
3 5.00 4.51
4 5.00 4.36
5 5.00 4.21
6 5.00 4.07
7 5.00 3.93
8 5.00 3.80
9 5.00 3.67
10 105.00 74.44
Call Price 112.47
6-18


As an example consider a firm issued a 10-year bond at coupon of 10%
payable semi-annually and redeemable at par. The issuer decides that the
earliest that the bond may be called back is 5 years. Further, the issuer would
like to call back only when the yields fall to as low as 7% from existing 10%. What
should be the price at which to call back the bond?

To answer that question all we need to value the remaining cash flow cash
flows of the bond at target yield of 7%. This is shown in Table 3-4. The price of the
bond after 5 years if the yields fall to 7% should be Rs 112.47. The issuer can
make the bond callable after 5 years at a price of Rs 112.50.

SOLVED PROBLEMS

Example 6-1: Valuing a Bond
What would be the value of the bond at the YTM of 10% that has 4 years to maturity,
pays semi-annual coupon of 12%, and redeemed at 5% premium to the par value of Rs
100?

Solution:
To find the value of the bond we discount the cash flows of the bond at 10%. The cash
flows would consist of regular coupon of Rs 6 every 6 months. At the end of 4 years the
issuer would pay Rs 105 (5% premium to face value) and the last coupon of Rs 6. The
value of the bond would be Rs 109.85 as shown below:

Period Cash flow Present Value at 10% p. a.
1 6.00 5.71
2 6.00 5.44
3 6.00 5.18
4 6.00 4.94
5 6.00 4.70
6 6.00 4.48
7 6.00 4.26
8 111.00 75.13
Bond Price 109.85

Example 6-2: Valuing Deep Discount Bond
Government of India decides to issue a zero coupon bond with face value of Rs 1000
redeemable at par after 20 years. If investors expect a return of 8% at what price the
bond can be issued?

Solution:
The price at which the issue can be made is governed by Equation 3-5. The issue price
would be Rs 214.55 as calculated below:

Issue price =1,000/1.08
20
=Rs 214.55

6-19

KEY TERMS

Bond A bond is an instrument for raising capital that promises to
pay a fixed rate of return for definite period of time.

Indenture An indenture to the bond consists o fall terms and
conditions of the issue of bond.

Coupon Rate The annual interest rate payable on the face value of the
bond is called coupon rate.

Floating Rate
Bonds

Deep
Discount
Bond

Callable Bond



Current Yield
The bonds, which pay varying interest when due according
to market conditions prevailing based on a benchmark.

A deep discount bond is a bond that is issued at substantial
discount to the face value with no coupon.


A callable bond is a bond that can be redeemed at the
option of the issuer at a time and price specified at the time
off the issue.

Current yield is the return that an investor gets by investing
in the bond.

Yield to
Maturity

Yield to Maturity (YTM) is the return a bond would provide to
the investor at current market price and holds on till
maturity.

SUMMARY

Bonds are the instruments of debt financing issued by governments and
corporations. Bonds offer a fixed return and repay the principal sum at the end
in one lump sum on maturity or in a phased manner. The key determinants of
the value of the bond include: face value, coupon rate, periodicity of coupon
payments; maturity period and redemption value besides tax benefits
attached.

Based on the nature of rate of return they are classified as fixed or floating rate
bonds. Callable bonds grant an option to issuer while puttable bonds give an
option to the subscriber to redeem prior to the maturity. Zero coupon bonds
offer no coupon rates while convertible bonds give an option of conversion into
equity shares to the holders.

Cash flows of the conventional bond consist of two parts; the periodic coupon
payments and the final redemption payment. The value of bonds is arrived by
discounting the future cash flows from the bonds at an appropriate discount
rate. Yield from bonds is the return that the investors earn from the bonds and is
a function of cash flows, price of the bond (market price or call price) and the
required rate of returns from the bonds. There are three variants of yield namely
6-20
current yield, yield to maturity, realised yield and yield to call. The most
common measure is Yield To Maturity (YTM), the yield available if bond is held
until maturity.

Zero coupon bonds do not pay any interest and instead provide all the returns
in the form of capital gains. They are issued at price substantially lower than the
par value and are redeemed at par value on maturity due to this feature they
are also termed as deep discount bonds. The value of zero-coupon bond is
arrived by discounting the par value (redemption price) at an appropriate
discount rate

SELF ASSESSSMENT QUESTIONS

1. How do you thing the value of the bond would change with a)
increasing face value b) increasing coupon rate c) increasing the
periodicity of coupon d) increasing the term to maturity.

2. Differentiate between Yield to Maturity and Current Yield.

3. What do you think are the advantages of convertible bonds?

4. How would you value bond a) while issuing, b) exactly after payment of
a coupon and c) at maturity?

5. On what factors the call price of the callable bond is determined?
Explain.

6. What is the relationship of the yield on the bond and its price?

7. What is the value of bond with 6 years remaining for maturity that pays
semi-annual coupon of 8% p.a. on face value of Rs 120 and redeemable
at par at a YTM of 10%?

8. What is the YTM of a bond that sells for Rs 110 with annual coupon of 10%
on face value of Rs 100 redeemable at pat after 3 years?

9. At what value would you market a zero coupon bond of face value of
Rs 10,000 maturing after 15 years if investors expectations are 8% p.a.?

10. What call price would you fix for a 15-year bond callable after 5 years if it
pays annual coupon of 12% till the YTM falls to 9%? The bond has face
value of Rs 100 and is redeemable at par.

FURTHER READINGS

1. Srivastava & Misra (2008), Financial Management, Oxford University Press,
Chapter 6
2. Prasanna Chandra (2009), Investment Analysis and Portfolio
Management: Theory and Practice, Tata McGraw Hill, Chapter 11
3. I M Pandey (2005), Financial Management, Vikas Publishing House Pvt
Ltd, Chapter 3
7-1
UNIT 7

VALUATION OF SHARES

7.0 OBJECTIVE
The chapter is aimed at
- Explaining the features of equity
- Determination of values of equity shares and the factors to be
considered.
- Providing insights to the Dividend Discount Model and its variant
that are helpful in valuation of equity shares;
DDM with no growth
DDM with constant growth
- Explaining how growth impacts the value of equity shares.
- Establishing a relationship of shareholders expectations of return
and growth estimate.
- Explain the relative valuation.

7.1 INTRODUCTION
In the previous Unit we discussed features of a financial instrument called bond
and its valuation. We have another extremely popular financial instrument
called share, also known as common stock or equity that is traded in the
capital markets. Investors buy and sell them at regular basis.

Unlike bonds shares are instruments that do not assure a fixed return but provide
for the proportionate share in the profit that a firm earns on periodic basis.
Therefore shares are fundamentally different than debt. Debt is commonly
issued by security called bond. Equity is generally issued by security called
share.

For regular buying and selling of these securities there exists a market called
stock exchange. Stock exchanges also deal in buying and selling of debt
instruments. By buying and selling of financial securities and instruments stock
exchange provides a platform for transfer of ownership of these securities.

One basic question that needs to be answered here is that at what price buyer
and seller would agree for transfer of ownership. This issue is referred as
valuation of equity shares, which is the subject matter of this Unit.

Before we discuss the valuation of equity shares we devote some attention to
the features of equity that will help understand its valuation too.
7.2 SHARES AND SHAREHOLDERS
One needs money to start a business activity. We call it a firm. Basically the
money needed to establish a firm and for its continuing operations can have
two forms debt or equity. These two forms have very distinct features from
each other though they serve the same purpose of meeting the requirements
of the firm. While debt can be issued by firm where it can promise a definite
7-2
and assured return and repayment, equity is issued where neither a definite
returns nor the repayment of the sum contributed are assured.

Need to issue equity arises because for large projects the capital outlay is large
and no single individual or group of individual (called promoters) is in a position
to meet the large outlay from their own resources. Only a limited amount of
debt can be given against the contributions made by the promoters. Where
capital resources of promoters meet the requirement of funds they can join
together by making a partnership firm to execute the projects. But when the
resources required become too large even a partnership cannot meet the
needs it becomes imperative on part of promoters to invite public at large to
contribute sums of money towards meeting the project cost.

For example if a project needs Rs 100 crore and only Rs 50 crore can be raised
by borrowing the remaining 60 crore needs to be mobilised from investors. The
prospective investors would have different paying capacities the amount can
be broken as 6 crore shares of Rs 10 each or even 60 crore shares of Rs 1 each.
This would enable different investors to subscribe in different amounts
according to their capacities and needs by placing their requirement in terms
of number of shares. An investor who wants to contribute Rs 100 could buy 10
shares of Rs 10 each while another investor willing to contribute Rs 50,000 can
buy 5,000 shares. Each of the two investors would be called a shareholder.
Naturally these two investors would get the reward in proportion to the amount
contributed.

7.3 FEATURES OF EQUITY SHARES
The above illustration described a share but did not elaborate on all the
features that equity shares carry. We discuss them now.

Ownership and Management
The distinguishing feature of the equity as compared to debt is that the
shareholders are owners and debt holders are not. The proportion of ownership
varies with the number of shares held. Shareholders manage the enterprise. The
debt holders are interested in the firm only to the extent that the promised
returns are paid to them. To acquire a firm one needs to buy the shares and not
debt. This makes trading in shares different than trading in debt.

Residual Claim
Next important feature of equity is the nature of claim on the cash flows of the
firm. The surplus cash generated in the firm has to be distributed to those who
contributed the capital. After meeting the usual obligations of employees,
suppliers, government etc the remaining has to go service the capital. Debt
holders are serviced first and residual, if any, is given to the shareholders. In the
priority of claims the shareholders come in the last. The residual that is left is not
fixed and varies from period to period. Hence the returns to shareholders are
neither guaranteed nor fixed.

Risk
As explained the entitlement only to the residual claim implies that the earnings
on the capital invested are uncertain. Debt usually specifies a rate of returns,
fixed or floating. There is no promised rate that the business is required to pay to
7-3
the investor in shares. The uncertainty attached with the return on the share
makes the financial asset substantially different from the perspective of
valuation because if the cash flows to the shareholders are uncertain the
discount rate needs to be adjusted accordingly.

Infinite Life
Unlike debt the capital contributed by individuals cannot be returned by the
firm. A business is different from the individual who promote it or who contribute
the capital. Firms are supposed to last forever (whether they actually do is a
different matter) while management changes from generation to generation.
Business has its own identity that is separated from the individuals who promote
and manage it. Debt has defined maturity and is extinguished at some point of
time. We cannot say so about equity shares. As firms last forever shares too
have to last forever. Infinite life of shares makes its valuation extremely difficult.

Trading of Shares
Since the contributions made by the shareholder cannot be refunded by the
firms, they have to be provided with an alternative exit route for the investor to
divest. For the same individual the investment cannot run for ever. Therefore the
only alternative that allows continuity of operations and yet provides an exit
route to the individual investor is to provide a market for exchange of shares.
Stock exchange does the job of replacing the existing investor, needing to
make an exit, with the investor wanting an entry into the business. Such markets
list these shares for trading amongst those investing and disinvesting. The price
for exchange of share is determined between the individuals by their mutual
consent. A vast number of such individuals and organisations form the market.
7.4 ISSUES IN VALUATION OF EQUITY
Valuation of shares would require minimum of two inputs i.e. the values of cash
flows to the owners of security for its life and the appropriate discount rate to
find the present value. For valuation of debt the cash flows were certain, for a
limited time and fixed. Can we value the shares in same manner? Yes, we do it
but from the perspective of valuation of the shares i.e. the price of any share,
each of the features discussed above presents a problem that needs to be
resolved. More specifically these issues would be:

Ownership Since shareholders are owners and manage the enterprise
the question is should they get more or less than the return
they expect? One argument is that being owners they
can influence the cash flows. Other argument is being
owners they deserve extra reward for managing the firm.
The question remains: Should the expectation of return be
modified?

Residual Claim What is left after meeting all obligations belongs to the
shareholders. The question is whether would there be any
thing for the shareholders to take home as reward. If the
cash flow is inadequate shareholders do not get anything
while if it is large their reward could well be in excess of
what debt holders get, even though the capital provided
by them performs the same job.
7-4

Risk Uncertainty of the residual cash flows adds to the risk of
returns. Even if some residual is expected one is always
uncertain about its quantum. That makes the returns to
shareholders variable.

Infinite Life For valuation we need to project the cash flows for the life
of the security. Since the life of equity shares is infinite we
need to project the cash flows for eternity. Farther the
cash flow in time more difficult is it to project, and even if
we do the accuracy of projection is questionable.

Trading Since the equity is not redeemed the exit route is through
selling it. While selling or buying raises a question of at
what price to trade. In case of bonds the necessity of
selling is obviated by holding the bond till its maturity.
Hence the question of pricing can be avoided by the
investor. Such cannot be the case with equity shares.

As explained above, while valuation of bonds was a rather easy the valuation
of the shares though on similar lines presents its own difficulties. There exist
problems of ascertaining the cash flow for indefinite period of time and finding
an appropriate discount rate.
7.5 METHODS OF VALUATION
There are two ways one can attempt to value equity.

1. One approach is holistic that attempts to estimate the cash flow and
value them according to the risk associated with them. The discounted
cash flow approach has its own problems as stated above. None of the
parameters required for DCF valuation are known with reasonable
accuracy. Neither the cash flows nor its timing are certain. Further the
discount rate too is unknown.

2. The second way of valuation rests on the premise that similar assets must
sell for similar values. The approach is called comparative or relative
valuation where assets of similar nature/attribute are compared in their
prices in the market and then the target asset is valued according to
similarities and dissimilarities. Apparently it is extremely easy to apply but
finding similar asset is difficult and the adjustment required to account for
the dissimilarities is a challenging area and not free from controversies.

The first approach is to find the intrinsic value of the asset while the second
approach values any asset relative to another and focuses on market value.
We discuss some of the models for valuing equity stock.
7.6 DIVIDEND DISCOUNTMODELS
In the holistic approach i.e. finding the intrinsic worth of the share, the model
that is adopted is called the dividend discount model. Dividend discount model
for valuation of equity is an extended application of the concept of time value
of money. According to time value of money the cash today is more valuable
7-5
than the cash tomorrow. How much is the cash tomorrow worth is dependent
upon the discount rate, r. The discount rate is the required rate of return for the
investor holding on to the equity. Clearly this required rate of return for equity is
different than what is used for valuing cash flows of other financial instruments
like bonds because of the features of equity already discussed. The discount
rate is a separate topic of discussion. We shall simply assume it to be given or
derive from observable data.

Under dividend capitalisation approach we assume here that the price of any
financial asset at any given point of time would be no more or no less than the
present value of cash flows attached with the ownership of that asset. If an
investor buys asset at Rs 100 he is willing to pay this price only if he believes that
future benefits obtained by owning the asset is no less than Rs. 100. Similarly the
seller of financial asset believes that the current price of Rs 100 is no less than
the worth of the future benefits that would be sacrificed by disowning.

Since we cannot look very deep into the future we analyse for limited horizon of
time. We assume only one period and for convenience this one period is set
equal to one year. Assume that the investor holds on to the asset for one
period. Using the discounted cash flow approach for valuation of equity the
current price of equity share, P0 is equal to the dividend expected during the
holding period, D1 and the price of the asset at the end of the holding period
P1. Expressed mathematically the price P0 is given by Equation 7-1.
) r 1 (
P
) r 1 (
D
P
1 1
0
+
+
+
= Equation 7-1
Therefore three inputs are required to value the share today the expected
dividend, the expected price after one period and the discount rate. All the
inputs must be projected. One would realise that Equation 7-1 is more of a
justification for the current price rather than its determination.

Now in order to determine the price today we need to project the price after 1
year. Like the todays price is dependent on the price a year later the price a
year later, P1 is dependent on the price two years later, P2. One would sell at
price, P1 if the desired returns are achieved which can be expressed as follows:
) r 1 (
P
) r 1 (
D
P
2 2
1
+
+
+
=

Substituting the value of P1 in Equation 7-1 we get,





Similarly the price at the end of period 2, P2 can be expressed as
) r + 1 (
P
+
) r + 1 (
D
= P
3 3
2

Again substituting the value of P2 and continuing in this fashion for indefinite
period of time the dividend discount model for equity share price looks like
Equation 7-2
2
2
2
2 1
2 2
1
0
) r + 1 (
P
+
) r + 1 (
D
+
) r + 1 (
D
=
) r + 1 (
) r + 1 (
P
+
) r + 1 (
D
+
) r + 1 (
D
= P
7-6
n
n
5
5
4
4
3
3
2
2 1
0
) r + 1 (
D
+ ..... ..........
) r + 1 (
D
+
) r + 1 (
D
+
) r + 1 (
D
+
) r + 1 (
D
+
) r + 1 (
D
= P ..Equation 7-2

Alternatively for indefinite period of time this may be abbreviated as

+
=
1
n
n
0
) r 1 (
D
P . Equation 7-3
The dividend discount model is based on discounted cash flow approach. The
owners of equity shares are entitled to the reward of dividend for as long as one
wants to hold on to the investment, and the price paid by the investor would
be equal to the discounted value of the dividends on the share. To value the
current price of the equity shares we need to estimate the dividend that would
be distributed over infinite period of time; indeed an impossible task. The
valuation of equity as given by Equation 7-3 is known as dividend discount
model (DDM)

7.6.1 DDM with Constant Dividend No Growth
If a) earnings remain constant period after period and b) all earnings, E are
distributed then earnings would be equal to dividend and all dividend would
be equal. In such a case the Equation 7-2 simplifies to

+
+
+
+
+
+
+
+
+
+
+
=
) r 1 (
D
..... ..........
) r 1 (
D
) r 1 (
D
) r 1 (
D
) r 1 (
D
) r 1 (
D
P
5 4 3 2
0

And the value of the stock would be given by Equation 7-4.
r
E
r
D
P
0
= = Equation 7-4
The simplest of valuation model as given by Equation 7-4 states that the value
of equity is given by expected dividend divided by the expected discount rate.
For example if the expected dividend on a share were Rs 6.00 and the
expectation of returns on the investor were 10% then the expected price would
be Rs 60 (6/0.10). It may be verified that if one buys stock at Rs 60 the dividend
of Rs 6 provides 10% return.

7.6.2 DDM with Constant Growth
If part of the earnings are retained to fund growth of the firm and part
distributed the valuation model as given by Equation 7-4 does not apply. The
retained earnings would be deployed in business and should result in growth of
earnings and hence dividend in future periods. If we simply assume that
dividend grows at a constant rate of g, the Equation 7-2 can be restated as

+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
=
) r 1 (
) g 1 ( D
..... ..........
) r 1 (
) g 1 ( D
) r 1 (
) g 1 ( D
) r 1 (
) g 1 ( D
) r 1 (
) g 1 ( D
) r 1 (
D
P
5
4
4
3
3
2
2
0
..Equation 7-5

Here dividend in next period is D. For convenience we may denote it by D1 = D0
(1+g) the dividend in Period 1. The dividend in subsequent period 2 is D1 x (1+g)
and in period thereafter is D1 x (1+g) x (1+g) = D1(1+g)
2
and so on. Upon
simplification Equation 7-5 reduces to
g) - (r
D
= P
1
0
..Equation 7-6

7-7
Valuation model as per Equation 7-6 states that the expected return is given by
the dividend yield and growth expected. For example if the dividend expected
next period is Rs 2 and is expected to grow at 10% while the investor expect 15%
return the stock price would be Rs 40. At the end of the period 1 the stock price
would be Rs 2.20/ (0.15 0.10) =Rs 44. The investor would earn Rs 2 as dividend
and Rs 4 as capital gains on the investment of Rs 40. Therefore the return on
investment would be 15% as desired.

7.7 DDM - MULTI-STAGE GROWTH MODELS
Valuation based on constant growth of dividend is a greatly simplifying
assumption that helps explain some of the complex phenomena of the share
price valuation. However, it seems rather unrealistic that the firm would
continue to grow at the same rate forever.

A more reasonable and realistic assumption would be to assume high growth
during the initial few years. Thereafter as opportunities for extra-ordinary growth
opportunities dry up, competition catches up and firms start registering a rather
normal growth consistent with the rest of the economy.

If we can forecast growth in the initial few years and thereafter assume normal
we can forecast the price of the share as follows:
n n
1 - n
1 1
4
3
1 1
3
2
1 1
2
1 1 1
0
) r + 1 (
Pn
+
) r + 1 (
) g + 1 ( D
+ .......
) r + 1 (
) g + 1 ( D
+
) r + 1 (
) g + 1 ( D
+
) r + 1 (
) g + 1 ( D
+
) r + 1 (
D
= P --Equation 7-7
High Growth Phase of n years Normal growth

where D1 represents dividend expected in next period 1, g1 represents high
growth rate lasting for n years, and Pn is the price of the share at the end of high
growth period.

As an example consider a firm has expected level of earnings of Rs 10 per
share. Due to extremely good prospects and opportunities the firm is
experiencing a high growth pays only 40% of its earnings as dividend and
retains the balance. It is expected to have high growth of 20% over next 5
years. Thereafter the growth in earnings is expected to settle down at to a
reasonable level of 6%. If the investors expect a return of 15% what should be
the value of the stock now.

To find the current value of the share we need to break it into two:
1. Value of dividend for next five years growing at 20%, and
2. Value of dividend thereafter growing at 6%. The second component is
called the terminal value.

The find the dividend for the next five years at the growth rate of 20% and apply
the dividend discount approach by projecting the dividend separately for
each of thereafter at 6% forever. The dividend for next 5 years would be:

Dividend expected in the next period 1, D1 =Rs 4.00
Dividend expected in the next period 2, D2 =Rs 4.00 x 1.20 =Rs 4.80
Dividend expected in the next period 3, D3 =Rs 4.80 x 1.20 =Rs 5.57
Dividend expected in the next period 4, D4 =Rs 5.76 x 1.20 =Rs 6.91
Dividend expected in the next period 4, D5 =Rs 6.91 x 1.20 =Rs 8.29
7-8

These dividend need to be discounted at 15% for the present value. The
second part of the value comes from the stable growth period extending
indefinitely. The value of dividend for 6
th
year is 8.29 x1.06 = Rs 8.7874. The
terminal value of this dividend stream using DDM for Equation 7-6 is Rs 97.64.

97.64 Rs =
0.09
8.7874
=
0.06 - 0.15
0.06) + 8.29(1
=
g) - (r
D
= P
6
5

The value of the stock today would be;
63.72 Rs 48.54 15.18
(1.15)
97.64
4.12 3.95 3.37 3.63 3.48
) 15 . 1 (
Pn
) 15 . 1 (
29 . 8
) 15 . 1 (
91 . 6
) 15 . 1 (
76 . 5
) 15 . 1 (
80 . 4
) 15 . 1 (
00 . 4
) 15 . 0 1 (
Pn
) 15 . 0 1 (
) 20 . 0 1 ( 00 . 4
) 15 . 0 1 (
) 20 . 0 1 ( 00 . 4
) 15 . 0 1 (
) 20 . 0 1 ( 00 . 4
) 15 . 0 1 (
) 20 . 0 1 ( 00 . 4
) 15 . 1 (
00 . 4
P
n
n 5 4 3 2
n
5
4
4
3
3
2
2
0
= + = + + + + + =
+
(
(

+ + + + =
+
+
(
(

+
+
+
+
+
+
+
+
+
+
+
+
+
=

The illustration above does not mean to suggest that firms can have only two-
stage growth. In practice firms may follow a more complicated pattern of
dividend growth. The underlying idea is to suggest that one must project the
dividend up to a period for which reasonable assumption and accuracy is
available and thereafter dividend discount price with constant growth may be
superimposed.

7.8 DIVIDEND AND GROWTH
The underlying assumption of the dividend capitalisation model was that the
entire growth was internally funded. To fund growth the firm must necessarily
curtail dividend. Would a cut in dividend result in decline in the price of the
share? Decrease in dividend would lead to price decline. Growth would lead
to increase in price. The net effect on price would depend upon whether
growth in dividend outweighs fall in current dividend.

In the previous section i.e. 7.7 it was implied that 60% retention was sufficient to
propel the growth of 20%. Whether or not the retention of dividend would result
in the increase in price of the stock is dependent upon at what rate the firm
deploys its funds. The investors expectations were of 15% return. In case firm has
projects that yield more than 15% the retention would lead to increase in share
price. If not then the retention of fund by non distribution of dividend would
result in decline of the value of the stock. Clearly if the retained earnings by the
firm are redeployed at a rate higher than expected any announcement of
dividend policy in favour of retention would be greeted positively. For example
if the firm decided to retain 75% instead of 40% to implement projects that have
IRR in excess of 15% the share price would increase.

We may simply think that the share price is the sum of the value of the firm
already in place, the value with zero growth and the present value of the
growth opportunities.

Value of the share =No growth value + PV of growth opportunities
P0 =E1/ r + PVGO.Equation 7-8
7-9

7.9 RELATIVE VALUATION
Relative valuation also called comparative valuation is based on a premise
that similar asset must sell for similar price. Unlike dividend discount model it is
not centred around finding the intrinsic worth of the share. Finding intrinsic value
by projecting the cash flows and finding an appropriate discount rate may
seem mathematically easy but is managerially difficult. The difficulties
associated with the valuation of the shares were the uncertainty of the amount
of dividend, their timing and the selection of appropriate discount rate. In
relative valuation we were not concerned about the actual market value of
the share and instead were focussed on finding what the market value should
have been.

In comparative valuation we attempt to find a comparable asset whose value
is observable and that closely resembles the asset being valued. Since we know
the value of the observed asset we also know the value of the unknown asset.
This is known as relative valuation. Under this approach of relative valuation the
aspect of cash flows and appropriate rate of discounting them is left to the
market. We depend upon the value the market assigns to similar asset, and our
task is limited to find an equivalent asset in the market that is already valued.

If we succeed in finding the equivalent asset then the suitable price adjustment
may be made for the minor variations in the features of the comparable asset
and the asset being valued.

7.10 PRICE EARNING (PE) RATIO/MULTIPLE
Most common amongst the relative valuation is based on price earning
multiple. We all agree that cash flow or earnings of the firm drive the value. The
market discounts the earnings based on several parameters. The ratio of price
with the current earning is called the price earning multiple, or PE ratio/multiple.
Much of the investors and analysts attention alike is focussed on PE ratio.
Mathematically, PE ratio or multiple is defined as Equation 7-8.
0
0
E
P
=
Share Per Earning
Price Market
= Ratio Earning Price Equation 7-8
Some analysts who believe place greater reliance of future period earning
rather than current earning. They compute the PE ratio based on next periods
earning called leading PE ratio and is defined by Equation 7-9.

1
0
E
P
=
Share Per Earning Expected
Price Market
= Ratio Earning Price Leading Equation 7-9

As an example consider valuation of a steel plant. We know the prices of stocks
of several firms in steel sector. We also know the earnings of each of them
being public companies. If we are valuing a new steel plant the market value
of its stock too should be similar to the ones that are traded. Assume that a
listed firm has earnings per share of Rs 12 and the market price is Rs 240. Then
we say the PE ratio of the firm is 20 i.e. the market discounts present earnings 20
times the current earnings. If the steel plant we are attempting to value shows
an earning of Rs 5 then we may say that the market price would be 20 x 5 =Rs
100.

7-10
Valuation based on PE ratio is rather simple. Here we have assumed that the
traded firm and the firm being valued are similar in all respects. Therefore if
market discounts earnings 20 times for the asset that is traded, it must also
discount the earnings of the non-traded asset at the same levels. Such logic
would hold good if two assets are indeed comparable in all respects such as
management, size of the plant, quality of machinery, product being made,
access to raw materials, markets for finished goods etc. One may argue that no
two assets are same and hence applying same PE ratio would be fallacious.
However, even though the exact match may not be possible some indications
can be had from the financial securities of firms in the information technology
being traded. PE ratio can serve as an important benchmark for valuation.

7.10.1 PE Multiple and DDM
Valuation based on PE multiple being easy to apply is sometimes argued as not
scientific enough. However, it is not so. A detailed look at PE approach would
show that it is no different than the fundamentally sound of dividend discount
model. If we denote b as the retention ratio and k as the reinvestment rate by
the firm for deploying funds for future the growth would be b x k i.e. if 40%
earnings are deployed in projects with returns of 20% then growth in earnings
would be 0.40 x 0.20 = 0.08 or 8%. The dividend discount model can be
represented as Equation 7-10:
bk) - (r
b) - (1
E
P
or ,
bk) - (r
b) - (1 E
g) - (r
D
= P
1
0
1 1
0
=
=
. Equation 7-10

From the above it is evident that the PE ratio reflects a composite measure of
dividend policy, b, reinvestment rate, k, and market expectations, r. By
assigning a PE multiple we are assigning a composite value to dividend policy,
growth opportunities and investors expectation of return, rather than finding
each independently. Further both earning and price are known and
observable hence PE approach eliminates the need to make assumptions.
Therefore valuation based on PE ratio is extremely popular and often provides a
basis of comparison of firms within the same industry.

The PE ratio would increase if k increases, and b increases as long as k >r. The
market places higher value to the firm, as reflected in its PE multiple, that has
capability to re-invest the funds at a rate higher than what the investors can do
by themselves and this value would be higher and higher if the retention ratio is
increased. Contrary to this if reinvestment rate by the firm is lower than the
return expectations the PE multiple would decline with increased retention
ratio.

The relationship of the PE ratio with respect to market capitalisation rate is
rather straightforward. Higher the r lower would be the PE multiple. Effectively it
means that more volatile earnings would be discounted at higher rate
reflecting the increased risk with the cash flows. Firms with more stable cash
flows would have higher PE multiple.

The growth is linked to economy and particular industry, which are common to
all the firms within the industry. How well the opportunities are exploited by the
7-11
individual firms within the same industry is the reflection of the managerial
competence of the firm that ultimately must be reflected in PE ratio. The quality
of management and investors confidence can be measured by the PE
multiple. All other thing remaining constant a higher PE multiple means greater
confidence reposed by the market in the management of the firm.

7.10.2 Implementing PE Approach
The PE approach involved following steps in valuing a share;
1. Find out the industry where the firm whose shares are to be valued,
2. Find the PE multiple of the industry, its average, maximum and minimum,
3. Project the relative position of the firm being valued in the industry into
broad class of good, average, below average,
4. Project the earnings of the firm being valued,
5. Project the value of the asset by using the appropriate multiples suitably
modifying for the asset being valued.

The use of PE ratio has several advantages like
1. It is simple to use and requires no complex calculations.
2. It is based on observable figure/data and can be relied upon.
3. It eliminates the need for making some unnecessary assumptions
regarding the firm, its policies etc.
4. It is independent of market imperfections because if market is inefficient
in valuing one stock the same imperfection is assumed to carry to the
asset being valued.

Some precautions are needed for applying PE based valuation. They are
1. PE ratios are based on historical data and use past earnings, E0 as base
for PE ratio. Whatever has been stated about the PE ratio applies to the
projected earnings E1 and one must be careful while making
observations and decisions based on published PE ratio.
2. Earnings that are used in published PE ratios are accounting earnings,
which are subject change as accounting policies change from firm to
firm, especially those related to depreciation, inventory valuation. The
bias generated due to different accounting policies must be eliminated
for fair comparison.
3. Reported earnings are computed under one set of law do not
correspond to the economic earnings that forms the basis of PE ratios.
4. No two assets are exactly alike. There would be some differences in the
assets and as such some modifications would be required in applying
the observed PE multiple to value the unknown asset.

7.11 OTHER RELATIVE VALUATIONS
The process of using the relative valuation is simple. It is not necessary that one
adopts only earning multiple for valuation. There are other bases on which the
comparative valuation can be done. Some of the other basic and popular
determinants of the value of the stocks are a) book value, b) revenue, c)
capital employed, d) replacement cost, etc.

Book value multiple is ratio of market price and the book value of the share.
Book value reflects how much funds have been deployed in the business since
its inception. It is a good way of valuing firms with long track record and history.
7-12
Similarly revenue multiple is the ratio of market price to revenue. It is normally
used where the profits are not considered true measure of value because the
firm is in its early phase.

Each of these bases has a relationship with the price of the stock. Some of them
become more relevant for certain industries. For example steel plants and
cement industries valued with respect to book value or capital employed as
they are capital intensive. These multiples also enable valuation of loss making
firms. For example telecom and internet firms may remain loss making for
substantial periods of time where the PE approach would fail but yet they can
be valued on the basis of revenue or number of customers/hits. The relevance
or replacement value often becomes very handy in case of acquisitions where
buyer values the target for the capacity installed where one compares the cost
of establishing the similar capacity as a greenfield venture with the cost of
acquisition.

Implementation of comparative valuation requires complete understanding of
the domain knowledge and establishing the value drivers for the firm and
industry. Experts with domain knowledge keep a close watch on the
technology, competitive position, market scenarios, management perception,
accounting policies and transparency etc. and continuously test the validity of
value drivers. In case of change either they re-rate the valuation parameter,
like changing the PE multiple or change the value drivers.

More often than not analysts do not rely on single value driver and seek
confirmation with other valuation parameters. For valuation of new enterprises
they do not rely on one comparable asset but instead base their observations
on average of several comparable assets. Further they also do not rely of single
multiple but instead choose many multiples in order to remove biases that may
creep in evaluation with single multiple.

The major limitation of relative valuation lies in identifying a comparable asset.
The asset being compared must be as close as possible to the asset with the
value known. We assume that a comparable asset in terms of size, equity, sales,
history, products etc already exists in the market. This assumption is difficult to
fulfil as no two organisations are exactly same, but nonetheless are somewhat
same.

To minimise errors in valuation most analysts use a) an average of multiple over
industry rather than multiple of one firm and b) use combination of many
variables rather than one variable to arrive at relative valuation.

SOLVED PROBLEMS

Example 7-1: Worth of the Current Share Price
The equity owners of a firm need a return of 12%. The current performance of
the firm confirms that it would pay a dividend of Rs 5 in the coming year. The
share price is estimated to be Rs 20 after a year.
a) If the current price of the share is Rs 22 do you think the share is worth
buying?
7-13
b) How do you justify that the positive return would be generated despite
the price falling to Rs. 20 after a year?
c) What maximum price do you think that the investor should pay today for
a share of ABC Ltd.?

Solution
The current price of the share using Equation 7-1 that would provide a return of
12% is Rs. 22.32.
22.32 Rs 17.86 4.46
0.12 1
20
0.12 1
5
r) (1
P
r) (1
D
P
1 1
0
= + =
+
+
+
=
+
+
+
=

a) The current price of the share is Rs 22 and buying at this price would
provide a return in excess of desired rate of 12%. Hence the share is
worth buying.
b) Despite falling price the returns are in excess of 12% due to cash flows of
dividend of Rs. 5 which more than compensates the loss in value.
c) The maximum price that can be paid for the share is Rs 22.32. Any price
above Rs. 22.32 would result in lesser than required return of 12%.

Example 7-2: Share Price and Growth
The earnings of Indian Plastics are growing at 25% for the last several years and
would continue the same way. Last year the firm paid a dividend of Rs 15. If
investors expectation from the firm is to provide a return of 30% find the worth
of the share of Indian Plastics.

Solution
The last year dividend is Rs 15. The current share price is governed by the
expected dividend in the next period. The expected dividend for next year D1 is
Rs 1.25 x 15 =Rs 18.75.

The worth of the share today as given by Equation 7-6 is
375.00 Rs =
0.25) - (0.30
18.75
=
g) - (r
D
= P

1
0


Example 7-3: Relative Valuation
Bharat Cements firm is in the business of cement is intending to come out with a
public issue of 5 crore shares. It is projecting a post issue earning of Rs 5 per
share with the revenue of Rs 500 crore. There exist 4 firms of comparable size
with following information available:


EPS
(Rs)
Revenue
(Rs crore)
Current Price
(Rs)
Firm 1 4.00 200.00 100.00
Firm 2 4.50 285.00 120.00
Firm 3 5.00 490.00 140.00
Firm 4 6.00 600.00 158.00

What price the firm can issue its shares?

7-14
Solution:
We find that Firm 3 resembles the most with the Bharat Cements in terms of EPS
and revenue. Therefore price of Rs 140 (the price of Firm 3) seems reasonable.
The multiples based on current market price and projected earning, book value
and revenue of the four firms are worked out.

EPS Revenue
Current Price
(Rs.)
PE
Multiple
Revenue
Multiple
Firm 1 4.00 200.00 100.00 25.00 0.50
Firm 2 4.50 285.00 130.00 28.89 0.45
Firm 3 5.00 490.00 140.00 28.00 0.29
Firm 4 6.00 600.00 160.00 26.67 0.27
Average 27.14 0.38

Since all the four firms are taken for comparison it is advisable to derive the
value of Bharat Cements on the basis of averages. There are no extra-ordinary
multiples that are not considered as representative of sample. The average of
PE multiple is 27.14 and revenue multiple is 0.38

Giving equal weight to the two multiples and the averages the value of the
shares of Bharat Cements is
=(27.14 x 5 +0.38 x 500.00)/ 2 =(135.70 +190.00)/ 2 =Rs 162.85

KEY TERMS

Dividend
Discount
Model (DDM)
Dividend discount model equates the current price of the
share equal to the expected dividend discount at an
appropriate rate reflecting the shareholders expectations.

DDM with
Constant
Growth
The current price of the share is given by expected dividend
divided by the difference of expected return and growth
rate.

Intrinsic Value The intrinsic value of the share is the present value of the
future cash flows attached to a share.

Relative
Valuation
Relative valuation states that the similar asset must be
priced similarly.

PE Multiple Price earning multiple is the ratio of current market price
and the earnings of per share.

SUMMARY

Valuation of equity shares is one of the most challenging exercises a financial
analyst faces. The valuation of the equity is similar to that of bonds i.e.
discounting of the cash flows attached with the financial instrument. Despite
the well-established principle the valuation of equity is an extremely tricky
exercise as none of the parameters can be determined accurately and with
certainty. The cash flows, its timing and maturity as well as rate of discount are
all uncertain.
7-15

The difficulties of valuation emanate from the properties equity has. It is a
financial instrument characterised by indefinite life bearing total responsibility
for the management and owns only the residual that is unknown. These features
of equity make estimation of cash flows uncertain as well as use of definite
discount rate a controversial issue.

One way of finding the intrinsic value of equity is to discount the cash flows
associated with the equity - the dividends. Dividend discount model and its
many variants attempt to find the intrinsic worth of the share and state that
current price must equal the discounted value of dividends for indefinite period
of time. Under special cases of constant dividend and constant growth the
model is relatively easy to solve. According to DDM the value of the share is a
function of expected dividend, shareholders expectations and the growth in
dividends. Equivalently the shareholders expectation consists of dividend yield
and the growth.

Another approach to value equity shares is relative valuation. This is based on
the premise that equivalent assets must command the same price. The
approach therefore concentrates on finding the equivalent asset whose
market value is known. The efficacy and accuracy of the approach is
dependent upon the existence of comparable asset and assumption that the
asset is correctly priced.

The most common market based valuation is PE multiple i.e. earnings divided
by the market price. PE multiple is regarded as a composite single parameter
that reflects market perception of how investors view the quality, stability and
growth in earnings of the firm. It also takes into account the industry average for
the PE multiple and relative position in that industry. As against the intrinsic
worth of the firm the relative valuation focuses on market valuation. Beside PE
multiple the other measures used in relative valuation are sales multiple, book
value multiple and return on net worth.

SELF ASSESSSMENT QUESTIONS

1. What is the difference in valuation of equity and bonds as both
derive the value by discounting the cash flow attached with the
instrument?

2. What are the features of equity shares that make its valuation
difficult?

3. What is intrinsic value?

4. What is dividend discount model with constant dividend and
constant growth?

5. What does PE ratio tell? Explain valuation using PE ratio with a suitable
example.

7-16
6. What are different measures of relative valuation and why are they
used alongside PE ratio?

7. Find the value of stock for a firm that declared last dividend of Rs 2
per share. The chairman promised the growth of 15% in the times to
come. Of the expected returns are 20% what is the value of the share
today?

8. Wealthy corporation has been showing a growth in earnings and
dividend at 12% which is expected to continue. The last dividend
declared was Rs 2.00. If the requires rate of return is 15% what is the
price of the share a) today b) after 1 year and c) after 4 years?

FURTHER READINGS

1. Srivastava & Misra (2008), Financial Management, Oxford University Press,
Chapter 7 and 10
2. Prasanna Chandra (2009), Investment Analysis and Portfolio
Management: Theory and Practice, Tata McGraw Hill, Chapter 11
3. Aswath Damodaran (1997), Corporate Finance; Theory and Practice,
J ohn Wiley & Sons Inc, Chapter 23


8-1
UNIT 8

FUNDAMENTALS OF LEVERAGE

8.0 OBJECTIVE
The objective of this unit is to
a) Explain the meaning of leverage
b) Describe the operating and financial leverages
c) Demonstrate the computation of degree of operating leverage
d) Demonstrate the computation of degree of financial leverage
e) Explain total leverage and its computation
f) Explain the impact of debt on the returns of the shareholders
g) Explain EBIT-EPS analysis and its use in determining the desired capital
structure

8.1 INTRODUCTION
We all know that the impact of the effort is magnified if we use a lever. In our
day-to-day life we do several jobs that use a lever. We can move a very heavy
stone with the help of a rod and a pivot to support the rod. Using a fulcrum the
effort involved in moving the heavy stone is very little. The advantage of lever is
getting a large payoff with smaller effort.

A firm deploys resources to generate revenues. The difference of revenue over
the utilisation of resources provides the income. The claims on these revenues
are of two types. One is a fixed charge, which needs to be incurred irrespective
of level of production, revenues, or cash flows. It is not dependent upon
revenue generation capacity. The other charge is not fixed and varies
according to level of production and sales. The residual left after the fixed
charges are met and is a claim of shareholders.

In finance the term leverage is used to denote the deployment of resources
such that returns to the shareholders are magnified. The returns of the
shareholders are variable, and therefore can be increased. The increase in the
shareholders wealth or return would take place if some resources with fixed
costs are deployed. Deploying resources with variable cost does not help as it
comes in direct conflict with the interest of shareholders. With favourable
conditions when the returns increase it would be shared among all. Hence the
shareholders would not benefit. If resources have fixed cost then the increased
return in business would leave more for the shareholders.

8.2 TYPES OF FIXED CHARGES
A typical profit and loss account of a firm can be condensed in following
format:

A. Revenue
B. Variable Costs: such as raw material, wages, electricity, sales
commission etc
C. Fixed Costs: such as rent, salaries, insurance, depreciation, etc
D. Total Cost (B + C)
8-2
E. Profit Before Interest and Taxes (commonly called EBIT) (A D)
F. Interest
G. Profit Before Taxes (PBT) (E F)
H. Taxes
I. Profit After Taxes

The PAT belongs to the shareholders. A look at the above representation of the
profit and loss account would reveal that there are two types of fixed charges.
There are fixed charges in the cost structure of the product by way of variable
costs and fixed costs. Fixed charges are the costs that have to be incurred
regardless of level of sales. Increasing fixed costs would cause an increase in
EBIT in times of increasing revenue.

The second fixed charge is incurred in terms of interest and emanates from
financing structure. All firms need capital. This capital can be arranged from
two types of sources debt and equity. The earnings derived from use of assets
have to be shared among the suppliers of capital. Debt has a fixed cost in
terms of interest rate while equity providers have residual claim left after
payment of interest and taxes, and therefore their claim is variable. It depends
upon level of sales, profit and interest and taxes. The study of financing structure
with respect to returns of shareholders forms a separate topic normally referred
as capital structure decision.

We study the impact of fixed cost on the shareholders return in two distinct
phases the fixed charge emanating from cost structure, and the fixed charge
emanating from financing structure.

8.3 OPERATING LEVERAGE
The presence of fixed charges in the cost structure magnifies the level of profit
with increase in revenue. As simple example consider a firm that hires sales
personnel purely on fixed salary or a share in profit. Assume there are 3 sales
personnel with one of fixed salary of Rs 20,000 and other two share the profit
equally. For revenue of Rs 60,000 the profit would be Rs 40,000 providing Rs
20,000 each to the two salesmen. For increase in revenue by 50% to Rs 90,000
the share of profit would rise to Rs 35,000 for each of the salesman while the
salesman with fixed salary continues to get Rs 20,000. This amounts to an
increase of 75% in the income of two salesmen with variable remuneration. If all
the three sales personnel were on variable remuneration the increased income
would have been Rs 30,000; an increase of 50% for an increase of 50% in
revenue. The situation is condensed in Table 8-1.

With all persons on variable remuneration the increase in remuneration was
proportional to the increase in revenue. There is 50% increase with revenue
increasing by 50%. With one person on fixed salary the increase remuneration
was 75% for a similar increase in revenue. Why the increase in the remuneration
was more than the increase in revenue by 50%. The precise reason for this was
that some component of cost got transformed from variable to fixed providing
opportunity to salesmen with variable remuneration to increase their reward.
This phenomenon is called operating leverage.


8-3
Table 8-1: Impact of Fixed Expenses in Cost Structure
Figures in Rs All three persons with
variable remuneration
One person with fixed and
two with variable
remuneration
Increase in revenue 50% 50%
Revenue 60,000 90,000 60,000 90,000
Fixed Salary - - 20,000 20,000
Profit 60,000 90,000 40,000 70,000
Income for salesmen
with variable
remuneration
20,000 30,000 20,000 35,000
% increase in variable
remuneration
50% 75%

8.3.1 Degree of Operating Leverage (DOL)
This ability of the firm to leverage the fixed cost to achieve more than
proportionate change in earnings is referred as operating leverage. It is
measured numerically by way of Degree of Operating Leverage (DOL), which is
defined as Equation 8-1.

F V) Q(P
V) Q(P
Cost Fixed Cost Variable Sales
Cost Variable Sales
Sales in Change %
EBIT in Change %
Sales
Sales
EBIT
EBIT
(DOL) Leverage Operating of Degree

..Equation 8-1

Excess of sales over variable cost is referred as contribution. Subtracting fixed
cost we get Earnings Before Interest and Taxes (EBIT). Hence operating leverage
is also defined as
EBIT
on Contributi
(DOL) Leverage Operating of Degree . Equation 8-2

For the data presented in Table 8-1 the degree of operating leverage (DOL) is
60,000/40,000 = 1.5 using Equation 8-2. DOL of 1.5 implies that for a 1% change
in revenue the EBIT would change by 1.5%. Therefore for an increase of 50% in
revenue the EBIT would increase by 1.5 x 50% = 75% as we found in Table 8-1.

Greater the degree of operating leverage greater would be the variability of
the profit level (determined by EBIT). In case of two firms the firm that has larger
DOL would have larger impact than the firm with lower DOL. For two
hypothetical firms A and B operating on the same level of sales and total cost
would have same level of EBIT. However the cost structures of the two firms are
different. The one with greater fixed costs would benefit more by increase in
revenue. The comparison of the two firms is presented in Table 8-2 with Firm A
having DOL of 1.00 and Firm B with DOL of 2.00.

8-4
Table 8-2: Operating Leverage: Effect of Change in Revenue on Earnings
Figures in Rs Firm A Firm B
Present Future Present Future
Sales 100 200 100 200
Variable Cost 80 160 60 120
Contribution 20 40 40 80
Fixed Cost - - 20 20
Earnings Before Interest and
Taxes (EBIT)
20 40 20 60
% Change in Sales 100% 100%
% Change in EBIT 100% 200%
Degree of Operating
Leverage
1.00 2.00

8.3.2 Properties of Degree of Operating Leverage
Some important observations about DOL are mentioned below that require no
explanation:
1. The minimum value of DOL is 1.0. As per definition it is contribution
divided by EBIT. DOL would always be larger than 1 because all firms
have some fixed costs. In an extreme but unlikely case of all cost
consisting of variable cost the value of DOL would be 1.
2. DOL does not remain static it changes with level of change in revenue.
For example for Firm B in the Table 8-1 the value of DOL at sales level of
Rs 100 was 2.00. At sales level of Rs 200 the value of DOL changes to 1.33
(Contribution/EBIT = 80/60). Any change from level of sales of Rs 200 the
EBIT would change by 1.33 times. Let us examine for a 30% increase in
sales. If sales now change to Rs 260 the contribution would be Rs 104 and
EBIT would be Rs 84. The increase in EBIT is Rs 24 i.e. 40% equal to 1.33 x
30%.
3. As level of sales increase the value of DOL would fall but at decreasing
rate and approach 1.00 for very high level of sales.
4. The value of DOL would be unique at each level of sales.
5. At breakeven point the value of DOL is infinity EBIT being zero.
6. Below breakeven level of operations the value of DOL would be
negative. The negative value does not imply opposite behaviours of
sales and EBIT. Negative values of DOL signify that the firm is operating
below breakeven point.

8.3.3 Degree of Operating Leverage and Risk
While we emphasised the magnification impact of DOL in case of increasing
sales, unfortunately this remains true for declining sales. Sales instead of rising
can fall too. If sales fall the firm with higher DOL would experience greater fall in
EBIT than the firm with lower DOL. Therefore DOL also signifies risk. It denotes
business risk of the firm. Business risk arises due to variability of sales. The
variability of sales arises due to business environment in which the firm operates.
It is a function of competitive scenario, demand situation, government policies,
consumer preferences, etc. Greater the DOL more risky is the return to
shareholders.
8-5

8.3.4 Degree of Operating Leverage - Applications
This provides an important management input. Though in most cases the cost
structure is governed by industry characteristics and there is a common belief
that little can be done by the management to configure the cost being
technology driven. However, there are a number of situations where the
management has the flexibility to determine whether to make cost fixed or
variable. For example building own premises or taking them on rent is one such
situation needing strategic management input. In case firm is optimistic of the
future potential it can deploy resources in fixed cost to benefit from booming
conditions by constructing the premises of its own. However, if the firm is
uncertain about the future it would be advisable to take office on rent. By
doing so, more costs become of variable nature. This keeps the DOL low. Similar
logic can be forwarded in case of owning vehicles or taking them on hire, or
owning the machines or leasing them.

With respect to manpower the decision rest with selecting people with fixed or
variable remuneration. Firms wanting to contain operational risk would opt for
subcontracting activities like payroll, maintenance, etc rather than hiring
personnel on its own. Such a decision would keep the degree of operating
leverage low implying reduced threat of business environment. However, such
decisions also limit the benefit of leverage in case situation turns out to be
promising later.

Here we are not concerned with the nature of cost. Conventionally rent, travel
cost, or lease rentals are treated as fixed cost rather than variable. However,
from viewpoint of strategic we need to consider the strategic nature of the item
of expenditure. The management philosophy in managing the risk is that if the
decision is reversible, it would be regarded as variable. In case of adversity the
management can reverse the decision.

Another way the management can hope to use the concept of operating
leverage is in the selection of product technology. Different technologies to
manufacture the same product have varying cost structures. Managers can
focus their attention on the cost structure associated with each technology
and choose the one that suits the requirements of levels of EBIT and the
acceptable level of its variability. Having made the choice the managers can
do little subsequently. DOL is fixed once the technology is chosen. Hence
operating leverage becomes a strategic issue rather than a tactical one.

It would be realised that choosing appropriate degree of operating leverage is
a managerial choice being a compromise between managements desire for
higher return and containing risk levels.

8.4 FINANCIAL LEVERAGE
As the firm faces a choice to keep cost structure fixed or variable, there are
many options available for the financing structure. The financing of assets can
be done from equity and/or debt. The debt is a fixed charge on the cash flow
generated by the asset. The cash flow entitlement for equity is variable
depending upon the level of cash flows generated by the asset.

8-6
This gives rise to the other kind of fixed natures of cost i.e. the fixed interest
payable on debt. This emanates from the capital structure where a firm
commits to pay fixed interest on debt. Besides debt there could be other similar
commitments to pay fixed charges for the funds deployed to acquire and
operate assets, independent of cash flow generated. These include preference
capital on which fixed rate of dividend is paid, and leased assets for which
fixed rentals are paid. Residual earnings after meeting fixed obligations are
used to service the shareholders, therefore making their claim variable.

Increased use of debt would magnify the returns of the shareholders much in
the same way the operating leverage does. Assume that a firm has financed its
assets with 100% equity of Rs 100 consisting of 10 shares of Rs 10 each. With no
debt and interest charges and assuming no taxes the entire EBIT belonged to
shareholders providing Rs 2.00 per share. In case the EBIT rises by 50% the new
level of EBIT would be Rs 30 and the earning per share (EPS) too would rise by
50% to Rs 3.00 per share.

Now let us consider the same assets financed by 50% debt at interest rate of
10%. The cost of debt is Rs 5. The total funding of Rs 100 comprises Rs 50 as debt
and consequently equity is Rs 50 consisting of 5 shares of Rs 10 each. For a level
of EBIT of Rs 20 the amount remaining for shareholders would be Rs 15 providing
EPS of Rs 3.00. In case the EBIT rises by 50% the new level of EBIT would be Rs 30
and shareholders would get Rs 25 providing EPS of Rs 5.00. The rise in the returns
for equity holders is more than proportionate. For an increase of 50% in EBIT the
returns grew by 67%.

The impact of financing on the returns of the shareholders is presented in Table
8-3.

Table 8-3: Impact of Fixed Expenses in Financing Structure
Figures in Rs Financing with no debt
Rs 100 as equity
(10 shares of Rs 10)
Financing with 50% debt
Rs 50 debt and Rs 50 equity
(5 shares of Rs 10)
Increase in EBIT 50% 50%
EBIT 20 30 20 30
Fixed Interest @ 10% - - 5 5
EBT 20 30 15 25
Taxes Assumed no taxes
Profit After Taxes 20 30 15 25
EPS 2.00 3.00 3.00 5.00
% increase in
shareholders return
50% 67%

Financial leverage refers to the use of debt financing and the resultant
sensitivity of the earnings available to shareholders i.e. EPS by the substitution of
their capital with the fixed charge finance, as is evident from the data of Table
8-3. If the firm has no debt then any change in the levels of EBIT will be
transferred to shareholders as it is. The change in the shareholders wealth would
be same as the change in EBIT. EBIT would change only due to business risk and
with no debt entire business risk is borne by shareholders.

8-7
However, if some of the equity capital is substituted by the fixed charge capital
the change in the EPS will be larger as compared to all equity financing option.
Replacing equity with debt leaves the risk with the remaining equity
shareholders. Debt compounds the business risk for the remaining shareholders.

8.4.1 Degree of Financial Leverage (DFL)
Just as we defined the impact of fixed cost over the changes in EBIT through
degree of operating leverage, we would measure the impact of change in EBIT
over EPS with degree of financial leverage (DFL). Fixed cost in the cost structure
magnified the EBIT for a change in sales. Similarly as seen from data of Table 8-3
the EPS was magnified by element of fixed cost in the financing structure. If
there were no capital with fixed cost the changes in EPS would be
proportionate with change in EBIT. Use of debt causes the fixed charge on the
capital by way of interest and since this fixed capital replaces more expensive
equity the remaining equity earns a greater return.

Financial leverage is defined by Equation 8-3 as below

T) - /(1 D - I - EBIT
EBIT
EBIT in Change %
EPS in Change %
EBIT
EBIT
EPS
EPS
(DFL) Leverage Financial of Degree
p

Equation 8-3
Where I = Interest on debt and all fixed financing charges which are tax
deductible, and
DP = Fixed dividend on preference capital and all other fixed financing
charges which are not tax deductible.

Equation 8-3 incorporates a factor of (1 T) for dividend on preference capital.
The reason is simple. While interest on debt is tax deductible the preference
dividend is not. A interest of Rs 10 on debt and preference dividend of Rs 10 are
not equivalent. For a tax rate of 40% the pre-tax cost of preference dividend is
not Rs 10 but Rs 10/0.6 = Rs 16.67 i.e. the firm would have to earn Rs 16.67 to pay
preference dividend of Rs 10 because it first has to pay a tax of Rs 6.67 (40% of
Rs 16.67).

Computing the degree of financial leverage in data of Table 8-3 the 100%
financing mode has DFL of 1.00, The DFL with 50% debt financing using Equation
8-3 is 20/15 = 1.33. A change in the level of EBIT by 50% therefore must change
the EPS by 1.33 x 50 = 67%. This was the precisely the change in the EPS when it
rose by Rs 2.00 from Rs 3.00 to Rs 5.00; a change of 67%.

8.4.2 Properties of Degree of Financial Leverage
The characteristics of DFL are similar to that of DOL stated as below:
1. The minimum value of DFL is 1.0. As per definition it is EBIT divided by (EBIT
Interest). DFL would always be larger than 1 because all firms have
some fixed costs of interest. In an extreme case of all funding consisting
of equity the value of DFL would be 1.
2. DFL does not remain static it changes with level of change in EBIT. For
example for the 50% financing in the Table 8-3 the value of DFL at EBIT
level of Rs 20 was 1.33. At EBIT level of Rs 30 the value of DFL changes to
8-8
1.20 (EBIT/(EBIT Interest) = 30/25). Any change from EBIT level of Rs 30 the
EPS would change by 1.20 times. Let us examine for a 30% increase in
EBIT. If EBIT now change to Rs 39 the EPS would be Rs 6.80. The increase in
EPS is Rs 1.80 i.e. 36% equal to 1.20 x 30%.
3. As level of EBIT increases the value of DFL would fall but at decreasing
rate and approach 1.00 for very high level of EBIT so that the impact of
cost of debt reduces to almost negligible.
4. The value of DFL would be unique at each level of sales.
5. At breakeven point the value of DFL is infinity EBIT being zero.
6. Below breakeven level of operations the value of DFL would be
negative. The negative value does not imply opposite behaviours of EBIT
and EPS. Negative values of DFL signify that the firm is operating below
breakeven point.

8.4.3 Degree of Financial Leverage and Risk
As DOL measures the business risk of the firm, DFL reflects upon the financial risk
of the firm i.e. the sensitivity of shareholders returns due to financing mix of debt
and equity in creating the assets. Larger the amount of debt would imply
greater amount of fixed charges of financing. To the increased extent of debt
the financing by equity would reduce correspondingly. Increase amount of
interest would increase the degree of financial leverage making returns to the
shareholders more sensitive.

Just as the DOL magnifies the returns, DFL too increases EPS. At the same time
the returns become more risky with higher degree of financial leverage. As the
rise with increasing level of EBIT is magnified so would be the fall in case of
decreasing EBIT. Degree of financial leverage denotes the financial risk i.e. the
risk carried due to financing structure of the firm. This essentially means that the
level of EBIT, which is a function of earning capacity of the asset, is kept
constant. The impact of changes in EBIT is measured by degree of operating
leverage.

Just as the management may decide the cost structure depending of business
scenario to whatever extent possible, the management has a choice of
selecting the financing structure from many available alternatives. While
flexibility of the management to control the degree of operating leverage is
limited, selecting appropriate degree of financial leverage is not as much
constrained.

8.5 DEGREE OF TOTAL LEVERAGE
We segregated the impact of changes in business environment and the
financing environment by way of degrees of operating leverage and degree of
financial leverage respectively. The combined impact on the shareholders
return due to changes in the business environment and financing structure is
estimated by degree of combined/total leverage.
8-9


Table 8-4: Total Leverage and EPS
Figures in Rs Firm A
No leverages
Firm B
With Operating and
financial leverages
Debt
Equity
Nil
10 shares of Rs 10 each
Rs 50 @10%
5 shares of Rs 10 each
Increase in Sales 50% 50%
Sales 100 150 100 150
Variable cost 80 120 60 90
Contribution 20 30 40 60
Fixed Cost - - 20 20
EBIT 20 30 20 40
Fixed Interest @ 10% - - 5 5
EBT 20 30 15 35
Taxes Assumed no taxes
Profit After Taxes 20 30 15 35
EPS 2.00 3.00 3.00 7.00
DOL
DOL = Contribution/EBIT
=20/20 = 1.00
DOL = Contribution/EBIT
=40/20 = 2.00
DFL
DFL = EBIT/(EBIT Interest)
=20/20 = 1.00
DFL = EBIT/(EBIT Interest)
=20/15 = 1.33
DTL
DOL x DFL
= 1.00 x 1.00 = 1.00
DOL x DFL
= 2.00 x 1.33 = 2.66
% increase in
shareholders return
50% 133%

Degree of total leverage is given by product of DOL and DFL. It is given by
Equation 8-4.

Interest EBIT
on Contributi
Interest EBIT
EBIT
x
EBIT
on Contributi
DFL x DOL (DTL) Leverage Total of Degree

Equation 8-4

For example consider two firms A and B with same level of operations. Firm A
has all variable cost and is funded 100% by equity. Hence values of DOL and
DFL are 1.00 and degree of total leverage too is 1.00. It implies that any change
in the business risk causing a change in sales would be reflected in shareholders
return proportionately. Firm B has fixed cost in the cost structure and financing
structure. Its total cost is same as that of Firm A providing same EBIT but part of
the cost is fixed. Its degree of operating leverage is 2.00. Similarly it has financed
the operations partly by debt reducing equally the equity. The degree of
financial leverage is 1.33.Hence it degree of total leverage is 2.66.

The cost structure and financing structures of two firms are presented in Table 8-
4. For Firm A with increase in sales of 50% the earnings to shareholders rise by
50% DTL being 1.00. However for Firm B the rise in the shareholders earnings for
8-10
50% increase in sales is more than proportionate. The increase is Rs 4 from Rs 3
to Rs 7. The rise of Rs 4 is Rs 50% x 2.67 = 133% of earlier earnings of Rs 3.

As with the rise in sales the earnings of Firm B increase more than
proportionately they would fall more rapidly in case of decrease in sales too.
Therefore DTL represents the aggregate of business and financial risk. The
implication of DTL is that the firm can look at the total risk. Inability to control the
degree of operating leverage can be compensated by having an appropriate
degree of financial leverage. Control over financing structure is relatively
unconstrained as compared to control over degree of operating leverage.

Deployment of leverage has both good and bad effects. While leverage
enhances the earnings to the shareholders it also makes them more risky.
Leverage becomes the choice between reward and risk. Desire for increased
reward has to be followed with increased risk.

8.6 EBIT EPS ANALYSIS
Another tool to examine the impact of debt on the returns of the shareholders is
EBIT EPS analysis. We know that the returns on equity can be enhanced with
borrowings. What is the optimum level of borrowing would depend upon the
target level of returns that the shareholders seek. To analyse the various options
we resort to analysis of change in EPS with changing capital structure i.e. the
debt equity ratio.

We observe that the return on equity increases as the debt ratio increases.
Mathematically the Return on Equity, RoE is expressed as % post tax earnings
after paying the interest on debt as stated in Equation 18-3.
E
T) I)(1 (EBIT
RoE Equity, on Return

.. Equation 8-5

Assume that a project of Rs 1,000 can be financed with following two options
Option I:
With 100% equity financing by issue of 100 lac equity shares at price of Rs 10.

Option II:
With debt of Rs 500 lacs at cost of 12% and balance 5 crore by issue of 50
lac shares at price of Rs. 10

Assuming that return on asset is 14% the EBIT would be Rs 140 lac. With no debt
and tax rate of 30% the return on equity would be

% 80 . 9
1000
70 . 0 x 140
E
T) I)(1 (EBIT
RoE Equity, on Return


The return on equity with debt of Rs 500 lacs at 12% would be

% 20 . 11
500
70 . 0 x ) 60 140 (
E
T) I)(1 (EBIT
RoE Equity, on Return

With increasing debt replacing equity the return on equity can be increased.
The rise in ROE is slower at lower levels of debt but becomes is steep higher
levels of debt. Depending upon the level of return on equity desired one may
fix the target capital structure. At the same time increased debt would make
8-11
the ROE riskier too. To understand the implications of debt financing on the
returns to the shareholders, we compare the earnings available to the
shareholders (EPS) with various financing alternatives.

Here we compare the two options in Table 8-5 for varying levels of return on
asset.

Table 8-5: Evaluating Financing Plan with Changing Business Risk
Investment 1,000 Rs Lacs
Return on Assets 6% 8% 10% 12% 14% 16% 18% 20%
OPTION I: ALL EQUITY FINANCING
EBIT 60 80 100 120 140 160 180 200
Interest - - - - - - - -
EBT 60 80 100 120 140 160 180 200
Tax 30% 18 24 30 36 42 48 54 60
PAT 42 56 70 84 98 112 126 140
Nos. of shares 100 100 100 100 100 100 100 100
EPS (Rs/Share) 0.42 0.56 0.70 0.84 0.98 1.12 1.26 1.40
OPTION II: 50% EQUITY & 50% DEBTFINANCING
EBIT 60 80 100 120 140 160 180 200
Interest 60 60 60 60 60 60 60 60
EBT - 20 40 60 80 100 120 140
Tax 30% - 6 12 18 24 30 36 42
PAT - 14 28 42 56 70 84 98
Nos. of shares 50 50 50 50 50 50 50 50
EPS (Rs/Share) - 0.28 0.56 0.84 1.12 1.40 1.68 1.96

We can see from Table 8-5 that it is not necessary that debt is always a
preferred option. The cost of debt is 12%. The post tax cost of debt would be
12% x (1-T) = 12 x 0.7 = 8.40%. If the return on the asset is greater than 8.40% the
debt option is preferred. It would be so because the return on asset would more
than cover the cost of debt, the differential accruing to the shareholders. In
case the return on asset is less than the cost of debt there would be erosion in
return on equity as the deficit would have to be borne by shareholders. In such
a case debt would prove more damaging as compared to equity financing.

The EPS as measure of return on equity for the two financing alternatives is
depicted in Figure 8-1.

8-12

Figure 8-1: EBIT EPS Analysis; A Graphical View


Following may be observed from Figure 8-1

For higher levels of EBIT the EPS is higher with debt while for lower levels of
EBIT, debt is an inferior option because EPS is higher with equity financing.

The rise of EPS in case of levered firm is steeper as compared to all equity
financed firm as can be seen from the slope of the two lines.

When the business scenario is not as good as expected the EPS in an all
equity firm be greater than the firm with debt financing.

8.6.1 Point of Indifference
The general effect of substitution of equity with debt is the earnings for the
equity shareholders are enhanced, as cheaper debt replaces more expensive
equity. Further, while the EPS for the shareholders increases its variability also
increases. This is indicated in the greater slope of EBIT-EPS line with debt.

Since slope of the EBIT-EPS line with debt is steeper than the one with pure
equity. Larger the debt greater is the slope. EBIT-EPS lines with different amounts
of debt would have varying slopes and hence would intersect at some point.
The level of EBIT at which the EPS with two different financing plans are equal is
called the point of indifference. At this point both the financing plans are same
from the view point of shareholders. It may be observed in Figure 8-1 that at EBIT
level of Rs 120 lacs the EPS under all equity option and 50% debt option is equal.

It can easily be derived from the following equation:

8-13
2
2
1
1
n
) T 1 )( I * EBIT (
n
) T 1 )( I * EBIT ( - - - -
. Equation 8-6
Where EBIT* = Level of EBIT for point of indifference
T = Tax Rate
I1 and I2 = Interest payments under financing options 1 and 2
respectively.
n1 and n2 are the numbers of shares under financing options 1 and
2 respectively

For the two financing options of 100% equity and 50% debt the point of
indifference is at EBIT of Rs. 120 lacs as shown below:
lac 120 Rs = EBIT* gives
50
-50)x0.7 * (EBIT
=
100
-0)x0.7 * (EBIT
n
) T 1 )( I * EBIT (
n
) T 1 )( I * EBIT (
2
2
1
1
- - - -

And the EPS under both the financing options at EBIT of Rs 120 lac is Rs 0.84.

The point of indifference of EBIT for the two financing options provides an
important decision making parameter while comparing the financing options. It
is a guiding tool for the managers to compare any two financing options and
make a choice between the two. If the level of EBIT for the point of indifference
is relatively low and managers are fairly confident of achieving that level then
the firm may decide to use increased level of leverage to maximise the EPS that
in turn maximises the shareholders wealth. However, if the EBIT at point of
indifference appears to be higher than the expected level, it is advisable to
decide the financing structure more in favour of equity. In a way, point of
indifference provides an insight to the level of risk the firm faces with respect to
the level of EBIT.

SOLVED PROBLEMS

Example 8-1: Understanding DOL
Pet Computers is operating at a level of sales of Rs 800 lacs having Rs 400 lacs
(50%) as variable cost and Rs 200 lacs as fixed expenses. What changes in profit
do you expect if the sales a) rise by 10% and b) decline by 10%?

Solution:
The Degree of Operating Leverage (DOL) of the firm is
00 . 2
200 - 400 - 800
400 - 800
Cost Fixed - Cost Variable - Sales
Cost Variable - Sales


This implies that 1% change in sales would result in 2% change in earnings.
Hence 10% decline in sales would cause income to fall by 20% and likewise 10%
rise in sales would result in 20% increase in income. This may be verified from the
following brief projections:
All figures in lacs
Current level 10% increase 5% decrease
Sales 800.00 880.00 720.00
Variable Cost (62.5%) 400.00 440.00 360.00
8-14
Fixed Cost 200.00 200.00 200.00
Profit 200.00 240.00 160.00
% change +20% -20%

Example 18-2: Understanding DFL
Suruchi Corporation has a project costing Rs 1800 lacs with expected earnings
of Rs 200 lacs under normal conditions. These earnings can change by 25%
respectively if the business scenario is good or is under recession. It can fianc
the project either by 100% equity by issuing 10 lacs shares issued at Rs 180 per
share or avail loan Rs 900 lacs at interest of 10% and issue 5 lacs shares at Rs 180.
a) What is the degree of financial leverage for Suruchi Corporation under
100% financing arrangement and with 50% debt?
b) What interpretations do you assign to the value of DFL?

Solution:
a) Calculation of DFL for both the options are as below:
100% equity 50% equity
EBIT 200.00 200.00
Interest, I - 90.00
EBT 200.00 110.00
Nos. of shares 10.00 5.00
EPS 20.00 22.00
DFL {EBIT/(EBIT I)} 1.00 1.82

b) With 100% equity financing the DFL is 1 indicating equivalent change in EPS
with EBIT. A 25% rise/fall in sales will lead to 25% rise/fall in EPS. Hence
expected EPS would be Rs 25and Rs 15 under conditions of expansion and
recession. Financing with 50% debt has larger DFL of 1.82. A 25% rise/fall
would change EPS to Rs 27.50 or Rs 16.50.

Example 8-3: EBIT EPS Analysis: Comparing Financing Plans
A firm is considering implementation of a project costing Rs 300 crore. The
current market price of its shares is Rs 75. It has got following two financing plans
available:
PLAN A : Raise 25% debt at 9% and remaining 75% by issue of shares at
market price
PLAN B : Raise 75% debt at 9% and remaining 35% by issue of shares at
market price

The firm expects a return on assets of anywhere between 6% and 20%. It
attracts a tax rate of 40% on its profit.
Find the following
a) EPS for Plan A and Plan B under all the entire range of return on the asset.
b) Plot the EPS against varying levels of EBIT
c) Which financing plan would you prefer if returns on asset is i) 8%, and ii)
16%?
d) At what level o f EBIT would you be indifferent to financing plan?

Solution:
a) The EPS for Plan A and Plan B are worked out below for levels of EBIT from
6% to 20%:
8-15
Plan A Plan B
Debt, Rs crore 75.00 225.00
Equity, Rs crore 225.00 75.00
Market Price, Rs Rs 75 Rs 75
Nos. of shares (crore) 3.00 1.00

Investment 300 Rs crore
Return on
Assets 6% 8% 10% 12% 14% 16% 18% 20%
PLAN A:75% EQUITY FINANCING; 25 % DEBTAT12.5%
EBIT 18.00 24.00 30.00 36.00 42.00 48.00 54.00 60.00
Interest 9.00 9.00 9.00 9.00 9.00 9.00 9.00 9.00
EBT 9.00 15.00 21.00 27.00 33.00 39.00 45.00 51.00
Tax 40% 3.60 6.00 8.40 10.80 13.20 15.60 18.00 20.40
PAT 5.40 9.00 12.60 16.20 19.80 23.40 27.00 30.60
Nos. of shares 3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00
EPS (Rs/Share) 1.80 3.00 4.20 5.40 6.60 7.80 9.00 10.20
PLAN B: 25% EQUITY & 75% DEBTFINANCING
EBIT 18.00 24.00 30.00 36.00 42.00 48.00 54.00 60.00
Interest 27.00 27.00 27.00 27.00 27.00 27.00 27.00 27.00
EBT -9.00 -3.00 3.00 9.00 15.00 21.00 27.00 33.00
Tax 30% -3.60 -1.20 1.20 3.60 6.00 8.40 10.80 13.20
PAT -5.40 -1.80 1.80 5.40 9.00 12.60 16.20 19.80
Nos. of shares 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00
EPS (Rs/Share) -5.40 -1.80 1.80 5.40 9.00 12.60 16.20 19.80

b) The plot of EPS for varying levels of EBIT for the two plans is depicted
below:

c) For 8% return the Plan B is loss making while Plan A is profit making. Hence
we would prefer Plan A. For EBIT at 16% Plan B is more profitable and
hence it would be preferred.


d) At an EBIL level of Rs 36 crore the EPS under both the plans would be
equal at Rs 5.40 as worked out below:

crore 36 Rs = EBIT* gives
1
-27.0)x0.6 * (EBIT
=
3
-9.0)x0.6 * (EBIT
n
) T 1 )( I * EBIT (
n
) T 1 )( I * EBIT (
2
2
1
1
- - - -

8-16



KEY TERMS

Operating
Leverage
The impact of deploying fixed cost in the cost structure on
the operating profits of the firm is called operating leverage.

Degree of
Operating
Leverage
% change in the operating income due to 1% change in
revenue is degree of operating leverage. It is a measure of
business risk and the sensitivity of earnings with revenue.

Financial
Leverage
Financial leverage refers deployment of debt and its impact
on the shareholders earnings.

Degree of
Financial
Leverage

Degree of financial leverage is the % change in the earning
per share with 1% change in EBIT

EBIT-EPS
Analysis
EBIT-EPS analysis is study of EPS for varying levels of EBIT. It is
done for choosing one of the various financing options
available.

SUMMARY

Use of fixed charge in the earnings statement of the firm can be used to
magnify the income. This is referred as leverage. These fixed changes on the
cash flow of the firm are of two types; one emanating from the cost structure
and the other from the financing structure.

8-17
The costs are of types; fixed and variable. Higher the proportion of fixed cost
greater is the increase or decrease in the earnings. When revenue exceeds
expectations, the firm employing larger fixed cost would see a greater rise in
earnings. Similarly the fall too would be larger if revenues are lower than
expected. This is known as operating leverage. Degree of operating leverage is
the sensitivity of the earnings with change in sales. It is a measure of business risk
the firm carries and is measured by % change in earnings with 1% change in
sales.

Like the fixed cost in the cost structure the firms also have fixed cost in their
financing structure. These fixed charges from the financing structure arise from
the use of debt. As we substitute equity with debt the returns to the remaining
equity holders become larger and larger. This happens due to cheaper cost of
debt. As interest costs increase the sensitivity of the shareholders return
measured as EPS also increases. A firm that uses more debt can enhance
earnings to the shareholders in good times but make them poorer in bad time
as compared to a firm with lesser amount of debt. The change in earnings to
the shareholders with changes in the EBIT is called degree of financial leverage.
It represents the financial risk of the firm as it emanates from the financing
structure.

The risk of the returns to shareholders can be measured by degree of total
leverage, which is the product of DOL and DFL. It gives the change in EPS with
change in sales. It is a composite measure to risk and combines the business risk
and financial risk.

EBIT-EPS is analytical tool that helps in analysing the different financing plans a
firm may have so as to determine what is best suited to them. A graphical
representation of EBIT-EPS analysis clearly depicts the relationship of EPS with
changing levels of EBIT. The slope of the line would reflect the sensitivity of EPS.
The financing plan that uses larger amount of debt would be steeper indicating
a greater rise or fall with same change in EBIT. With desired level of returns to the
shareholders and most likely EBIT level the firm may decide upon a most
favourable financing plan.

SELF ASSESSSMENT QUESTIONS

1. What do you understand by business risk? How can this be measured?
2. What is degree of operating leverage and how can it be used for
determining the capital structure.
3. What is meant by financial leverage? What is the measure of financial
risk of the firm?
4. List the various properties of degree of operating leverage and degree
of financial leverage.
5. With the help of a graph explain the relationship of EBIT and EPS with
changing financing plans?
6. What does point of indifference on the EBIT-EPS analysis signify? What
happens when the EBIT level is below and above the point of
indifference?

FURTHER READINGS
8-18

1. Srivastava & Misra (2008), Financial Management, Oxford University Press,
Chapter 17
2. M Y Khan and P K Jain (2004), Financial Management: Text, Problems
and Cases, Tata McGraw Hill, Chapter 14
3. I M Pandey (2005), Financial Management, Vikas Publishing House Pvt
Ltd, Chapter 14

9-1
UNIT 9

THEORIES OF CAPITAL STRUCTURE

9.0 OBJECTIVE
The objective of this unit is to
a) Explain the meaning of optimal capital structure
b) Describe theories of capital structure such as net income approach and
net operation income approach
c) Describe Miller and Modigliani (MM)propositions for irrelevance of
capital structure
d) Describe how MM approach changes when corporate taxes are
present
e) Explain financial distress and trade off theory of capital structure
f) Explain some practical considerations that matter in deciding the
capital structure.

9.1 INTRODUCTION
The issue of capital structure revolves around how the value of the firm is
affected by the capital structure. It is perhaps the key strategic decision that
has occupied much of the time and attention of academicians and managers
alike. Capital structure decision related to the proportion of debt and equity
and finding out whether is there a capital structure that can be said to be
optimum for the shareholders of the firm.

We know there are primarily two sources of funds i.e. debt and equity. Since the
cost of debt is lower than the cost of equity one may be inclined to believe that
financing of asset by progressively increasing proportions of debt would
increase the value of the firm. The question of capital structure deals with
whether a firm must borrow and if yes to what extent so as to increase the
value of the firm. Unfortunately there is no definite answer available. However,
there are conflicting theories about the existence of optimum capital structure.
We would examine if these theories that advocate relevance or irrelevance of
capital structure for determination of the value of the firm. If relevant the firms
must strive to achieve the desired capital structure if irrelevant, one should
ignore the issue of capital structure.
9.2 ANALYTICAL FRAMEWORK
Before we analyse different theories pertaining to capital structure, we state the
framework under which the decision of capital structure would be examined.

In all the analysis to find the impact of capital structure, the aggregate amount
of the different forms of capital needs to be kept constant. Any increase in the
aggregate resources would increase the size of the firm and enhance the
earning capacity. This would change the value of the firm for two reasons
increase in resources of the firm, and change in capital structure. In such a
case isolating the impact of changing capital structure would indeed be
difficult.

9-2
The direct implication of keeping the earning capacity of the firm constant is to
keep the asset base or capital employed unchanged. Hence for analysing the
impact of changes in the capital structure increasing one form of capital would
mean an equivalent decrease in another form of capital, so that the total
resources are held constant.

For varying capital structure, we may compute the value of the firm to examine
if there is an optimum capital structure. At times it may be easier to compute
the cost of capital than computing the value of the firm. Alternative hypothesis
can be that minimisation of weighted average cost of capital implies
maximisation of the firm. The cost of debt and equity the two primary sources of
supply of capital and weighted average cost of capital are given as Equations
9-1, 9-2 and 9-3 respectively.
3 - 9 uation ........Eq
E + D
EBIT
=
firm the of value Market
suppliers capital all to Earnings
= r WACC;
2 - 9 .Equation ..........
E
I - EBIT
=
equity of value Market
rs shareholde equity for Earnings
= r Equity; of Cost
1 - 9 qaution .........E ..........
D
I
=
debt of value Market
Interest
= r Debt; of Cost
e
d


With the objective of maximisation of the value of the firm we now consider the
various approaches to finding optimum capital structure.

9.3 NETINCOME APPROACH
Net income approach for capital structure focuses on the cash flows to the
respective suppliers of capital and their capitalisation. As we all know debt
suppliers get interest on the amount of debt provided by them and equity
holders get the residual.

Important assumption of net income approach is that the cost of debt as well
as equity remains constant irrespective of level of debt. It implies that suppliers
of debt and equity capital are not concerned with the proportion of debt firm
has. Instead they are concerned only with their desired returns respectively. The
expected returns of the debt and equity holders are governed by Equation 9-1
and 9-2 respectively.

Assume a firm is implementing a project costing Rs 10 crore. The assets are
expected to yield an EBIT of Rs 5 crore every year. We analyse 3 scenarios of
debt and equity to implement the project with three different debt equity ratios
of 9:1, 1:1 and 1:9. Further it is assumed that the debt and equity demand a
return of 8% and 25% respectively. Further we assume no taxes. With debt equity
ratio of 1:9 the market values of debt, equity, WACC, and total value of the firm
are computed as per Equations 9-1, 9-2 and 9-3 respectively.

24.18% = .
1968 + 100
500
=
E + D
EBIT
=
firm the of value Market
suppliers capital all to Earnings
= r WACC;
lacs. 1,968 Rs =
0.25
492
=
r
rs shareholde equity for Earnings
= E Equity; of Value Market
lacs 100 Rs =
0.08
8
=
r
Interest
= D Debt; of Value Market
e
d


9-3
Value of the firm =value of debt + value of equity =100 +1,968 =Rs 2,068 lacs.

Using same method we also compute the values of debt, equity, WACC and
firm for the two other modes of financing. The outcome is presented in Table 9-
1.

TABLE 9-1: NETINCOME APPROACH Rs. in lacs
D:E = 1:9 D:E = 1:1 D:E = 9:1
Project Cost 1,000.00 1,000.00 1,000.00
Sources of Finance
Equity (Book Value)
Debt (Book Value)

900.00
100.00

500.00
500.00

100.00
900.00
Capitalisation Rate
Equity, re
Debt, rd

25%
8%

25%
8%

25%
8%
EBIT 500.00 500.00 500.00
Interest (I) 8.00 40.00 72.00
EBT 492.00 460.00 428.00
Taxes Assumed no taxes
Earnings available to
shareholders
492.00 460.00 428.00
Market value of debt (I/rd) 100.00 500.00 900.00
Market value of equity
(EBIT I - Taxes)/re
1,968.00 1,840.00 1,712.00
Total Value of the firm 2,068.00 2,340.00 2,612.00
Overall capitalisation rate (r) 24.18% 21.37% 19.14%




Since the capitalisation rate of debt is lower than that of equity the overall
capitalisation rate of firm would keep declining, and total value of the firm
would keep increasing with increasing debt ratio. According to Net Income
Approach therefore the optimal capital structure is 100% debt.

A graphical view of rates of return with different levels of debt is presented in
Figure 9-1.
Figure 9-1: NETINCOME APPROACH: CAPITALISATION RATES
Rates of
Return

re



r



rd


D/E
0 1.00
9-4

Assuming no taxes the relationship among the cost of capital, cost of equity
and cost of debt can be stated by following Equation 9-4.
D E
D
r
D E
E
r r
d e
+
+
+
= Equation 9-4

9.4 NETOPERATING INCOME APPROACH
In the net income approach we assumed that suppliers of debt and equity are
indifferent to how much the other party contributes to the firm. Their aspirations
of return were independent of each other. The value of the firm was aggregate
of the values of debt and equity.

Under Net Operating Income approach, we assume that the value of the firm
remains constant, because the asset base of the firm has not changed. If total
resources available remain same the firm would have same value irrespective
how much debt or equity it has. The basic premise of Net Operating Income
approach is that the net operating income of the assets is constant. It cannot
change simply because sources of finance to acquire these assets should have
no impact on the earning capacity of the asset.

Therefore in terms of the cost this approach assumes that the total cost of
capital remains constant regardless of the level of debt. As cheaper debt
replaces equity, the shareholders recognise the increased level of threat to
their returns and hence revise their expectations of return. The market
capitalisation rate of equity adjusts exactly to offset the advantage of cheaper
debt. As such overall capitalisation rate remains constant. Changing capital
structure will merely allocate the proportions of cash flows between suppliers of
debt and equity capital.

We analyse the same data in Table 9-2 with the net operating income
approach with modified assumptions of keeping the value of the firm constant
at Rs 2,500 lacs at overall capitalisation rate of 20%, and accordingly adjusting
the value of equity. This value of equity would determine the equity
capitalisation rate.

lacs 2,500 Rs.
0.2
500
=
r
suppliers capital all to Earnings
= firm the of value Market =

For debt level of 10% the value of debt is same at Rs 100 lacs.

The market value of equity is the difference between total value and the value
of debt i.e. 2,500 100 = Rs 2,400 lacs. Likewise we may find the market value of
equity for the other two scenarios of capital structures as done in Table 9-2.
9-5
Figure 9-2: NETOPERATING INCOME APPROACH: CAPITALISATION RATES

Rates of
Return


r
e



r
0

r

r
d



0 D/E


Table 9-2: Net Operating Income Approach Rs. in lacs
D:E = 1:9 D:E = 1:1 D:E = 9:1
Project Cost 1,000.00 1,000.00 1,000.00
Sources of Finance
Equity (Book Value)
Debt (Book Value)

900.00
100.00

500.00
500.00

100.00
900.00
Capitalisation Rate
Debt
Overall

8%
20%

8%
20%

8%
20%
EBIT 500.00 500.00 500.00
Interest (I) 8.00 40.00 72.00
EBT 492.00 460.00 428.00
Taxes Assumed no taxes
Earnings available to
shareholders (EAT)
492.00 460.00 428.00
Market value of debt (I/rd) 100.00 500.00 900.00
Market value of firm
(EBIT/r)
2,500.00 2,500.00 2,500.00
Value of equity (E) 2,400.00 2,000.00 1,600.00
Equity capitalisation rate
(EAT/E)
20.50% 23.00% 26.75%

With overall capitalisation rate, r and cost of debt, rd constant the cost of equity
would rise as ratio of debt increases. If we denote the capitalisation rate for an
all-equity financed firm as r0, then at any level of debt the WACC, r too must
equal r0. Therefore we may write
d e 0
r
D E
D
r
D E
E
r
+
+
+
= .. Equation 9-5

Equation 9-5 can be rewritten as to express the cost of equity as function of
debt equity ratio as Equation 9-6.



The graphical view of net operating income approach is given in Figure 9-2.
6 - 9 uation ........Eq .......... .......... .
E
D
) r - (r + r = r
d 0 0 e
9-6

The major implication of net operating income approach is that all capital
structures are optimal. Alternatively stated none of the capital structure is
optimal.

9.5 MODIGLIANI AND MILLER (MM) THEORY WITHOUTTAXES
Franco Modigliani and Merton Miller, known as MM made a case in favour net
operating income approach providing behavioural justification for the
irrelevance of capital structure in determination of the value of the firm. They
postulated three propositions regarding capital structure under two conditions
of a) no taxes and b) with corporate taxes. We first examine their propositions
with no taxes.

9.5.1 PROPOSITION I (No Taxes)
MM proposition I under no taxes is:
The market value of the firm is independent of its capital structure
and is given by capitalising its expected return at a rate
appropriate to its class.

The total value of the firm remains same and is determined by its assets. It does
not matter how these are acquired. The earning capacity of the assets remains
same and the manner of financing only decides the nature of claims of
different suppliers of capital on these earnings. The capital structure only
changes distribution of earnings not the aggregate earnings per se. Therefore

VU =VL Equation 9-7

Where VU and VL are the market values of unlevered (firm with no debt) and
levered (firm with some debt) firms respectively

9.5.2 PROPOSITION II (No Taxes)
MMs Proposition II provides a relationship of the expected return on equity as
the leverage increases, in terms of overall capitalisation rate and the capital
structure. It is stated as below:

The expected yield on the equity capital is equal to the pure equity
return plus a premium for the financial risk which is equal to spread
between pure equity return and cost of debt in the proportion of
debt equity ratio.

In an all equity firm the entire cash flows belong to the shareholders. They
assume all the business risk and there is no financial risk. There is no superior
claim on the cash flow of the firm. In such a case the cost of equity would be
opportunity cost. Let us call this pure equity return as r0. This capitalisation rate
will be equal to the expected returns from the assets.

Even though the total value remains constant the debt equity ratio causes
important changes in the values of debt and equity. The cost of equity in the
levered firm re will rise as the leverage increases thereby changing the value of
equity. The cost of equity in a levered firm will be as given in the net operating
income approach is given by Equation 9-6 reproduced here.
9-7



Hence the cost of equity, re depends upon, the required rate of return on the
assets, r0, the required rate of return by the debt holders, rd and the D/E, the
debt equity ratio. The cost of equity is a linear function of debt equity ratio with
the slope given by difference of the asset capitalisation rate and the cost of
debt.

9.5.3 PROPOSITION III
This provides rule for evaluating WACC. It states

the cut-off rate for investment purposes will in all cases be
WACC and will be completely unaffected by the type of
security issued to finance the investment.

WACC of the unlevered firm will be given by r0. WACC for the levered firm
would also be r0 as can be seen below







9.6 THE ARBITRAGE ARGUMENT
The proposition I of MM is no different than Net Operating Income approach.
The assumption that overall capitalisation rate remains constant due of exact
offsetting effect of on the cost of equity with increased leverage of Net
Operating Income Approach is proved by MM.

Consider two firms, U and L identical in all respects except their capital
structure. The asset base of both the firms is Rs 50 lac that provides 20% return
with EBIT of Rs 10 lac. Firm U is unlevered having no debt while Firm L has 60% (Rs
30 lac) debt costing 10%. The comparative performance of Firms U and L is
presented in Table 9-3.

Table 9-3: Financial Data of Levered and Unlevered Firms
Figures in Rs lac
No Debt, U With Debt, L
EBIT 10 10
Interest @ 10% - 3
EBT 10 7
Taxes (Assumed no taxes) - -
EAT 10 7
Cash flow to capital providers 10 10
Market value of debt - 30
Market value of equity,
capitalisation rate 20%
50 35
Value of the firm 50 65
0
d 0 0 e
d e
r firm unlevered WACC firm levered for WACC
get we ,
E
D
) r (r r r e. i. II n Propositio Using
8 - 9 Equation .......... ..........
D + E
D
r +
D + E
E
r = firm levered for WACC
= =
+ = -
E
D
) r r ( r r
d 0 0 e
- + =
9-8
The value of the firm would be sum of the value of debt and value of equity. For
Firm U the entire earnings belong to shareholders. Assuming they need 20%
return the value of the equity would be Rs 50 lac.

The value of Firm L would have two parts, the value of its debt and value of the
equity. Assuming it is perennial debt and the interest rate reflects the
expectations of debt holders its value would be equal to the par i.e. Rs 30 lac.
Again assuming that the equity holders are content with 20% return (as was the
case with Firm U) the value of equity would be 7/0.20 =Rs 35 lac. Therefore the
aggregate value of the Firm L is Rs 65 lac (30 + 35) as against the value of Rs 50
lac for Firm U.

According to MM such a position is not sustainable because it would offer an
arbitrage opportunity to investors. Since the levered firm L is overvalued the
investors would sell their holding and invest in undervalued unlevered firm U. By
doing so the investors would have a more profitable position. This may be
achieved as follows.

1. An investor who owns 10% of Firm L decides to sell his holding and realise
Rs. 3,50,000 (10% of the market value of Firm L).

2. Since the investor was holding the stock of Firm L it may be interpreted
that he was comfortable with the levels of debt of Firm L. This may be
replicated by the investor in his personal capacity. Hence he borrows
10% of debt of Firm L in his personal capacity. The borrowing is Rs
3,00,000.

3. The aggregate resources with the investor would now by Rs 6,50,000

4. The investor now buys the 10% holding in unlevered Firm U at Rs 5,00,000
leaving a surplus of Rs 1,50,000.

5. However his income would remain same at Rs 70,000 (10% share of
levered Firm L)

6. The investor in present value terms can benefit by Rs 1,50,000.

The actions of the investor are condensed in Table 9-4.

Table 9-4: Initial and Regular Cash Flows by Switching Positions Rs.
Initial cash flow
Selling 10% of CODEQ
Borrowing
Investing 10% in ALLEQ
Surplus (Deficit) cash

+3,50,000
+3,00,000
- 5,00,000
+ 1,50,000
When with Firm L When with Firm U
Returns
10% of shareholders fund
Less: Borrowing cost
Net Income

70,000
-
70,000

1,00,000
30,000
70,000

9-9
This process of arbitrage would cause selling pressure on Firm L and buying
pressure on Firm U. This would result decrease in value of Firm L and increase in
value of Firm U. The process of arbitrage would continue till the two firms are
equally valued. Hence the two firms would be valued same irrespective of their
capital structure.

The process of arbitrage would also work the other way i.e. when the value of
levered firm is less than the value of unlevered firm. One would always sell the
overvalued firm and buy the undervalued firm.
9.6.1 MM Proposition II and Proposition III
Since the value of levered firm and unlevered firm cannot differ the adjustment
would be made in the capitalisation rates. Since the earnings level and total
value remain unchanged with increased borrowing the equity holders must
revise their expectation. With no debt financing the expectations of equity
holders, r0 would be the governing factor for determination of the firm value.

VU =VL or
r
) levered ( EBIT
r
) unlevered ( EBIT
0
=
Since EBIT (unlevered) and EBIT (levered) are same the WACC of levered firm
would be same as capitalisation rate of unlevered firm, i.e.
d e 0
r
D E
D
r
D E
E
r r
+
+
+
= =

This may be re-organised as follows:



9.7 MMs APPROACH WITH CORPORATE TAXES:
So far we assumed no taxes. However, in real world taxes are payable. Let us
examine what would be the position of levered and unlevered firms when taxes
are applicable.

9.7.1 Proposition I
For the same level of assets and hence earnings the cash flows to the capital
suppliers are projected in Table 9-3 with an assumed tax rate of 40%.

Table 9-5: Financial Data of Levered and Unlevered Firms
Figures in Rs lac
No Debt, U With Debt, L
EBIT 10.0 10.0
Interest @ 10% - 3.0
EBT 10.0 7.0
Taxes 40% 4.0 2.8
EAT 6.0 4.2
Earnings to shareholders 6.0 4.2
Earnings to debt holders - 3.0
Total cash flow to capital
providers
6.0 7.2

A comparison of Table 9-3 and 9-5 would reveal that while the capital providers
received Rs 10 lac (Rs 3 lacs and Rs 7 lac to debt and equity suppliers
E
D
) r - (r + r = r
d 0 0 e
9-10
respectively) when no taxes were present, the same EBIT was shared with tax
authorities also. This is shown in Table 9-6.

Table 9-6: Sharing of Cash Flow amongst Stakeholders
Figures in Rs lac
No Debt, U With Debt, L
No
Tax
With
Tax
No
Tax
With
Tax
Earnings to shareholders 10.0 6.0 7.0 4.2
Earnings to debt holders - - 3.0 3.0
Cash flow to tax - 4.0 - 2.8
Total cash flow to capital
providers and Taxes
10.0 10.0 10.0 10.0

It may be noticed that when there are taxes:
1. Earnings available to suppliers of capital are not identical for levered
and unlevered firms, as was the case with no taxes.
2. Earnings available to capital providers in levered firm i.e. Rs 7.2 lac are
higher than the unlevered firm i.e. Rs 6.0 lac.
3. The extra earnings of Rs 1.2 lac to the suppliers of capital have accrued
at the expense of tax. With taxes the unlevered firm pays Rs 1.2 lac extra
taxes.

Since the levered firm offers more cash flow to suppliers of capital, Rs 1.2 lac in
our example the value of the levered firm should be greater than that of the
unlevered firm. Further since taxes are saved by the levered firm the additional
value would be derived from the taxes only. The tax saved is on the amount of
interest paid to debt holders i.e. 40% of Rs 3 lac. From the viewpoint of
shareholders the decline in their earnings has not been 40% being the tax rate.
Since interest is tax deductible the decline in earnings be lesser by the amount
of tax saved.

This is known as the tax shield of debt. The cost of debt therefore is not the
interest rate charged (10%) but is lesser by the amount of taxes saved thereon.
With tax rate, T of 40% the effective cost of debt reduces to 6% only, or rd x (1-T).
Therefore the value of levered firm would be greater by the amount of tax
saved.

Thus, Proposition I of MM with taxes can be restated as
The value of the levered firm will be higher than the unlevered
firm by the amount of tax shield on debt enjoyed by the
levered firm

Shield Tax of Value + V = V
U L
........... Equation 9-9

With no debt the net earnings available to the shareholders would be EBIT(1-T).
If the earnings were perennial the value of the firm would be given by the
earnings divided by the capitalisation rate r0. The value of the unlevered firm
which is given by Equation 9-10:

9-11
0
U
r
) T 1 ( EBIT
V =
Equation 9-10
With assumed capitalisation rate of 20% the value of the unlevered firm works
out to Rs 12 lac.

Let us now see the value of the tax shield. In case of perpetual debt the value
of levered firm will exceed by an amount equal to tax rate multiplied by the
amount of debt; being the present value of the tax shield. For an amount of
debt of D the tax is saved every year is rd x T x D then the present value of the
amount of tax saved would be given by Equation 9-11.

Debt x Rate Tax DxT
r
xDxT r
) r (1
xDxT r
........
) r (1
xDxT r
) r (1
xDxT r
) r (1
xDxT r
) r (1
xDxT r
shield tax of PV
d
d
1 n
n
d
d
4
d
d
3
d
d
2
d
d
d
d
= = =
+
=
+
+
+
+
+
+
+
=
=

..Equation 9-11

Note that the tax savings would be discounted at the cost of debt as the
interest paid is certain. The cash flows of interest are unlike operational cash
flows, which are discounted at WACC or any such other discount rate
consistent with the risk of cash flows.

For perennial debt D and tax rate of T The value of the levered firm is stated as
Equation 9-11.

VL =VU + T x D.. Equation 9-11

9.7.2 MM Proposition II with taxes
When there were no taxes we have seen that the values of the unlevered and
levered firms are equal. The cost of equity for the levered firm undergoes a
change with the amount of debt such that it offsets the advantage of cheaper
debt replacing expensive equity keeping the value of the firm constant.

With corporate taxes the debt becomes more valuable due to tax shield
provided by interest paid on the debt. This tax shield benefits the equity holders,
and hence the cost of equity would not rise as much had there been no taxes.

If value of equity in levered firm is E and value of its debt is D then the cash flow
to the stake holders in the firm are
=Cash flow to equity holder + Cash flow to debt holders
=E x re +D x rd,

Also VL =VU + T D, and VL =E +D gives value of unlevered firm in terms of equity
and debt of levered firm is
VU =E + D (1 T)

In terms as cash flows to suppliers of capital this can be expressed as
=VU x ro +T x D x rd;

Finally, equating the two cash flows; E x re +D x rd ={E +D (1 T)}r0 + T D rd gives
9-12
) r T)(r (1
E
D
+ r = r
d 0 0 e
.Equation 9-12

The proposition II of the Miller & Modigliani with increased debt the cost of
equity would rise because equity holders would like to be compensated for the
additional risk they assume because of likely threat to their cash flows. Debt
holders having a prior and fixed claim on the cash flows leave lesser for equity
holders at increased risk.

We verify the validity of the MM proposition for the Firm U and Firm L as per the
data given in Table 9-5.
% 35 = + =
=
= = =
= + =
= = =
+ =
= = =
12,00,000
0.4) - (1 30,00,00
10%) - (20% 20% r
E
T) - D(1
) r - (r - r r L; Firm for rate tion capitalisa Equity
12,00,000 Rs 30,00,000 - 42,00,000 D - V E L; Firm levered of equity of Value
42,00,000 12,00,000 30,00,000 V L; Firm levered of Value
12,00,000 Rs 0.4 x 30,00,000 T x D shield tax of value Present
TD V V firm levered of Value
0 30,00,00 Rs
0.2
0.4) - (1 x 10,00,000
r
T) - EBITx(1
V firm unlevered of Value
e
d 0 0 e
L
L
U L
0
U


This may be checked with the cash flow approach to valuation. The value of
levered firm, L would be the value of cash flows of shareholders and debt
holders discounted at the respective rates. The value of the firm based on cash
flow would be

Value of the firm =PV of the cash flows to shareholders and debt holders
42,00,000 Rs 30,00,000 12,00,000
0.10
3,00,000
0.35
4,20,000
r
holders debt to flow Cash
r
holders equity to flow Cash
d e
= + = + =
+ =

9.7.3 MM Proposition III - Under Taxes
We have noticed that for the market value of levered firm is more as compared
to unlevered firm. The increased value of levered firm accrues to equity
shareholders and hence the cost of equity does not rise as much as it would for
unlevered firm. The third question is that of cost of capital of the levered firm.
The weighted average cost of capital (WACC) declines for the levered firm
despite increased capitalisation rate of equity capital. The WACC for the
levered firm will be
% 29 . 14
42
30
) 4 . 0 1 ( 10
42
12
35
E D
D
) T 1 ( r
E D
E
r WACC
d e L
= + =
+
+
+
= - -

Optimal capital structure with MM Propositions
Due to continuous reduction in the cost of capital with increasing leverage it
will be beneficial for the firm to keep borrowing and increase value. Hence
the optimal capital structure; the one that maximises the value of the firm or
minimises the cost of capital, will be 100% debt. The minimum cost of capital
will be equal to the post tax cost of debt.

9-13
9.8 ASSUMPTIONS AND LIMITATIONS OF MMS THEORY OF IRRELEVANCE
The assumptions made in the MM propositions include a) homogeneous
expectations, b) all earnings are distributed, c) no transaction costs, and d)
perfect markets. The most notable assumption while explaining how arbitrage
would drive the values of the firm equal was the home-made leverage. It
assumed that the individual investors can replicate the capital structure of the
firm in their individual capacities by borrowing and lending at the same rate as
the firms do. In the real world none of the assumptions hold good particularly
the assumption of home-made leverage. The borrowing capacity of individual
is limited as compared to the firms both in terms of the cost and quantum.
Individuals borrowing normally is with recourse to personal assets, which serves
as deterrent to investors to borrow.

The implications of Miller & Modigliani with and without taxes are summarised in
Table 9-7.


9.9 LEVERAGE AND FINANCIAL DISTRESS
As per MM propositions the optimal capital structure with taxes is 100% debt.
However that would leave no shareholder in the firm. While MM recognised the
increasing cost of equity with mounting debt it was assumed that the debt
holders continue to provide funds at same rate irrespective of levels of debt.
High amount of debt possibly has been the single largest reason for corporate
failures and bankruptcies. Contrary to the theoretical positions we find the
practice to be exactly opposite. Most successful firm have tendency to have
no or very little debt. Also most of the firms that have failed had inordinately
high amount of debt.

The sole consideration of the advantage of tax shield on debt is not overriding.
Apparently, there seem to be some disadvantage of debt too.

9.9.1 Cost of Financial Distress
One of the factors that seem to dominate the tax advantage is the financial
distress the firm undergoes when it assumes debt. Financial distress is described
as the difficulty a firm may face in meeting its commitments, which also
includes interest to be paid to the lenders of the funds. It may range from minor
liquidity crisis to total insolvency. When financial distress becomes severe and
firm actually makes a default in the commitments the costs associated with
Table 9-7: MMs Propositions With and Without Corporate Taxes

Without Taxes With Taxes
Proposition I
Value of the
firm

VL =VU
VL =E + D

VL =VU + PVTS
VU =EBIT (1-T)/r0
Proposition II
Cost of equity

E
D
) r r ( r r
d 0 0 e
- + =
E
) T 1 ( D
) r r ( r r
d 0 0 e
-
- + =
Proposition III
Cost of capital

WACCU =WACCL =r0
D E
D
r
D E
D
r r ; WACC
d e
+
+
+
=
D E
) T 1 ( D
r
D E
E
r r ; WACC
E D
PV
1 WACC WACC
d e L
TS
U L
+

+
+
=
|
|
.
|

\
|
+
=

Where PVTS =Present value of tax shield; For perennial debt it is T x D
9-14
debt increase significantly. However, at low levels of leverage these costs may
not be felt by the firm as the probability of default is low.

It is extremely difficult to estimate the cost of financial distress. Financial distress
cost can be categorised as i) direct costs: such as cost of litigation and
administration, loss due to distress sale, reduction in value of assets due to non-
use etc, and ii) indirect costs: such as management time in warding off the
creditors, managing by crisis rather than planning, faulty decision making in
choosing right business opportunities etc.

Lenders in order to protect their own interest put several covenants that come
in the way of making free and fair decisions from the viewpoint of shareholders.
The interest of the lenders is often conflicting with those of shareholders.
Consent to the covenants put by lenders, is not seen favourably by
shareholders, and markets. The value of the firm may not rise despite the
availability of the tax shield of debt. With increasing debt the cost of financial
distress rises and offset the tax advantage. As long as cost of financial distress is
lower than the tax advantage the value of the firm will rise with increasing
leverage. As leverage keeps increasing the perceived costs of financial distress
offset the benefits of tax savings. Any increase in the probability of financial
distress raises the cost of capital.

9.10 TRADE OFF THEORY OF CAPITAL STRUCTURE
With the introduction of cost of financial distress with increasing debt the tax
advantage of debt reduces. This gives rise to a trade off between the
advantage and disadvantage of debt.



Figure 9-3: TRADE OFF THEORY: COST OF FINANCIAL DISTRESS AND TAX SHIELD

Market value of the firm

Cost of financial
distress

Value of
the firm

Value of tax shield




Value of unlevered firm





Optimal capital Debt/Equity
structure

9-15
Trade-off theory would state the value of levered firm as
Value of levered firm =Value of unlevered firm +PV of Tax shield
PV of costs of financial distress

Therefore with cost of financial distress offsetting the tax advantage there
would be an optimal capital structure as depicted in Figure 9-3.

9.11 CAPITAL STRUCTURE IN PRACTICE
In practice capital structure is determined on various considerations that in the
opinion of all stakeholders are relevant. These stakeholders are shareholders,
financial institutions, creditors, customers. government etc. Even though the
primary concern about the capital structure is that of equity and debt suppliers
all stakeholders are affected by the risks that emanate from capital structure.
Some of the considerations that govern the capital structures are discussed
below:

9.11.1 Capital structure ratios
The financial risk is determined by the financial leverage as studied in the
previous unit. The lenders to the firm are interested in the safety and timely
repayments of the sums lent. The borrowing capacity therefore gets
constrained by ability to generate revenue and service the debt obligations.
The servicing of debt obligations are normally measured by following ratios that
may be computed from the financial statements of the firm.

One prominent ratio that is considered while providing debt is the interest
coverage ratio. It is defined as
Interest
EBIT
= Ratio Coverage Interest

Interest cover provides impressions about the safely of interest portion of debt
only. For determining the capital structure it is a relevant figure because we
assume continuing debt.

Besides interest the other repayment obligation is that of repayment. To assess
the recovery of principal amount the ability of the firm to provide sufficient
cover is adjudged by the cash coverage ratio defined as under:

T) - (1
Instalment Loan
+ Interest
Expense Cash - Non + on Depreciati + EBIT
= Coverage Flow Cash
The third important parameter that both the financial institutions and the
industry follow in providing the debt is the norms on the debt equity ratio
prevailing in the industry. These norms develop over a period of time and are
time tested. Generally speaking the institutions follow these norms and in case
of deviation the reasons need to be explained. Assuming that in auto
component industry the debt equity norms is 1:2 the debt capacity can be
fixed at 1/3
rd
of the cost of the project subject to the cash flow and adequate
debt service.

The focus of financing based on ratios and the cash flows places emphasis on
the liquidity and safety of operations.
9-16

9.11.2 Liquidity and Norms
The second important consideration in defining the capital structure is
governed by the environment in the financial markets particularly the
institutional finance. The ratios discussed above are normally compared with
the prevailing norms in the industry. The debt equity ratio and interest cover
have been developed on the basis of vast experience over a period of time
and are normally adhered to unless some special circumstances warrant
deviation. The amount and /or proportion of debt is governed by its availability.
Availability of loan cannot be taken for granted if the amount or proportion of
loan does not conform to the norms of debt equity ratio, debt service etc.

While EBIT-EPS analysis may focus on the reduced cost and the tax advantage
of debt and financing norms place an upper limit on the borrowing capacity is
not purely governed by analytical considerations.

9.11.3 Market and Operational risks
Use of debt magnifies the business risk. If business is already high the financial
risk need to be controlled to keep the overall risk within manageable limits. If
business risks are low, higher financial leverage is permissible. Business risks are
primarily determined by industry characteristics. In conventional industry like
steel, cement, FMCG are relatively stable and hence can have more
borrowing capacity as compared to firms in relatively new products, new
markets and technology.

9.11.4 Security
As a last resort the lenders would like to have recourse to the physical asset
created from the borrowing. The security of loan is an important consideration
for the lenders. The firms that have more immovable assets like land, building,
and machines provide greater security than movable assets such as human
resource. If the assets are tangible and form a good security the debt is easier
to mobilise and at favourable terms. Investment in real estate and plant and
machinery are regarded as better collateral for loans. Contrary to this industries
such as software development, information technology etc. who derive their
worth based on the human capital have capital structure heavily oriented
towards equity as getting debt is rather difficult because of the lack of
confidence on the security of the assets.

SOLVED PROBLEMS

Example 9-1: The Cost of Equity and WACC
A firm if financed by all equity would provide returns of 15% to its shareholders.
However, it decides to have debt to equity ratio of 1:2. The cost of borrowing is
12%. Find the cost of equity of the firm. What will be its WACC if the firm
mobilises further debt so as to have the debt equity ratio of 1:1? Will the cost of
equity remain same as before? Assume no taxes.

Solution:
The cost of equity can be arrived at from Equation 9-6.

=15 + (15 - 12) x1/ 2 =16.5%
E
D
) r r ( r r
d 0 0 e
+ =
9-17

With changed capital structure WACC will remain same for the firm. This would
cause the cost of equity to change Again using Equation 9-6, we get the new
cost of equity with modified capital structure of 1:1

=15 + (15 12) x1 =18%

We may verify that the WACC of the firm remains same irrespective of level of
debt using Equation 9-8.
D E
D
r
D E
E
r r
d e
+
+
+
=
=18 x 0.5 + 12 x 0.5 =10.5 + 4.5 =15%.


Example 9-2: Valuation for Levered and Unlevered firms under MM
A firm is financed entirely by equity capital with expected rate of return of 15%.
It has EBIT of Rs 500 lac. The corporate tax rate is 40%. As a financing option and
considering the capital structure the firm is expecting to borrow Rs 900 lacs at
an attractive rate of 10% and retire equity by an equivalent amount. Find out
the following:
a) The market value of the firm when it is financed entirely by equity.
b) The market value of the firm after it borrowing.
c) The value of equity after borrowing?
d) The cost of equity after borrowing?
e) What is the cost of capital for the firm after borrowing?
f) Verify the market value of equity using answer to d).
Assume perpetual income and debt.

Solution:
a) When the firm is financed entirely by equity:

lacs 2,000
0.15
) 4 . 0 500x(1
r
T) EBITx(1
rate tion Capitalisa
rs shareholde for Earnings
firm the of value Market
=

=
=


b) When the firm replaces equity with debt worth Rs 900 lacs, the value of the
firm increases by the amount of tax shield. For perennial debt the value of
the tax shield is given by
Present value of tax shield =Tax rate x Debt amount
=0.4 x 900 =Rs 360 lacs

The total value of the firm would increase by Rs 360 lacs from the earlier
position of all equity financing. Hence the value of the firm after availing
debt would be

Value of levered firm =Value of unlevered firm +Amount of tax shield
=2000 +360 =Rs 2,360 lac

c) Value of equity =Value of the firm Value of debt
=2360 900 =Rs 1,460 lacs.

9-18
The benefit of tax shield accrues to the equity shareholders as the remaining
value of equity of Rs 1,100 lac now stands increased by Rs 360 lac to Rs 1,460
lac.

d) The revised cost of equity after raising debt is
% 85 . 16
1460
) 4 . 0 1 ( 900
) 10 15 ( 15
E
) T 1 ( Dx
)
d
r
0
r (
0
r
e
r =

+ =

+ =

e) The cost of capital for the firm after debt
% 71 . 12
2360
900
) 4 . 0 1 ( x 10
2360
1460
85 . 16
E D
D
) T 1 ( x r
D E
E
r WACC
d e
= + =
+
+
+
=

f) Using cost of equity arrived at in d) we may find the value of equity in the
levered firm from:

lacs 1460 Rs =
0.1685
) 0 1 0.10x900)( (500
=
r
T) xD)(1 r (EBIT
Equity of Value
e
d
.4
=

KEY TERMS

Optimal
Capital
Structure

An optimal capital structure is one that maximises the value
of the firm. Value of debt being constant it implies
maximisation of shareholders wealth.
MMs
Proposition I
The market value of the firm is independent of its capital
structure with no taxes. With taxes it increases by the value
of the tax shield provided by debt.

MMs
Proposition II
The expected yield on the equity capital is equal to the
pure equity return plus a premium for the financial risk which
is equal to spread between pure equity return and cost of
debt in the proportion of debt equity ratio.

Tax Shield The present value of the tax saved on the interest on debt is
called tax shield.

SUMMARY

Capital structure decision relates to finding out an optimum level of debt that a
firm must have in order to maximise its value. There are two opposing schools of
thoughts regarding optimum capital structure. One school of thought believes
that the value of the firm is dependent upon its capital structure and there
exists an optimal capital structure. The opposing school of thought argues that
capital structure is irrelevant to the value of the firm.

To analyse the impact of capital structure on the value of the firm we keep the
total resources constant and therefore raising debt implies equivalent reduction
in equity and vice versa.

Net income approach assumes that value of the firm is determined by the cash
flows to the respective capital suppliers discounted at appropriate
9-19
capitalisation rates. These capitalisation rates are assumed to remain constant
at all levels of debt. Since debt is cheaper than equity the overall capitalisation
rate (WACC) of the firm would fall as proportion of debt increases. The optimal
capital structure would be 100% debt.

Net operating income approach suggests that the value of the firm is
determined by the earning capacities of its assets and not how are they
acquired. Therefore overall capitalisation rate remains constant irrespective of
level of debt. The constancy of the capitalisation rate is achieved by an
increase in the cost of equity with the increasing level of debt. Any capital
structure is optimal.

Modigliani and Miller (MM) agree with the net operating income approach and
provide a justification through the process of arbitrage for the irrelevance of
capital structure. With no taxes, the cost of equity would rise proportionately
with the increasing proportion of debt keeping the overall cost of capital
constant. With corporate taxes the value of the levered firm is greater than the
value of unlevered firm by the amount of tax shield. The advantage of tax also
causes a smaller increase in the cost of equity in a levered firm as compared to
the unlevered firm. While with no taxes the capital structure is irrelevant. With
taxes 100% debt is the optimal capital structure.

Yet firms do not have 100% debt in their capital structure because the tax
advantage of debt is offset by the perceived cost of financial distress that arises
only when the firms have debt in their capital structure. Under extremely high
level of debt the cost of financial distress tend to reduce the tax shield of debt.
The optimal capital structure is therefore a trade-off between the tax
advantage of debt and cost of financial distress and agency cost of debt.

SELF ASSESSSMENT QUESTIONS

1. Differentiate between net income and net operating income
approaches for determining the value of the firm with the changes in the
capital structure.

2. What does MMs Proposition I state about the value of the firms in the a)
absence of taxes and b) in the presence of taxes? What different
implications it has for the optimal capital structure?

3. Net operating income (NOI) approach and MMs propositions conclude
that capital structure is irrelevant to the value of the firm. Is there any
difference between the two approaches?

4. What do you understand by a) arbitrage and b) homemade leverage?
Explain their relevance in establishing the theory of irrelevance of capital
structure?

5. What is tax shield and how does it change the value of the levered firm
as compared to the unlevered firm?

9-20
6. What is cost of financial distress and its implications on the capital
structure?

FURTHER READINGS

1. Srivastava & Misra (2008), Financial Management, Oxford University Press,
Chapter 16 and 17
2. Prasanna Chandra (2004), Financial Management: Theory and Practice,
Tata McGraw Hill, Chapter 19 and 20
3. I M Pandey (2005), Financial Management, Vikas Publishing House Pvt
Ltd, Chapter 15

10-1
UNIT 10

UNDERSTANDING DIVIDEND POLICY

10.0 OBJECTIVE
The objective of this unit is to
a) Explain how dividend can affect the value of the firm
b) Describe theories of relevance and irrelevance of dividend in
determining the value of the firm.
c) Describe Walters Model and Gordons Model of dividend and value.
d) Describe how Miller and Modigliani explained the irrelevance of
dividend.
e) Demonstrate execution of home-made dividend
f) Explain signalling by dividend
g) Explain how residual dividend policy work
h) Highlight factors that affect the dividend in real world.

10.1 INTRODUCTION
Dividend policy relates to the decision of the firm to determine the proportions
of earning that must be distributed among its shareholders for maximising the
value of the firm. The income generated after meeting all obligations by the
firm belongs to the shareholders. The shareholders need to determine the use of
the income earned. Basically they face one question whether to retain the
earnings in the firm to fund the growth or distribute it to the individual
shareholders. These are apparently conflicting choices. If earnings are
distributed lesser is retained in the firm sacrificing the growth. If not distributed
the shareholders may feel disheartened by not being able to earn on the
capital contributed.

Normally firms make a compromise in retention and distribution. Naturally this
compromise raises another question of what fraction to retain or distribute as a
policy of the firm. The question of what ratio to retain or distribute of the earned
income is referred as dividend decision or policy. The guiding philosophy of the
dividend decision is naturally to adopt a policy that maximises the shareholders
wealth. Therefore from financial management viewpoint the objective is to find
out the dividend policy that will maximise or enhance the value of the firm.

There are two schools of thoughts on the dividend policy that are divergent.
One school of thought believes that dividend policy matters in determining the
value of the firm, while the other school of thought advocates that dividend
decision is irrelevant to the value of the firm. We shall have a look at both the
philosophies.

10.2 RELEVANCE OF DIVIDEND
There are two prominent proponents of relevance of dividend. There are two
models that attempt to determine the value of the firm based on the dividend
i.e. Walters Model and Gordons Model. Both the models are almost similar and
make similar assumptions with similar conclusions. We discuss both of them now.

10-2
These models of valuation of the firm link the dividend policy to the investment
opportunities available. These models support the view that dividend is material
to the value of the firm and is dependent upon what kind of investment
opportunities are available to the firm in comparison with the expectations of
the shareholders.

Assuming sufficient business opportunities are available to the firm then the
dividend policy affecting the value will depend upon what returns are being
offered by these opportunities compared to the expectations of the
shareholders. If these business opportunities offer higher return than the
expectations of the shareholders then dividend policy oriented towards
retention is more rewarding as it should lead to larger increase in the value of
the firm than the dividend policy favouring distribution of earnings.

On the contrary if available business opportunities provide a return that is lesser
than the expected return by the shareholders, then retention of earnings to
finance the new business opportunities will destroy the value of the firm. In such
a situation distribution of earnings to the shareholders rather than retaining
should be more rewarding.

10.3 WALTERS MODEL
Walter developed one of the earliest models linking the value of the firm to the
dividend policy. The value of the firm as per Walters Model is given by Equation
10-1.
r
D)/r - k(E
+
r
D
= P
0
.. Equation 10-1
Where P0 = Current Price, D = Dividend, E = Earnings
r = Expected Returns by shareholders and
k = Reinvestment rate of the firm

Walters model considers the value of the firm as sum of two components; 1) an
infinite stream of dividend, D and 2) an infinite stream of retained earnings, E
D reinvested at constant rate of k, which are generated each year for infinite
length of time.

Equation 10-1 can be viewed as returns to the shareholders consisting of sum of
1) dividend yield and 2) the capital appreciation in price as Equation 10-2.
0 0
P
P
P
D
r

.. Equation 10-2

Capital appreciation is provided by the retained earnings as amount retained
with the ratio of reinvestment rate and shareholders expectations.
r
D E
r
k
D
P
) (
is firm the of value the and D) - (E
r
k
= P
0
-


10.3.1 Assumptions of Walters Model
Following assumptions are made in the Walters Model:

10-3
1. The growth of the firm is funded by retained earnings alone and no
outside financing either by additional equity or by additional debt is
sought.
2. The growth opportunities do not affect the risk profile of the firm. As we
know that the returns expected by shareholders are dependent upon
the risk. If risk profile changes the returns expectations too change. This
assumption essentially means constancy of market capitalisation rate r.
3. The model also assumes perpetual and constancy of earnings and same
payout.
4. Lastly there is an implied assumption that the reinvestment rate k
remains constant i.e. growth opportunities have same rates of return.

These assumptions seem inconsistent and place a limitation on applicability of
Walters Model.

10.3.2 Dividend and Growth Opportunities
According to the Walters model the capital budgeting decision and dividend
decision are interrelated. Capital budgeting policy determines the value of the
firm as the assets created provide value to the firm. Since dividend policy will
materially affect the capital budgeting process, the dividend policy becomes
key determinant of the valuation of the firm.

As per Equation 10-1 the value is a function of expected dividend,
capitalisation rate, reinvestment rate and the amount reinvested that provide
the capital appreciation in future. The present value of the investment
opportunities is reflected in the current market price of the share.

The impact of dividend policy of the firm on its value can be seen from
following example. Consider a firm has current earnings of Rs 20 with 50%
dividend payout. The expected return by shareholders is 16% while the growth
projects with the firm offer return of 20%. The value of the firm as reflected in the
share price as per Equation 10-1 is Rs 140.63.
140.63 Rs =
.16
10) - (20
0.16
0.20
+ 10
r
D) - (E
r
k
+ D
=
0
P

If the firm revises the dividend policy from current 50% to 75% it would have
lesser to invest in the growth projects that offer more than expected returns.
Therefore the value must decline. As per Equation 10-1 the new value of the
firms would be Rs 132.81 i.e. lesser than the value with 50% dividend payout.
132.81 Rs
16 .
) 15 20 (
16 . 0
20 . 0
15
0

-
P

However, if the firm revises the dividend policy from current 50% to 25%
reducing the payout and increasing the retention it would have more to invest
in the growth projects that offer more than expected returns. Therefore the
value must increase. As per Equation 10-1 the new value of the firms would be
Rs 148.44 i.e. more than the value with 50% dividend payout.
148.44 Rs
16 .
) 5 20 (
16 . 0
20 . 0
5
0

-
P
10-4

The outcome would reverse if the investment opportunities available with the
firm offered a lesser return than expected by the shareholders. In such
circumstances the increased payout would result in increase in the share price
while decreased payout would decrease the value. Reader may verify it by
assuming the re-investment rate if 12% as against 16% desired by shareholders.

If the returns of the shareholders and re-investment rates are identical then
Walters model implies that the value of the firm would be independent of the
dividend policy. For all values of dividend payout the value of the firm remains
same. Reader may again verify this by putting k = r = 16% for different payout
policies.

10.3.3 Implications of Walters Model
It is evident from foregoing that key determinant of value of the firm is the
reinvestment rate of the retained earnings and hence the dividend policy.
Following observations can be made

a) For firms having reinvestment rate exceeding the expected return of
shareholders the market value will i) increase if dividend payout is
decreased and ii) decrease if dividend payout is increased. Since
reinvestment rate is greater the shareholders of their own cannot earn
more on the earnings distributed than what the firm can provide.
Therefore a 0% payout would maximise the value of the firm.

b) For firms with lower reinvestment rate that that expected by shareholders
the opposite will happen. Here the shareholders can earn more on the
earnings distributed than the firm can provide by retaining. A dividend
policy of 100% payout will maximise the value of the firm.

c) However, for normal firm that match the reinvestment rate with the
return expectations the dividend policy is irrelevant because
shareholders can earn as much as the firm can provide and vice-versa.
Retaining or distributing does not make any difference. Therefore, the
value of the firm remains constant and the dividend policy becomes
irrelevant.
10.4 GORDONS MODEL
Gordons model for value of the firm is similar to Walters model. According to
Gordons model the value of the firm is the discounted value of the dividends in
perpetuity, assuming a going concern. If dividend, D is constant the value of
the firm is given by D/r. When dividend is not constant since the part of earnings
retained are reinvested in the growth of the firm. The growth of firm implies
growth of dividends period after period. If earnings and dividend for the next
period 1are denoted as E1 and D1 respectively and the growth in dividend
each year is g then the value of the firm is given by Equation 10-3.
g r
D
P
-
1
0
Equation 10-3

We modify the Equation 10-3 to incorporate the dividend policy of the firm. If
earnings level for the next period is E1 and if b is the retention ratio the amount
10-5
of dividend is E1(1 - b). The reinvested funds are E1 x b and if they are reinvested
at k the growth in absolute terms will be E1 x b x k. The relative growth g will be
b x k. Incorporating the above changes the valuation of the firm can be given
by Equation 10-4.
bk r
b x E
P
-
- ) 1 (
1
0
..Equation 10-4

Hence the value of the firm is dependent upon level of earnings, their retention,
growth opportunities and expected returns. We may analyse Gordons model
in similar manner as we did for Walters model.

10.4.1 Dividend, Growth and Value
Again assume same level of earnings at Rs 20, dividend payout of 50%,
reinvestment rate of 20%, and expected return of 16%. Using Equation 10-4 the
value of the firm is Rs 166.67.
67 166. Rs =
0.10 - 0.16
10
=
bk - r
b) - x(1 E
= P
1
0


If the dividend payout is increased with reinvestment rate of 20% higher than
the expected return then we expect the value to come down because the
available funds for higher growth opportunities have reduced. The new value of
the firm with 75% payout is Rs 136.36.
136.36 Rs
0.05 - 0.16
15
= P
0


However, if the firm revises the dividend policy from current 50% to 25%
reducing the payout and increasing the retention it would have more to invest
in the growth projects that offer more than expected returns. Therefore the
value must increase. As per Equation 10-4 the new value of the firms would be
Rs 500 i.e. more than the value with 50% dividend payout.
500.00 Rs =
0.15 - 0.16
5
= P
0


The outcome would reverse if the investment opportunities available with the
firm offered a lesser return that the expected by the shareholders. In such
circumstances the increased payout would result in increase in the share price
while decreased payout would increase the value. Reader may verify it by
assuming the re-investment rate if 12% as against 16% desired by shareholders.

If the returns of the shareholders and re-investment rates are identical then
Walters model implies that the value of the firm would be independent of the
dividend policy. For all values of dividend payout the value of the firm remains
same. Reader may again verify this by putting k = r = 16% for different

The impact of the dividend policy on the value of the firm is evident from
Equation 10-4. When the firm matches the investors expectations (k = r) the
value becomes independent of dividend policy. The value of the firm under
such circumstances becomes purely a function of the earning power of the
assets, E1 and the shareholders expectations, r as shown in Equation 10-5.
r
E
=
bk - r
b) - x(1 E
= P ; r = k When
1 1
0
Equation 10-5
10-6
The crux of Gordons model lies in the relationship of dividend and growth and
the balancing of the two. An increase in dividend taken in isolation would lead
to an increase in price as the value of numerator in Equation 10-3 increases. But
as we increase the dividend lesser amount is retained and hence lesser growth,
g is expected. Reduction in growth would push the price of the share
downwards. There would be two opposite forces operating on the value of the
f i r m .

When the firm is unable to match the expectations of the shareholders (k < r)
the retention is not favourable since investors can generate more than what
the firm can provide. The optimum dividend policy then be 100% pay out i.e. b
= 0. Then again the value of the firm would be same as given by Equation 10-5.
r
E
=
bk - r
b) - x(1 E
= P ; 0 b at be would value optimum then r, k When
1 1
0


Since the earning power of the firm is lesser than expectations (k<r) the value of
the firm would naturally be less to that extent.

What happens when k exceeds r? It implies that firm can exceed the
expectations of the investors and hence the optimum dividend payout would
be 0% i.e. b = 1.00. This makes the price of the share indeterminable by the
Equation 10-5. An additional assumption in Gordon model would then be that b
x k < r or b < r/k. This seems reasonable because the growth rate of dividend g
cannot exceed the market capitalisation rate r. This is realistic as it is difficult to
imagine a situation where the firm can offer a growth of say 20% in dividend
and the investors seem pleased with a lesser return than 20%.

10.5 WALTERS MODEL VS. GORDONS MODEL
Both Walter and Gordon make identical assumptions. The conclusions too are
identical. Yet for the same set of parameters both the models arrive at different
values. With earnings and dividend at Rs 20 and Rs 10 respectively and
reinvestment rate of 20% and shareholders expectations at 16% the value of
the firm as per Walters model was Rs 140.63. For the same parameters the
value of the firm as per Gordons model is Rs 166.67

The difference in value is due to the assumption of growth. Walters model
assumes constant earnings and dividend for each period while Gordons model
assumes a growth of dividend as well as earnings period after period. Dividend
payout is constant but the dividends are not constant in Gordons model.

10.6 BIRD- IN-THE-HAND THEORY DIVIDEND AND DISCOUNTRATE
Do the returns expected by shareholders get affected by the dividend payout?
As per Gordonss model the value of the firm is independent of the dividend
policy only when k = r. However, the argument of Gordon is stretched further
which says that the return expected by shareholders is not completely
independent of dividend payout. The argument is referred as Bird-in-the-Hand
argument.

The returns of the shareholders consist of dividend yield and capital gains. It
may be argued that the dividend yield component is more certain than the
capital gain component. Therefore it would be logical that the more certain
10-7
component of dividend must be discounted at lower rate than the more
uncertain component of capital gains.

Therefore if the earning level remains same the expected market capitalisation
rate must change with the change in dividend policy. Higher the dividend
lower must be the discount rate. If current dividend is withheld with a promise to
make them available later, the discount factor must increase due to
uncertainty of promise. And therefore the price must fall if dividend payout is
reduced. Conversely, when greater proportion of earning is distributed greater
is the certainty of returns reducing the discount rate leading to an increase in
the share price. As most investors are risk averse they must prefer dividend over
capital gains, which is inherently risky.
10.7 MILLER & MODIGLIANIS THEORY OF IRRELEVANCE OF DIVIDEND
Miller and Modigliani, MM for short hold the opposite view to that of Walter and
Gordon. They believe that dividends are irrelevant for the value of the firm. They
argued that the market capitalisation rate, r is governed by earning power of
the firm and the risk associated with it rather that how these earnings are
distributed or retained. The shareholders wealth is governed by the firms
investment policy. As long as investment policy is held constant both the basic
earning power of the assets as well as the risk to the cash flows remains same.
Therefore the value of the firm must also remain same irrespective of dividend
policy.

The MM argument does not suggest irrelevance of dividend per se but only
emphasise the irrelevance of dividend policy. According to them all the cash
flows belong to the shareholders and dividend policy is merely a question of
timing of distribution of these cash flows to the shareholders. For any increase in
the current dividend the shareholders must give up an equal amount from the
future dividends in present value terms. As per MM the increased dividend
would be offset by the present value of future dividend foregone. While current
dividend may raise the value an equal effect in decline of value would result
due to growth opportunities foregone keeping the value of the firm constant.

In their presentation of the irrelevance MM assume constancy of capital
structure and investment policy. Now let us examine the impact of change of
dividend policy on the price of the share keeping the investment policy and
capital structure constant. Assume that the current price of the share is P0 and
desired return by shareholders is r.

Assume that the firm wants to increase the amount of dividend to D1 from the
earnings per share of E1. Keeping the investment same as before at I, any
increase in dividend will leave a shortfall in the investment. To fill the gap the
firm will have to issue fresh shares, which can be sold at ex-dividend price P1,
else the value of the firm would be lost if desired investment is sacrificed.
However, keeping the capital structure same as before any increase in
dividend will have to be substituted by issue of fresh capital. Considering
holding period of one year, as we know the current market price of the share is
the sum of present value of the expected dividend and the expected price at
the end next period. Mathematically,

10-8
7 - 10 uation ........Eq .......... )......... nP + (nD
r + 1
1
= nP
is g outstandin shares of number n' ' having firm the of value market the and,
6 - 10 ion .....Equat .......... .......... )......... P + (D
r + 1
1
= P
1 1 0
1 1 0

Where P0 = Current market price of the share, D1 = Expected dividend in next
period, P1 = Ex-dividend price, n = Number of shares outstanding, r=
Equity capitalisation rate

To compensate for the dividend the firm has to issue new shares. If n is the
additional number of shares then fresh equity would be raised at P1, the ex-
dividend price. To meet the shortfall in the desired investment, the number of
additional share is issued must be governed by Equation 10-8.

n x P1 = I (nE1 nD1) = I nE1 + nD1. Equation 10-8

The Equation 10 - 7 can be combined with Equation 10-8 and re-written as
9 - 10 uation Eq .......... .......... }......... nE + I - n)P + {(n
r + 1
1
=
)} nD + nE - (I - nP + nP + {nD
r + 1
1
=
) nP - nP + nP + (nD
r + 1
1
= nP
1 1
1 1 1 1 1
1 1 1 1 0


The current value of the firm n x P0 is independent of the dividend as shown in
Equation 10-9 and instead is a function of the investment, I earnings, E1 and
discount rate, r. The incremental dividend, D is replaced by new equity by
issuing n shares.

Consider an example. A firm has 1,00,000 shares outstanding with current
market value of Rs 450 per share. The value of the firm therefore is Rs 450 lacs. It
has investment plan of Rs 650 lacs and expected earnings of Rs 200 lacs
providing EPS of Rs 200. All the earnings are to be used for investment. Hence it
requires additional Rs 450 lacs to be raised. With current price of Rs 450 per
share it needs to issue another 1 lac shares. The value of the firm would now be
Rs 900 lacs (2 lacs shares at Rs 450 each).

Now consider announcement of dividend of Rs 50 per share. That would
consume Rs 50 lacs and leave only Rs 150 lacs available for investment. The
investment shortfall is now Rs 500 lacs as against Rs 450 lacs in case of no
dividend. Hence additional Rs 50 lacs need to be mobilised.

With dividend of Rs 50 the ex-dividend price would be Rs 400. New shareholders
would pay no more and no less than the value they get i.e. Rs 400 per share.
The numbers of new shares that are required to be issued are
lacs 1.25 =
400
150 - 650
=
ice DividendPr - Ex
required Funds
= issued be to shares new of Nos.

The total share would now be 2.25 lacs at a price of Rs 400. The value of the firm
would remain at Rs 900 lacs as in case of no dividend. The amount disbursed as
10-9
dividend is collected back for investment needs. When dividend is distributed
the net impact is the increase of shares and redistribution of wealth as new
issue would involve induction of new shareholders. There would be transfer of
wealth from old shareholders to new shareholders.

Irrelevance of dividend highlights that given constant earnings and constant
investment policy, the value of the firm remains constant. The dividend out of
earnings is like a flexible pipe where the outflow of dividend to shareholders
needs to be ploughed back as new capital to keep the investment constant.
Larger pay out of dividend implies equivalently large mobilisation of fresh
capital. As long as earning potential and investment policy are constant the
value of the firm does not change.

10.7.1 HOME MADE DIVIDEND
Irrelevancy of dividend can also be demonstrated from the ability of the
investors to make their own dividend policy in their individual capacities in case
the firms dividend policy does not suit them. On an aggregate basis one
cannot assume that dividends are preferred or hated. Some investors may
prefer dividend and while some may like retention. Flexibility to individual
investor is an important dimension in the argument of irrelevancy of dividend.
MM have demonstrated that individual investor has the capacity to have the
desired dividend irrespective of the dividend policy of the firm.

In case the dividend policy does not match the investors expectations, the
desired dividend can be simply achieved by selling or buying the shares to
supplement the shortfall or convert the excess cash into investment. Investors in
their personal capacity can undo the corporate actions by buying and selling
the fractions of the holding to achieve the desired dividend payout irrespective
of the firms dividend decision.

This can be best highlighted by an example. Assume Mr X holds 100 shares
equivalent to 1% of share capital with the expected return of 20% that firm
provides by way of capital appreciation in the stocks. The firm declares no
dividend. The current price is Rs 1,000. It is expected to go up by 20% to Rs 1,200.
The expected wealth of Mr. X by the end of the period is Rs 1,20,000 (100 shares
at Rs1,200). However, Mr. X desires a dividend of Rs 6,000 for his own reasons
that the firm does not provide.

What can Mr. X do to satisfy his urge for current income of Rs 6,000? Mr. X can
definitely sell some shares to have current income. He needs to sell 5 shares at
Rs 1,200. The returns for Mr X would then be:

Cash realised by selling 5 shares = 5 x 1,200 = Rs 6,000
Value of the remaining 95 shares = 95 x 1,200 = Rs 1,14,000
Total wealth = Rs 1,20,000
Returns obtained =10,000/50,000 = 20%

Therefore Mr. Xs position is same as that of other investors who desire no current
income. The value of the investment for those not needing dividend would be
100 x 1,200 = Rs 1,20,000; same as that of Mr X.

10-10
In case the firm changes the dividend policy then Mr X too can alter the
strategy. Mr X needed Rs 60 per share as current income. Now assume the firm
decides to give a dividend of Rs 100 per share. Assuming the stock continues to
provide the same return of 20% the expected price after the announcement of
dividend would be Rs 1,100 (Rs 1,200 Rs 100).

With this price all shareholders earn a return of 20% that includes dividend of Rs
100 and capital appreciation of Rs 100 providing a total of Rs 200 per share.
Now Mr X gets Rs 10,000 against his requirements of Rs 6,000. He has Rs 4,000
surplus which may be used for buying additional shares. He would get
4,000/1,100 = 3.64 shares. By doing so his returns stay same at 20%, like the fellow
investors in the firm.
Total number of shares =103.64
Market Value of shares = 103.64 x 1,100 = Rs 1,14,000
Dividend retained = Rs 6,000
Total wealth at the end of Period 1 = Rs 1,20,000
% Return = (1,20,000 1,00,000)/1,00,000 = 20%

Thus irrespective of the dividend policy of the firm Mr. X can have the same
returns and yet fulfil his desire to have current income. He can construct his own
home-made dividend policy making dividend policy of the firm irrelevant.

From the foregoing discussions following can be concluded:
1. The firm can remain unaffected by the dividend policy by funding
through issue of new equity,
2. The shareholders too can remain indifferent to firms dividend policy
because of home- made dividends they can implement of their own.
3. Hence dividend policy is irrelevant to the valuation of the firm.

10.7.2 Assumptions for Irrelevance of Dividend
In the above analysis following assumptions were made:

1. Constancy of investment policy: Investment policy is the key determinant
of the value of the firm and is set independent of dividend policy.
Decisions of dividend do not influence the investment policy.
2. Indifference to dividend income and capital gains: From the discussion
on home-made dividend it is clear that investors must be indifferent to
gain by dividend or capital gains. However this may not be true if the tax
treatment of the two streams of income is different. For investors to be
indifferent to capital gains and dividend income as stated above, it is
necessary that neither dividend nor capital gains are taxed at all or if
taxed then the treatment is tax neutral.
3. Uniform/homogeneous expectations: Investors and firm face
homogeneity in the expectations of future cash flows. The growth
contemplated in dividends will actually fructify, and even if not, all the
investors at least believe so. That would eliminate speculation about the
future price of the share.
4. Perfect capital markets: In creating the home-made dividend policy of
the firm it was assumed that investors can buy and sell shares to adopt
their own dividend policy independent to that of the firm. It effectively
implies that
10-11
i) there were no transaction (brokerage) costs involved
ii) the shares were infinitesimally divisible and could be sold and
bought
iii) buying/selling actions of the investor does not influence the price
iv) all investors are equally well informed and incur no cost of
information, and
v) there exist no floatation costs.

10.7.3 Gordons Model vs Irrelevance:
Gordons model places emphasis on dividend. The valuation as given by
Equation 10-3 is reproduced below
g - r
D
P
1
0


We have seen that the value remains unaffected in case the reinvestment rate
is equal to the capitalisation rate. Increasing dividend implies fall in the growth
rate of the firm. MMs theory of irrelevance implicitly makes this assumption
when the increased amount of dividend is replenished by fresh issue of capital.
If the increased outgo of dividend does not result if sacrificing of the investment
policy, the growth would remain intact. Hence the value of the firm would
remain same.

The two theories of irrelevance of dividend and capitalisation model are often
presumed to be contradictory. It is a misconception. Gordons model is not at
loggerheads with theory of irrelevance. It must be clarified that irrelevance of
dividend does not state that the value of the firm is not equal to the discounted
value of the stream of dividend. It remains so. What theory of irrelevance states
is that the value of the firm cannot be altered by changing the amount of
dividend because it is a mere reallocation of cash flow from one period to
another. Gordons model also states the same if the reinvestment rate is
maintained.

10.8 PASSIVE RESIDUAL DIVIDEND POLICY
Practical considerations of dividend limit lead us to another strategy called
Passive Residual Dividend Policy. These practical considerations are taxation,
floatation costs, under pricing, and legal compliances.

1. Dividend distribution and capital gains are taxed differently. Most nations
provide for lesser tax rate for capital gains. Hence distributing dividend
rather that retaining it for growth would tend to reduce post tax returns
for the shareholders.
2. Increasing dividend and then mobilising equal capital afresh also suffers
from floatation cost, that need to be incurred. Hence firms need to issue
more number of shares than warranted by increased dividend.
3. Another disadvantage is that due to inherent volatility of equity the fresh
issue of capital cannot be made at the current market price. The firm
would have to make the offer more attractive for subscription if they
price the issue lower than the current market price. This again warrants
issue of more number of shares than warranted.
4. Also issuance of fresh capital is subject to several legal compliances and
is a time consuming exercise. The firms do not like to make issue of
10-12
capital frequently to avoid cost of managing the issue and legal
compliance. Further the fresh capital raised cannot be made available
immediately causing time lag between need and availability.

The limitations present in the real world favour retention of earnings rather than
cash dividend. Due to factors overwhelmingly supporting retention the firm
ought to follow the following dividend policy of a) funding all possible positive
NPV projects through internal accruals so as to maximise the value of the firm
and enhance returns to shareholders b) distribute the balance left after all
positive NPV projects are funded, and c) Raise fresh capital only when internally
generated earnings are not enough to accept all the positive NPV projects.

Such a policy of dividend is referred as passive residual dividend policy. It
means returning only the excess cash. Following such a policy must lead to
optimal results.

Passive residual dividend policy would imply fluctuating dividend from period to
period because flow of earnings and availability of positive NPV projects can
hardly be said to be steady. Both earnings and available opportunities are
volatile by nature. Therefore following a passive residual dividend policy
essentially implies volatile dividends from period to period.

10.9 INFORMATION CONTENTOF DIVIDEND (SIGNALLING THEORY)
Due to variability of earnings and investment opportunities makes dividend
volatile under passive residual dividend policy. In practice it is seen that
dividends are sticky i.e. firms like to maintain constant dividend rather than
making it passive or proportional to earnings. Fluctuating dividend can make
the stock price volatile too.

The reason attributed to the stickiness of dividend is the belief that amount of
dividend signals prospects of the firm. Beyond returning the cash flow to the
shareholders the dividend is also seen as potential or otherwise of the firm to
sustain the new level of dividend in times to come.

It is well accepted that the share prices move constantly as new information
flows in. Investors continuously strive for new and new information and the value
of the firm keeps changing. Much of the information available publicly to
investors pertains to the past but the stock prices are mainly driven by the
prospects of the firm. Markets work on future expectations rather than present
or past.

Managers tend to raise dividend only when they are confident of maintaining
the increased level of earnings in foreseeable future. Similarly a decline in
dividend is announced only when the prospects of the firm seem bleak.
Dividend is neither decreased nor increased with minor change in the earnings
level. The attempt is to maintain an absolute level of dividend till such time a
major change in earnings is anticipated that can support the new level of
dividend. Therefore, an announcement of increased dividend provides a signal
to the investors that management is confident of enhanced earnings levels that
can be sustained. Likewise an announcement of decreased dividend conveys
managements poor business scenario in future.
10-13

The signalling via dividend assumes that other information available to investors
such as directors report, financial statements, press releases, etc. for judging
the future prospects is not as convincing compared to a simple announcement
of dividend. Further management of the firm, more often than not underplays
negative factors and over emphasises positive factors. Financial analysts, being
conservative in approach too generally overstate the negative and underplay
the positive factors. Dividend helps resolve the conflict of management and
analysts.

The signalling hypothesis loses its significance and argument if the firm follows
an erratic dividend policy. If dividends are changing from period to period, the
signal cannot be credible. It is only when a stable dividend policy is pursued by
the firm the information content is maximum. Since by and large most firms
follow a stable dividend policy, the signalling hypothesis becomes significant.
Information content of the dividend tends to reduce the uncertainty
surrounding the functioning of the firm.

10.10 FACTORS AFFECTING DIVIDEND POLCY
The foregoing discussions would reveal that in perfect market conditions the
dividend policy is irrelevant but in real world situation there are several factors
that impact the dividend policy and the valuation. A firm has to consider many
factors while setting a dividend policy in practice. The objective remains the
undisputed maximisation of shareholders wealth.

Factors that favour high dividend payout are 1) lower investment needs and
excess cash after exploiting all opportunities, 2) desire of investors for current
income as against the buying and selling to form own home-made dividend
policy, 3) resolution of uncertainty about future potential of earnings level, 4)
presence of transaction cost, and 5) presence of agency cost high dividend
payment tend to reduce the agency cost etc.

The factors that favour low payout are 1) increased investment opportunities
and need for larger outlays, 2) preferential treatment of capital gains as
compared to dividend income, 3) presence of floatation costs, 4)
phenomenon of under pricing, and 5) constraining legal and administrative
factors for issue of new shares etc.

Based on several practical considerations as stated above the firms decide
their dividend policies.

10.11 ALTERNATIVE FORMS OF DIVIDEND
Firms normally make regular cash payments as dividend to shareholders as
reward. Besides cash payments firms also have alternative methods to provide
rewards to the shareholders that directly or indirectly are in the interest of
shareholders and enhance the value of the firm. These special types of
dividend avoid possibilities of miscommunication through raised dividend,
because such actions are taken as one-off measures.

There are ways other than regular or periodic cash dividend that reward the
shareholders. Three other ways of rewarding the shareholders are
10-14
1. Bonus Shares
2. Stock Splits, and
3. Share Buyback

10.11.1 Bonus Shares
Bonus share is a way of capitalising the reserves. Over a period of time the firms
keep accumulating earnings even after the dividend distribution. This
accumulation may be because of precautionary motive or result from sticky
dividends or potential investment opportunities not fructifying. These retained
earnings however belong to shareholders. Rather than providing cash dividend,
the firm may decide to increase the share capital by issuing fresh shares to
existing shareholders in proportion of their holding.

Issue of bonus shares is mere reorganisation of shareholders fund, keeping its
overall value same as before and merely changes the capital structure. For
example consider the following structure of shareholders fund of a firm A that
issue 2 bonus shares for one share held.
Pre Bonus Post Bonus
Paid-up share capital 500 1500
Reserves and Surplus 4500 3500
TOTAL SHAREHOLDERS FUND 5000 5000

The funds of Rs 1,000 from reserves & surplus are transferred to paid-up capital
reducing the reserve and increasing the paid-up capital. The shareholders get
additional shares without paying cash. Hence the value of the firm does not
change, but the stock price does. Now there is three times the number of
shares hence the stock price becomes 1/3
rd
of the pre-bonus price. Mere
reallocation of capital does not change any fundamental determinants of
value.

Issue of bonus shares results in following:
1. The proportionate holding of each investor remains the same because
all investors get the bonus shares in proportion of their existing holding in
the firm. It neither has an impact over control nor affects the ownership
or shareholding pattern.
2. The book value of the shares falls proportionately. In this case it would
become 1/3
rd
of initial book value from 5000/50 to 5000/15.
3. It is a mere restructuring of the shareholders fund. The earnings level of
the firm remains same. However, EPS falls because number of shares has
increased. In this case the EPS will fall to 1/3
rd
of the earlier level as the
number of shares has tripled.
4. In accordance with fall in book value and EPS the key value drivers, the
market value also falls proportionately conserving the total wealth of the
shareholders. The share price will fall to 1/3
rd
as the number of shares
triple.

Some respectable firms have a history of issuing bonus shares for variety of
reasons. Some of them are as follows:

1. Price of the shares has gone too high to favour small investors is one
reason. As the post bonus the price would decline, it becomes more
10-15
amenable to small investors. It is believed that issue of bonus shares
brings the price of the share down to more acceptable trading range
inviting greater participation by the investors.
2. With the increased number of shares and reduced price the liquidity in
the market increases. This is supposed to be benefiting small investors.
Firms also believe that the investor base too would expand.
3. Issue of bonus shares is regarded as a very strong signal that the firm is
confident of improving the EPS and book value of the share in future. The
investors do not expect dividends to fall proportionately. Instead the
expectations are that the dividend would fall less than proportionately
providing greater cash flow to the investors.

10.11.2 STOCK SPLITS
Stock split is similar to bonus issue. Under stock split the firm provides additional
shares to the investors without affecting the reserves.

Stock splits are identical to issue of bonus in respect of effects on valuation,
liquidity, price, book value and EPS. The only difference between the two lies in
the books of accounts. In case of bonus issue reserve & surplus is capitalised
and transferred to paid up capital while in case of split reserve & surplus as
well as capital remain unaffected. Simply the number of shares gets
multiplied.

Pre Bonus Post Bonus Post Split
Number of shares* 50 150 150
Paid-up share capital 500 1500 500
Reserves and surplus 4500 3500 4500
SHAREHOLDERS FUND 5000 5000 5000

* Under stock split the shares are increased without disturbing the share
capital or reserves

The impact of stock split is the same as that of issue of bonus shares. It is merely
a different tool of communication. Book value of shares would change in both
the cases but by different amounts. In case of split the change in book value is
due to increased number of shares while in case of bonus issue the impact on
book value is two-fold- increase in capital and reduction in reserves.

For long-term investors split and bonus shares are extremely advantageous. In
India the tax laws treat the cost of acquisition for bonus and split shares as zero.
The ex-bonus or ex-split price can be taken in entirety as capital gains. Though
dividends too are tax free in the hands of investors firms can save dividend
distribution tax (currently at about 16%).

10.11.3 Share Buyback
Share buyback is another way of rewarding the shareholders. Here the attempt
is to reduce the number of shares outstanding that is contrary to bonus shares
or stock splits that increase the liquidity. Also unlike bonus or stock splits it is a
cash reward. Flushed with excess cash the firm faces two choices - returning
the excess cash by bumper one-time dividend or buyback shares. Under share
buyback the firm buys its own share from whosoever wanting to sell his holding
10-16
at a specified price during a specified period. Till 1998 share buyback was not
allowed in India. Since the time it has been allowed several firms in India have
offered share buyback.

Share buyback is can be done in two ways:
1. Through tender offer: where firm announces a buyback programme to
all its shareholders to buy a specified number of shares at a
predetermined price. The offer remains open for a short period usually 15
to 30 days. Or
2. Through open market purchases in the stock exchanges: where the firm
announces a maximum price and buys the shares up to the prescribed
limit set in money terms from the stock market. These remains open for a
long time usually a year and enables procurement at market-oriented
price. This also keeps price of the share stable for a longer time.

The buyback programme has to be devised in the following framework:
The amount of share buyback cannot exceed 25% of the paid up share
capital and free reserves.
Post buy back the debt equity ratio should not exceed 2:1
Shares bought back cannot be re-issued.
No fresh shares can be issued by the firm till 6 months of the conclusion of
buyback programme.

In theory it is really immaterial whether the firm pays its shareholders a higher
amount of dividend or offers them share buyback. However, real world
conditions render many advantages to the share buyback as compared to
one-time huge dividend. There are two key parameters to be decided in the
share buyback the nos. of shares to be bought back and the price at which
to buy them.

10.11.3.1 Advantages of Share Buyback
There are several advantages that share buyback has.

Communicate the worth of the firm: At times management feels that the value
of stock is not fairly determined by market, the buyback price reflects the
value the management attaches with the firm. Besides communication, the
worth of the share in the opinion of the management, buyback would
create an upward pressure on the price due to reduced supply of the
shares after the buy back. It may be noted that shares bought back cannot
be re-issued and the firms are not allowed to have any fresh public issue for
some time.
Control shareholding pattern and threat of take-over: Buyback of shares results
in increased proportion of shareholding of the promoter and associates. It is
due to the fact that promoter group is not allowed to participate in the
buyback programme for obvious reasons of possible misuse and unjust
enrichment. The increased shareholding of the promoters is indicative of
their sustained interest, involvement and good long-term prospects of the
firm.
Control the capital structure: With reduced number of shares after the
buyback, the debt equity ratio in terms of book values would increase.
10-17
Since debt may be used to buyback equity shares the route can be used to
control or modify the capital structure of the firm.
A choice to shareholders: Share buyback is open to those who are willing to sell
and there is no compulsion for the shareholders to participate in it. Those
who want to stay invested in the firm can do so. Those who want a cash
dividend need not create their own home-made dividend. The firm creates
it for them.
Preserve information content of the dividend: Share buyback permits stable
dividend policy to be pursued. Instead of a large dividend were to be
distributed the firm would have to make extra efforts to communicate that
this is a one-off event and should not be construed as increased ability of
the firm to generate increased earnings. It lets the preservation of the
signalling value of the dividend.

10.11.3.2 Disadvantages of Buyback
However there can be some disadvantages in the share buyback and include
the following:

It cant be recurring: Since cash dividends are sticky (they are maintained or
exhibit steady growth unless situation changes drastically) the shareholders
may prefer dividend being more predictable to share buyback, which is
rather a one-time opportunity which cannot be a regular feature.
Excessive pricing: To induce shareholders to exercise option of buyback the
firms tend to overprice the buyback. It may be considered by some of the
shareholders as waste of money, which could be saved if the same amount
were distributed as dividend and could have created more value.

SOLVED PROBLEMS

Example 10-1: Value with Walters Model and Gordons Model
Assume a firm has current earnings of Rs 20 per share. It can use these earning
in the projects that provide a return of 15%. The expected return by
shareholders is 20%. What is the value of the firm under a) Walters Model and
b) Gordons Model if it retains i)) 40% ii) 50% and iii) 60% of the earnings?

Solution:
a) As per Walters Model the market price of the share is
85.00 Rs =
.20
8) - (20
0.20
0.15
+ 8
=
r
D) - (E
r
k
+ D
= P out pay 40% With
0

87.50 Rs =
.20
10) - (20
0.20
0.15
+ 10
= P out pay 50% With
0

90.00 Rs =
.20
12) - (20
0.20
0.15
+ 12
= P out pay 60% With
0

b) As per Gordons Model the price of the share would be
10-18
85.72 Rs =
0.15 x 0.4 - 0.20
0.4) - (1 20
= P out; pay 60% With
80.00 Rs =
0.15 x 0.5 - 0.20
0.5) - (1 20
= P out; pay 50% With
72.72 Rs =
0.15 x 0.6 - 0.20
0.6) - (1 20
=
bk - r
b) - x(1 E
= P out; pay 40% With
0
0
1
0


Example 19-2: Dividend Policy
Shares of ABC Ltd are trading at Rs 350. It has 1, 00, 00,000 shares outstanding. It
has current income of Rs 40 core providing EPS of Rs 40. Its earnings are
earmarked for capital investment. ABC Ltd announces a dividend of Rs 20 per
share and to meet the shortfall of Rs 20 core by issuing fresh shares. Find the
following:
a) At what price new shares can be issued?
b) How many shares would be issued?
c) What is the value of the firm after the issue of new shares?
d) How do the pre-issue and post issue values compare?

Solution:
The ex-dividend price of the share = 350 20 = Rs 330

a) The value of new shares = Amount of the proposed dividend = Rs 20 x 1,
00, 00,000 = Rs 20 core.
b) Nos. of new equity shares to be issued = 20, 00, 00,000/330 = 6, 06,061.

c) Total Nos. of shares after the new issue
= 1, 00, 00,000 + 6, 06,061 = 1, 06, 06,061
Total value of the firm after the new issue
= Nos. of shares x Price = 1, 06, 06,061 x 330 = Rs 350 cores

d) Value of the firm before the new issue
= Nos. of shares x Price =1,00,00,000 x 350 = Rs 350 crore
The value of the firm remains same and is independent of the dividend policy.

KEY TERMS

Homemade
dividend
The ability of the individual investors to adjust the current
income by buying and selling the shares without affecting
the returns is referred as homemade dividend.

Passive
Residual
Dividend
Policy
The practice of fixing the dividend as residual; of earnings
only after meeting the investment needs and utilising all
internal equity without mobilising external equity.


Signalling
Theory
Change in dividends communicates the future prospects of
the future earnings of the firm. It is referred as signalling.

10-19
Bonus Shares The shares issued by capitalisation of reserves into capital
increasing the number of shares are bonus shares.

Stock Split The shares issued by firm splitting a share into more than
one, without capitalisation of reserves is called splitting the
shares.

Share
Buyback
A method of returning excess cash to shareholders in lieu of
dividend providing option to them to remain invested or
convert holding into cash.

SUMMARY

Dividends are the periodic payments by the firms to its shareholders as reward
for their investment. Dividend policy refers to maximisation of shareholders
wealth. There are two schools of thoughts the relevance or irrelevance of
dividend for the value of the firm.

Major proponents who believe in the relevance of dividend are Walter and
Gordon who have developed similar models for valuation of the firm based on
dividend. They believe that investment policy and dividend policy are inter-
related and not independent of each other. Depending upon the returns of the
investment opportunities available with the firm the value of the firm can
increase or decrease with dividend policy. Only when the ability of the firm
exactly matches the shareholders expectations the dividend policy has no
impact on the value of the firm.

The opposite view is expressed by Miller and Modigliani who believe that the
dividend policy is irrelevant to the value of the firm. According to them the key
determinant to the value of the firm are level of earnings and the investment
policy. As long as investment policy is held constant there is no reason for the
value of the firm to change. MMs argument is based on individuals capacity
to resort to buying and selling of the holding of shares to earn the desired
dividend. This is referred as homemade dividend that can undo the corporate
dividend policy at individual investors level.

Dividends are thought to resolve the uncertainty of the cash flow. Since
dividends are certain and nearer the increased amount must lower the
discount rate and raise the firms value. This is called bird-in-the-hand argument.

However, in the real world there are several factors that influence the dividend
policy. Factors such as taxation, floatation costs, legal framework etc favour
retention. The factors that favour high payout of dividend include transaction
costs, investors preference of current income and reluctance to sell capital
assets. Recognising the conflicting factors it is opined that a passive residual
dividend policy must be optimal. It recognises the value of the investment
opportunities and the increased cost of replacing the internal equity with
external equity. Only the remainder from the investment can be paid as
dividend.

10-20
Bonus shares and stock splits are the rewards that are non-cash in nature. The
rationale for bonus shares and stock splits is to bring the share price to a more
acceptable trading range to increase investors interest, liquidity and broaden
the shareholder base. They also communicate the increased ability of the firm
to service the larger number of shares in future.

Share buyback is another unique method of returning the excess cash back to
shareholders with many more advantages. It gives the choice to the
shareholders to either remain invested or sell the shares back to the firm. It also
communicates to the shareholders the managements perception that the firm
is undervalued. Share buyback can influence the shareholding pattern,
increases promoters holding and alters the capital structure. The disadvantage
of the share buyback is the possibility of excess price being paid for
shareholders for exiting.

SELF ASSESSSMENT QUESTIONS

1. Explain Walters model of valuation of the firm based on dividend.

2. How does Gordons Model differ with Walters Model in valuation of firm
based on dividend?

3. What are the differences in the assumptions made in theories of
relevance and irrelevance of dividend?

4. What is home-made dividend and how can it undo the dividend policy
of the firms? Explain with an example.

5. What do you understand by passive residual dividend policy? If it is
optimal why do firms not follow it in practice?

6. What are the practical considerations that make favour a) retention of
earnings and b) distribution dividend?

7. What are the implications of signalling theory on the dividend policy of
the firm?

8. Differentiate between bonus shares or stock split?

9. What are the advantages and disadvantages of share buyback?

FURTHER READINGS

1. Srivastava & Misra (2008), Financial Management, Oxford University Press,
Chapter 19
2. Prasanna Chandra (2004), Financial Management: Theory and Practice,
Tata McGraw Hill, Chapter 21 and 22
3. Khan and Jain (2004) Financial Management: Text, Problems and Cases,
Tata McGraw Hill, Chapter 24 and 25
4. I M Pandey (2005), Financial Management, Vikas Publishing House Pvt
Ltd, Chapter 18
11-1
UNIT 11

FINANCIAL PLANNING

11.0 OBJECTIVE
The objective of this unit is to
a) Explain the meaning of financial planning
b) Explain why financial planning is important
c) Describe the process of financial planning
d) Understand the limitations and constrains in financial planning
e) Demonstrate how proforma profit and loss account and proforma
balance sheet are drawn
f) Explain what is sustainable growth in sales
g) Explain on what factors the sustainable growth rate depends.

11.1 INTRODUCTION
Financial planning is a precursor to all financial decision making. It provides a
broad framework and guidelines for future courses of actions and decisions
related to finance. These decisions relate to investment, financing, dividend
and working capital. The strategic directions for these decisions are crystallised
in what is called a financial plan.

A financial plan usually incorporates the history of the firm in case there is one,
because no financial plan can afford to ignore what has been achieved in the
past. Where the past data does exist, it usually forms the basis of future course
of action. Substantial deviations from the past need sound reasons so as to lend
credibility to the proposed future plan, otherwise it becomes unrealistic. A
financial plan that is not executable is not the worth the paper it is written on.

A financial plan also serves as an effective and efficient monitoring tool for
assessing the actual performance against the planned attributes. In case of
deviation a plan must provide for corrective action that the management must
adopt. Besides, one must also recognise that financial plan should provide for
some flexibility since it is based on set of assumptions, some of which are not
likely to come good.

11.2 OBJECTIVE OF FINANCIAL PLANNING
Financial planning integrates various functions of the firm. Commencing from
top strategic level, where the vision and mission of the firm are stated it flows
down to operational levels of production, marketing, purchase, stores, human
resources etc. Mission statements are normally stated qualitatively. Some of the
mission and vision statements are condensed in the Box.
11-2

BOX: SAMPLE OF MISSION AND VISION STATEMENTS OF SOME LEADING
ENTERPRISES OF INDIA
TATA STEEL
States the mission and vision as
Endurance: Oneness with society, adaptability, to the changing
environment, empowerment of people, financial prudence and ethical
governance.
Continuous Improvement: Encourage employees to work towards
innovation in process and product development
Growth: to drive value and become one of the top 10 global steel
companies
Tata Steel, Annual Report 2008-2009

IDEA CELLULAR
Our goal is to become a US $ 65 billion Group by 2015 from US $ 30 billion
today. We expect your company to contribute significantly to this growth
and earnings
Kumar Mangalam Birla (Idea Cellular, Annual Report 2009-10)

ITC Ltd.
Vision: Sustain ITCs position as Indias one of the most valuable
corporations through world class performance, creating growing value for
the Indian economy and companys stakeholders.

Mission: To enhance the wealth generating capability of the enterprise in a
globalizing environment, delivering superior and sustainable stakeholder
value.

The potential of an enterprise for wealth creation is set apart by the
distinctive amalgam of its Vision, Values and Vitality. It represents a mix of
constancy and change; of timeless core and constantly evolving strategies
and processes built around the core
YC Deveshwar, Chairman, ITC Ltd.

Financial planning essentially is a process of transforming the qualitative mission
and vision statements into quantitative representations, broken down to
suitable and smaller time intervals that are easy to comprehend. The mission
and vision statement provides strategic direction for the firm over a long term
period often stretching to a decade. These statements are seldom quantitative.
The qualitative vision statements need to be communicated down to the last
level through the hierarchy of the firm. How the objectives would be
accomplished over a longer time horizon need to be broken down in the
smaller goals for shorter periods of time periods, the aggregate of which must
be consistent with the vision statement.

Therefore financial planning process serves the useful purpose of integrating the
firm across various functions and for widely differing levels. The views of the top
management must be understood by one and all in the organisation in an
unambiguous manner to provide synergy of efforts by various functions, who
work in their own domain with functional sub-objectives. These sub-objectives
11-3
though consistent with the mission may not be consistent with each other. For
example marketing function may need to have unduly large inventory to meet
customer demand on time while production department may like to produce
only with confirmed order. Various functions and levels of operations within an
organisation must not work at cross purposes with each other. Financial
planning would bind them to a common objective and ensure minimisation or
avoidance of conflicts.

11.3 PROCESS OF FINANCIAL PLANNING
As is evident from the foregoing financial planning is a process of converting
the mission and vision into smaller targets to be achieved over a period of time,
usually a year. The annual targets in a financial plan emanate from the fact
that all firms have in place a regular system of recording and presenting the
financial performance annually. Most mission and vision statements have
growth of the firm as a central theme directly or indirectly. Rarely do the firms
state the growth in terms of quantitative figure. This is even true for non-profit
organisations.

The growth of the firm is measured in terms of value creation for stakeholders.
Of the several stakeholders in the firm shareholders occupy the dominant
position since they are the owner of the residual i.e. what is left after satisfying
the claims of other stakeholders like labour, government, lenders etc. Hence
value creation implies increase in wealth of shareholders. Though subordinated
to other claims the maximisation of shareholders wealth automatically implies
satisfaction of all other claims to the fullest.

The starting point for a financial plan is forecast for revenue, making certain
assumptions of likely changes in the economic and competitive environment.
The focus on revenue growth is natural since revenue drives profit which in turn
drives shareholders wealth. The revenue growth must take into account the
relative strengths and weaknesses of the firm, besides competition, product
features, pricing, capacity to produce and reach customers, consumer
preferences, and distribution network etc. For revenue plan a firm would make
three sets of assumptions. One set of assumptions would include those imposed
by external macro environment like economic growth, interest rate etc about
which the firm in its individual capacity can do little. Second set of the
assumptions would be industry specific like the technology, substitutes etc
about which firm can exercise some control. Yet another set of assumptions
would be internal to the firm like distribution network, capacity enhancement,
resource deployment which are in the domain of the firm. A revenue plan that
makes most assumptions that are controllable is likely to succeed more. Growth
estimates of revenue and hence profit and cash flows would be more realistic
then.

The growth in revenue implies increased deployment of additional resources.
Estimation of requirement of additional resources is the second component of
the financial plan. This is referred as investment decision that propels the desired
growth objectives. The feasibility to garner may constrain growth objective. In
such a case growth estimates may have to be revised.

11-4
The third component of the financial plan would be the evaluation of financing
alternatives. There could be several options available for generation of
additional resources. A financial plan would concentrate on additional
financial resources such as owned funds, borrowing, deposits from dealers,
suppliers credit, external equity financing etc. A financial plan has to choose
amongst the several alternatives available realising the constraints of the firm
with each course of financing.

The three components of financial plan i.e. the growth objective, the
investment plan, and the financing options have to be consistent with each
other. They are mutually dependent on each other. Of the several feasible
combinations the management has to opt for the one that is likely to be least
dependent on external factors. Larger the assumptions that are uncontrollable
lesser is the likelihood of the success of the financial plan.

Once the financial plan is adopted it must incorporate the monitoring
mechanism to assess how well the desired growth objective is being met. The
monitoring parameters must be measurable against the actual and capable of
suggesting corrective actions.

Hence a financial plan is a) estimation of realistic growth estimates of revenue,
profit and cash flows, b) establishing the investment needs, c) evaluating
financial options and d) developing performance measures.

11.4 METHODS OF DEVELOPING A FINANCIAL PLAN
Development of financial plan requires complete understanding of economic
environment, industry structure, competitive scenario, technological
development and processes. Besides in order to develop a financial plan
requires a sales and cost forecast that needs understanding of market
conditions, competitive position of the firm, cost structure of products, financial
strength etc.

As a first step to financial plan we need to have the sales forecast that must
recognise all the constraints but must create necessary pressure towards
achievement of mission of the firm. It may not be wrong to state that a
complacent sales forecast is a disservice to mission.

Sale forecast derives the profitability statement. A projected profit and loss
statement is referred as proforma income statement. Further on the basis of
proforma income statement and investment and financing plans one can
construct a proforma balance sheet throwing light of the future capital
structure, liquidity and solvency of the firm. These two proforma statements
constitute the basic backbone of financial plan.

A forecast may be made on the basis of
a) what has been achieved in the past, or
b) on the basis of subjective and qualitative factors if there are structural
changes in the industry, market, product improvement etc.

Alternatively, the firm may adopt a combined approach where historical and
qualitative factors together may be used.
11-5

For older firms financial plan is often developed on the basis of past data. The
method is referred as percentage of sales method. Since we assume that
revenue is the basic driving force behind growth of the firms all parameters
such as variable costs, fixed expenses and finally the profit margin are assumed
as % of sales. For example if historically a firm is earning 3% of revenue as net
profit we presume it to be added in the subsequent year. Other ratios are also
used in projection of the proforma balance sheet. Such a financial plan is likely
to have greater credibility as history supports the projections. A financial plan
not based on historical performance needs radical assumptions that may not
hold good for the planning horizon.

11.5 DEVELOPING A FINANCIAL PLAN
The best way to understand how to work out a financial plan is by way of an
example. Assume a firm that has a history of two years. One may consider a
history of several past years but for the purpose of understanding immediately
preceding two years may be more relevant because any older data may not
be a true basis of financial plan. Assume that performance of the firm and the
conclusion based on that are as contained in Table 11-1.

Table 11-1: Performance for Last Two years Rs lacs
2008 2009 Historical conclusions
Profit and Loss Account
Sales 1400.00 1820.00 Increased by 30%
Variable costs like raw
materials, wages 840.00 1092.00 60% of Revenue
Contribution 560.00 728.00
Fixed administrative expenses 125.00 137.50 Increased by 10%
Depreciation 110.00 99.00 10% of WDV
EBIT 325.00 491.50
Interest 55.00 50.00 10% of long term debt
EBT 270.00 441.50
Tax 108.00 176.60 at 40%
PAT 162.00 264.90
Dividend 81.00 132.45 Dividend payout at 50%
Retained earnings 81.00 132.45 Retain balance for growth
Balance Sheet
Liabilities
Capital 700.00 700.00 Paid up capital
Reserves 81.00 213.45 Accumulated earnings
Debt 500.00 450.00 Repayable in 10 years
Total 1281.00 1363.45
Assets
Fixed Assets 990.00 891.00
Current Assets 350.00 455.00 25% of revenue
Less: Current Liabilities 87.50 113.75 25% of current assets
Net Working Capital 262.50 341.25
Cash balance 28.50 131.20
Total 1281.00 1363.45
11-6
The historical trends of various items in the profit and loss account and balance
sheet are stated in the last column of Table 11-1.

The cash flow statement for the firm for the year 2009 is as follows:
Sources and Uses of funds Rs lacs
Sources:
Opening cash balance 28.50
PAT 264.90
Add: Depreciation 99.00
Operating cash flow 363.90
Uses:
Debt repayment 50.00
Dividend 132.45
Increase in net current assets 78.75
Total uses 261.20
Closing balance 131.20

11.5.1 Proforma Profit and Loss Account
Assume that we intend to project a financial plan for next year. The firm
believes that the 30% growth achieved in the past has been lesser than the
potential the firm had. Given the competitive strength of the firm and the
better quality of the product it offers the management believes that 50%
growth is not only desirable from the perspective of the growth mission but also
achievable.

Since the targeted growth in revenue and the physical output is substantial at
50% there would be operational efficiencies. In view of larger off-take the
variable costs are likely to come down as suppliers of material would be willing
to offer quantity discounts to the firm. Hence it is reasonable to believe that
variable cost can come down by 2% from existing 60% to 58%.

The management believes that in order to achieve 50% growth in the sales,
internal control mechanisms would have to be strengthened. Need for
augmenting the sales effort too is ominous. Therefore the increase in
administrative cost would be more than the historical figure of 10%. An increase
by 20% is considered reasonable. Depreciation would continue to be charged
at same rate of 10% on written down value. The assumptions of future
profitability based on historical data and qualitative judgements are contained
in Table 11-2.

Table 11-2: Summary of Assumptions for Proforma Profit and Loss Account
Item of Profit & Loss Account Historical Conclusions Planned Assumptions
Sales Increased by 30% Increase by 50%
Variable cost 60% of revenue 58% of revenue
Administrative cost Increased by 10% Increase by 20%
Depreciation 10% of WDV 10% of WDV
Cost of funds 10% of long term debt 8% on fresh debt
Tax rate at 40% at 40%
Dividend policy Dividend payout at 50% Payout ratio of 60%
Retention policy Retain balance for growth Balance for growth
11-7

11.5.2 Investment and Financing Plan
The existing asset base is inadequate to achieve the targeted sale. The firm
needs to add another production line costing Rs 400 lacs. The firm has cash
balance of Rs 131.20 lacs. Looking at the current capital structure and ability to
generate surplus the firm can borrow additional Rs 300 lacs. Since the interest
rates have fallen to 8%, the firm would like to use the debt capacity to the
maximum. The proposed financing plan is as follows:
Rs in lacs
Additional investment required 400.00
Cash available 100.00
Fresh debt at 8% 300.00
The existing debt of Rs 450 lacs would continue to attract interest at 10%. The
existing repayment plan of Rs 50 lacs annually would also continue.

11.5.3 Changes in Net Working Capital
Historically the investment in current assets representing gross working capital
has been 25% of sales. The firm is managing current liabilities at 25% of the
current assets. The management feels that there is need for greater liquidity.
The suppliers of materials are not willing to extend more credit as they have
already granted quantity discounts. Hence it is believed that the firm would
continue to avail 25% of the investment in the current assets as credit from
suppliers. Also with quantum jump in the revenue and resultant operational
difficulties the level of current asset level must rise to 30% of revenue from
existing 25%. Any increase in net working capital would be funded by internal
accruals.

Based on the above discussions the proforma profit and loss account statement
along with assumptions made for the coming year (2010) is presented in Table
11-3.

Table 11-3: Proforma Profit & Loss Statement Rs lacs
2008 2009 2010 Basis for Proforma Statement
Proforma Profit and Loss Account
Sales 1400.00 1820.00 2730.00 Growth by 50%
Variable costs like
raw materials, wages
840.00 1092.00 1583.40 58% of revenue against historical
60%
Contribution 560.00 728.00 1146.60
Fixed administrative
expenses
125.00 137.50 165.00 Increase by 20%
Depreciation 110.00 99.00 129.10 at 10% of existing and new
assets
EBIT 325.00 491.50 852.50
Interest 55.00 50.00 69.00 10% on existing debt and 8% on
fresh debt
EBT
270.00 441.50 783.50
Tax
108.00 176.60 313.40 Remains at 40%
PAT
162.00 264.90 470.10
Dividend 81.00 132.45 282.06 Stands increased to 60% against
existing payout policy of 50%
Retained earnings 81.00 132.45 188.04 Retained for future needs
11-8

The increase in working capital would result from a) increased level of revenue
and b) increased need for higher level of current assets. There is substantial
increase in the investment towards working capital and is worked out as below:

Rs lacs 2008 2009 2010
Current Assets 350.00 455.00 819.00
Less: Current Liabilities 87.50 113.75 204.75
Net Working Capital (NWC) 262.50 341.25 614.25
Increase/ decrease in NWC 78.75 273.00


11.5.4 Cash Flow Statement:
We can now draw a cash flow statement for the year 2010 indicating how the
investment and financing has taken place. The sources of funds would be a)
profit from operations, b) depreciation and c) additional borrowings. These
would be utilised against a) increase in the asset base b) repayment of existing
debt obligations c) increase in the net working capital and d) payment of
dividend. These are indicated as below:

















It may be noted that the plan leaves little balance of cash. There is very little
cushion available. In case growth rate of revenue does not materialise the firm
may run into liquidity problem. Of the sources and uses of the fund all except
dividend payout are obligatory and binding. The only discretionary use is the
declaration and payment of dividend. The firm would resort to curtailment of
dividend if any of the assumptions of the financial plan do not fructify.

11.5.5 Proforma Balance Sheet
Based on the projected profit and loss account for the year 2010 and the cash
flow statement the financial position as at the end of year 2010 is recast below:
Proforma Sources and Uses of Funds Rs lacs
Sources:
Opening cash balance 131.20
Profit After Tax (PAT) 470.10
Add: Depreciation 129.10
Operating cash flow 599.20
Increase in long term debt 300.00
Total Sources 899.20
Uses:
Increase in fixed assets 400.00
Debt repayment 50.00
Dividend 282.06
Increase in net current assets 273.00
Total uses 1005.06
Closing cash balance 25.34
11-9

Proforma Balance Sheet Actual
Projected
Basis of projection for Year
2010
Liabilities 2009 2010
Capital 700.00 700.00 Remains unchanged
Reserves 213.45 401.49 Increase by the amount of
retained profit
Debt 450.00 700.00 Existing debt repaid by Rs
50 lacs and fresh amount
of Rs 300 lacs raised
Total 1363.45 1801.49
Assets
Fixed Assets 891.00 1161.90 Addition worth Rs 400 lacs
and depreciation of 10%
charged thereafter
Current Assets 455.00 819.00 Projected at 30% of
revenue
Less: Current Liabilities 113.75 204.75 Projected at 25% of
current assets
Net Working Capital, NWC 341.25 614.25
Increase/decrease in NWC 78.75 273.00
Cash balance 131.20 25.34 From the cash flow
statement
Total 1363.45 1801.49

11.6 SUSTAINABLE GROWTH RATE
In the earlier example we assumed that in order to achieve 50% growth in the
revenue the firm needed external financing of Rs 300 lacs. In matured firms the
focus is to rely only on internal generation of funds. This has several reasons that
emanate from the disadvantages of issuing fresh equity or fresh debt.

Additional fund raising by issuance of fresh equity compromises on the interest
of the existing shareholders as follows:
a. If equity is raised the proportionate holding of the existing owners falls
down.
b. Also while raising fresh equity the firm necessarily has to underprice the
issue. With under pricing the new entrants not only dilute the
proportionate holding of the existing shareholders but also do so at a
lower price. This cannot be liked by the existing owners.
c. Further the issuance of new equity is a tedious and time consuming
process subject to many disclosure norms and regulations. Some of the
mandatory disclosures like risks associated with the firm highlight the
threats that existing owners may not like to disclose.

Raising debt for further growth also presents few issues that discourage the use
of debt as means of financing growth as follows:
a. Debt causes deterioration in the capital structure increasing the
proportion of debt and hence the prior claims on cash flows of debt
holders over equity holders.
b. Though debt enhances the returns for the shareholders, it also magnifies
the risk resulting in an upward revision of return expectations.
11-10
c. Issuance of debt also comes with certain protective covenants that
impinge upon the freedom of management to take some crucial
decisions.
d. Besides like equity issuance of debt is also subject to disclosure
requirements albeit to a lesser extent.

No growth can be achieved without augmenting the resources. Assets in either
fixed or current must increase if the revenue has to grow. For addition to the net
current assets capital is required. There are three sources that can provide
capital fresh equity, fresh debt and existing profits called internal accrual. As
discussed above issuance of fresh equity is detrimental to existing shareholders
and raising debt in excess of existing proportion alters the capital structure.
Under these circumstances firms need to grow with internal accruals and
whatever proportion of debt the accrual can add without changing the
current capital structure.

Such a philosophy would place an upper limit to the growth the firm can
achieve. It naturally would be governed by a) how much profit the firm
generates, b) how much is retained c) what additional debt it can bring with
retained earnings and) how effectively the firm utilises the funds. The growth
that can be achieved without a) resorting to fresh equity, b) keeping dividend
policy intact, and c) disturbing the current capital structure is called sustainable
growth. The sustainable growth, g in the current sales of S is found as follows:

Profitability ratio (Net Profit/Sales) =p
New level of profit = p x (1+g) S
Retained earnings with dividend payout, d = p x (1+g) S x (1- d)

Retained earnings would be addition to equity and hence with the existing
debt equity ratio D/E additional debt can be raised in proportion of D/E making
total resources available are (1 + D/E) x p (1+g) S x (1-d).

New funds available =
Addition to net assets, A = p (1+g) S x (1 d) x (1+D/E) Equation 11-1

If asset to sales ratio is n then with growth in sales of g x S the growth in assets
must be
A = n x g x S . .. Equation 11-2

Equating A in the above equations and solving for g we get

v x b x p n
v x b x p
* g
v x b x g)S p(1 D/E) (1 x d) - (1 Sx g) (1 p = S x g x n

Equation 11-3

Where b = (1 - d) and v = (1 + D/E)

If a firm earns 10% return on sales, retains 40% of earnings and has debt equity
ratio of 0.5 with asset to sales ratio of 1.2, then p =0.1, b = 0.4, v = 1.5 and n =
1.2 the growth rate g* that can be sustained by the firm can be found using
Equation 11-3 as follows:
11-11

5.26% 0.0526
1.5 x 0.4 1x 0. 1.2
1.5 x 0.4 x 0.1
v x b x p n
v x b x p
* g

Hence the growth rate is dependent of profit margin and asset turnover that
are constrained by industry characteristics. They have limited role to play in
influencing the growth rate unless management adopts a newer more efficient
technology. The other two parameters i.e. the dividend payout and capital
structure are firm specific. Growth can be increased either by curtailing the
dividend or diluting debt equity ratio or both. Keeping capital structure
constant leaves only one variable i.e. dividend policy in control of
management to guide the course of growth. As we increase retention the
sustainable growth would increase. With 100% retention i.e. b =1 the maximum
growth rate achievable and sustainable is 14.28%.

SOLVED PROBLEMS

Example 11-1: Developing a Financial Plan
Following are the profit and loss account and balance sheet for two successive
years of ABC Ltd, are as below:

Balance Sheet Rs lacs
Year I Year II Year I Year II
Equity capital 100 100 Fixed assets 280 240
Reserves 200 250 Current assets 450 610
Long term debt 300 350
Current liabilities 130 150
TOTAL 730 850 730 850

Profit and Loss Account Rs lacs
Year I Year II
Sales 1050 1300
Variable costs 790 975
Fixed costs 85 110
Depreciation 47 42
Interest 48 55
Net profit 80 118
Dividend 55 68
Retained earnings 25 50

Prepare a proforma profit and loss account for a projected sales of Rs 16 crore on the
assumptions a) variable costs and fixed costs are projected as % of average sales, b)
depreciation remains at 15% c) the interest cost remain same as previous year as no
loan is repaid during the year d) dividend is 60% of the earnings. The current liability
would rise by fixed sum of Rs 20 lacs.

SOLUTION
Following is the proforma profit and loss for the coming year based on the assumptions:

Projected P & L Account Rs lacs
11-12
Year I Year II Average % of sales Projected
Sales 1050.00 1300.00 1175.00 1600.00
Variable costs 790.00 975.00 882.50 75% 1201.70
Fixed costs 85.00 110.00 97.50 8% 132.77
Depreciation 47.00 42.00 44.50 15% of fixed assets 36.00
Interest 48.00 55.00 51.50 Same as last year 55.00
Net profit 80.00 118.00 99.00 174.53
Dividend 55.00 68.00 61.50 At 60% of profit 104.72
Retained earnings 25.00 50.00 37.50 69.81

Base on the proforma profit and loss account following balance sheet is projected
Balance Sheet Rs lacs
Year I Year II Projected Year I Year II Projected
Equity capital 100.00 100.00 100.00
Fixed
assets 280.00 240.00 204.00
Reserves 200.00 250.00 319.81
Current
assets 450.00 610.00 735.81
Long term
debt 300.00 350.00 350.00
Current
liabilities 130.00 150.00 170.00
TOTAL 730.00 850.00 939.81 730.00 850.00 939.81

Example 11-2: Sustainable Growth
ABC Ltd has net profit at 15% of sales, of which 50% is distributed as dividend.
The firm maintains a debt equity ratio of 1:1 and turns over the assets one time
during the year. Maintaining the same basic parameters what sustainable
growth in sale the ABC Ltd can have sustain without accessing fresh equity and
altering the capital structure?

Solution
The sustainable growth rate may e found using Equation 11-3. We have p =
0.15, b = 0.5, v = 2.0 and n = 1.0 the growth rate g* that can be sustained by the
firm can be found to be 17.65% as follows:
% 0.1765
2.0 x 0.50 15x 0. 1.0
2.0 x 0.50 x 0.15
v x b x p n
v x b x p
* g 65 . 17

KEY TERMS

% of sales
method

A method that links most financial parameters to the level of
sales and then using them for projecting financial
statements is called % of sales method.

Proforma
Statement
A projected statements on the basis of certain assumptions
are called projected or proforma statements.

Sustainable
Growth rate
A growth in sales that can be achieved through internal
accruals without accessing the fresh capital and disturbing
the current capital structure is referred as sustainable
growth rate.

11-13
SUMMARY

Financial planning is a precursor to all financial decision making. It provides a
broad framework and guidelines for future courses of actions and decisions
related to finance. These decisions relate to investment, financing, dividend
and working capital. The strategic directions for these decisions are crystallised
in what is called a financial plan.

A financial plan contains the history of the firm and realistic assumptions on the
basis of which the forecast is made. A financial plan also serves as an effective
and efficient monitoring tool for assessing the actual performance against the
planned attributes. Financial planning integrates various functions of firm.

Commencing from top strategic level where the vision and mission of the firm
are stated it flows down to operational levels of production, marketing,
purchase, stores, human resources etc. Financial planning essentially is a
process of transforming the qualitative mission and vision statements into
quantitative representations, broken down to suitable and smaller time intervals
that are easy to comprehend.

Therefore financial planning process serves the useful purpose of integrating the
firm across various functions and for widely differing levels. It is a process of
converting the mission and vision into smaller targets to be achieved over a
period of time, usually a year.

The growth of the firm is measured in terms of value creation for stakeholders.
Of the several stakeholders in the firm shareholders occupy the dominant
position since they are the owner of the residual. The growth in revenue implies
increased deployment of additional resources. The three components of
financial plan i.e. the growth objective, the investment plan, and the financing
options have to be consistent with each other. They are mutually dependent
on each other.

As a first step to financial plan we need to have the sales forecast. Sale forecast
derives the profitability statement. A projected profit and loss statement is
referred as proforma income statement. Further on the basis of proforma
income statement and investment and financing plans one can construct a
proforma balance sheet. Financial plan is often developed on the basis of past
data. The method id referred as percentage of sales method.

A growth in sales that can be achieved through internal accruals without
accessing the fresh capital and disturbing the current capital structure is
referred as sustainable growth rate.

SELF ASSESSSMENT QUESTIONS

1. Define a financial plan and its purpose.

2. How does a financial plan integrate the organisation?

3. What are methods of developing the financial plan?
11-14

4. Describe in brief the process of financial planning.

5. What do you understand by sustainable growth rate?

6. What parameters drive sustainable growth rate in revenue?

FURTHER READINGS

1. Khan and J ain (2004), Financial Management: Text, Problems and Cases
Tata McGraw Hill, Chapter 9
2. Prasanna Chandra (2004), Financial Management: Theory and Practice,
Tata McGraw Hill, Chapter 6
3. I M Pandey (2005), Financial Management, Vikas Publishing House Pvt
Ltd, Chapter 28




12-1
UNIT 12

WORKING CAPITAL MANAGEMENT

12.0 OBJECTIVE
The objective of this unit is to
a) Explain the meaning of working capital
b) Explain how working capital decision is different from other decisions of
finance.
c) Describe operating cycle and cash cycle
d) Describe gross working capital and net working capital
e) Demonstrate how to compute operating and cash cycle from financial
statements
f) Explain inventory management concept with EOQ model
g) Demonstrate how to evaluate the various credit terms and policies.

12.1 INTRODUCTION
Working capital is one of the key decision making area of finance. Though it
concerns day-to-day operations of the firm it is regarded as strategic in nature
because its consequences are repetitive and impact firms value continuously.
Wrong decisions cause spiralling damage. Another feature of the working
capital decision is its dynamic nature that demands constant review. Working
capital decisions are subject to review at periodic intervals and provide
opportunities for corrective actions. Working capital decisions provide frequent
learning based experiences, which other decisions of finance functions like
investment, financing and dividends do not which essentially are one-off in a
given period.

Due to constant review and its repetitiveness the working capital decisions
occupy much of the management time. Concerned with the minimisation of
the capital locked up in working capital the attention for controlling the level of
assets is great. Besides managing the efficient utilisation of assets it also
concerns the means of raising the working capital finance. Hence working
capital is focussed on both sides of assets and liabilities, while other decisions of
finance function concern only one side, either asset or liability of the balance
sheet.

Being a decision that involves rotation or recycling of funds on short-term basis
typically in few months the concept such as time value of money, risk adjusted
discounting are absent from decision making. Other decisions of finance have
typically a longer time horizon adding to risk.

12.2 WORKING CAPITAL - DEFINED
Traditionally working capital has been defined as the firms investment in
current assets. It is the capital that is required for day-to-day operations of the
firm. The assets that are quickly convertible into cash are called current assets.
Typical composition of current assets in manufacturing firms includes inventories
at various levels of production, sales made to customers on credit, loans and
advances, and cash balances; the combined value of which is termed as
12-2
current assets. They are different from fixed assets like land and building, plant
and machinery the decisions relating to which are relatively infrequent.

One definition of working capital is the amount of funds locked in the current
assets. This is called gross working capital. Gross working capital reflects the
liquidity position of the firm. Current assets are convertible into cash in relatively
short period of time, typically within 12 months which may be recycled for
replenishment.

In contrast to gross working capital we have net working capital. It emanates
from the principle of matching sources and uses of the funds for specific
purposes and for specific time horizon. The build up of current assets requires
investment. The investment may come from variety of sources like equity, loan,
suppliers etc. Since current assets are short term in nature i.e. they would
convert to cash in short time. Similarly there would be liabilities that have to be
met over near future. These are called current liabilities. Typically current
liabilities comprise credit by raw material suppliers and banks that help build up
of current assets.

The excess of current assets over current liabilities is termed net working capital.
It is a truer measure of liquidity of the firm. It also signifies that how much of the
current assets are financed by the long term sources. Generally speaking, larger
the net working capital more liquid and healthier is the firm.

12.3 OPERATING AND CASH CYCLES
The concept of working capital can be best understood in terms of the cash
cycle. Cash cycle refers to time elapsed between deployment of cash in the
operations and its realisation. There is a lag in deployment and realisation of
cash typically due to a) necessity of holding raw material inventory, b) the
processing time needed for conversion of raw material into finished foods, c)
necessity of holding finished goods inventory d) making sales on credit and e)
finally realising the cash for sales. This cash cycle is depicted in Figure 12-1.

Typically firms procure raw
material and need to
maintain certain level of
stock for uninterrupted
production. Similarly
production process
determines how much of
material and
consequently funds are
required in shop floor
inventory usually referred
as work-in-process (WIP). It
is also constrained by
batch processing
requirement. Finished
goods produced are normally not sold instantaneously due to commercial
considerations. For competitive reasons firms tend to keep the stock of finished
goods, referred as finished goods inventory. Further again for competitive
Figure 12-1: Operating/Cash Cycle

Cash




Credit Stock of
Sales raw material



Stock of
WIP and FG
12-3
reasons firms extend credit to customers. Only after the expiry of credit period
firm expects realisation of cash. Only after realisation of cash firm sales the firm
can replenish the raw material for another round of production and sales.
Alternatively, the firm can use its own cash for continuous production. The time
period elapsed from stocking of raw material to realisation of cash is called
operating cycle.

When cash outgo for procurement of raw material coincides with the purchase
the operating cycle becomes the cash cycle too. This would be the case when
raw material suppliers do not extend any credit to the firm. However there can
be some gap between the stocking of raw material and its payment. Cash
cycle starts with the time of payment for raw material and ends with the time of
realisation of sales. In case of advance payment, cash cycle would be longer
than operating cycle and when the credit is available cash cycle would be
shorter than operating cycle. This is shown in Figure 12-1.

Comprehending of operating cycle and cash cycle is crucial for understanding
of working capital. It requires knowledge of technology for manufacturing
process, commercial environments governing markets for raw material and
finished goods, business practices on the industry concerned, the competitive
position of the firm. At times operating/cash cycle can be controlled to some
extent depending upon the flexibility of the factors just described.

12.4 COMPUTING WORKING CAPITAL
How much working capital is required depends upon a) length of
operating/cash cycle and b) level of operations. Longer the operating cycle
and increased level of sale imply greater amount of working capital. Stocking
requirements and credit period are normally specified in terms of days/months.

An example would best illustrate the computation of working capital. Consider
a condensed income statement of the firm. The first step is determination of
components of operating/cash cycle. Assume that after due considerations to
technical and commercial factors following periods for different components of
operating cycle are appropriate:
Raw materials : 1 month
Work in process : 1 week
Finished goods : 2 weeks
Figure 12-2: Differences Cash and Operating Cycles

Operating Cycle

Raw Material WIP and FG Sales Realisation



Cash Cycle with Advance
Advance Credit period
payment for materials
for materials Cash Cycle with Accounts Payable
12-4
Credit period availed : 3 weeks
Credit period extended : 2 months

After determination of
operating/cash cycle we need to
find the amount of investment in
each. Since at each stage the
value of investment is not the
same we need a basis of
estimating the value. Raw
materials are valued at cost. For
work in process certain
production expenses like wages, electricity etc. are incurred. Hence value of
work in process is higher than the value of materials. For finished goods certain
other expenses like packing, transportation etc are incurred. Hence finished
goods are valued at cost of sales. Selling price is normally the basis of valuing
receivables. Consider the income statement for a firm as in Table 12-1 along
with the operating cycle parameters listed above. The working capital for the
firm based on requirement of operating cycle and valuation method is shown
in Table 12-2 that needs no further elaboration.

Table 12-2: Valuation Basis for Components of Operating Cycle
Component Basis Period Computation Value
(Rs lac)
Raw Materials Cost of materials 1 month
12
600
1x

50.00
Work-in-Process Cost of production 1 week
52
800
1x

15.38
Finished Goods Cost of sales 2 weeks
52
1050
2x

40.38
Account
Receivables
Sale value 3 weeks
52
1200
3x

69.23
Gross Working Capital 175.08
Account Payables Cost of materials 2 months
12
600
2x

100.00
Net Working Capital 75.08
Note: There other items in current assets like loans and advances and in current liabilities like
expense payable, which have been ignored.

12.4.1 Common Denominator
We note that gross working capital works out to Rs 175.08 lacs. The credit
available is Rs 100 lacs making net working capital requirement at Rs 75.08 lacs.
Note that there were different bases, like cost of production, or cost of sales for
assessment of different components of working capital. Sometimes these
become difficult to obtain due to non-uniform classification of expenses. Still at
other times they may make comparison of peers difficult. As matter of
convenience most financial analysts prefer to use a uniform basis such as sales
for assessment of working capital needs to facilitate comparison and reduce
data requirements. All components are expressed as days/ weeks/months of
sales. It does not cause much deviation in computation.

Table 12-1: Income Statement Rs lacs
Sales 1200
Raw materials 600
Production expenses 200
Cost of production 800
Selling expenses 250
Cost of sales 1050
Profit 150
12-5
12.4.2 Working Capital from Financial Statements
In the absence of understanding of technical aspects and commercial
environment in which the firm operates direct computation of length of
operating cycle is not possible. However, the operating cycle can also be
derived from financial statements as described in Table 12-3.

Assume that the revenue of a firm is Rs 1500 lacs. We can arrive at operating
and cash cycle composition using common denominator as days of sales. Raw
material inventory of Rs 80 lacs is equivalent to 19.5 days of sales (80 x
365/ 1500). Likewise we may work out the levels of other components of working
capital. These are given in Table 12-3. The level of gross current asset is Rs 520
lacs equivalent to 126.5 days of sales. The net current assets (Current Assets
Current Liabilities) are equal to 90 days of sales.

Table 12-3: Operating Cycle and Working Capital from Financial Data
Item
Value (Rs in lacs) Computation Days of sales Current Assets
Inventory
Raw material 80
1500
365
80x

19.5
Work in process 70
1500
365
70x

17.0
Finished goods 100
1500
365
100x

24.3
Account receivable 250
1500
365
250x

60.8
Cash and bank
balance
20
1500
365
20x

4.9
Gross current assets 520
1500
365
520x

126.5
Current Liabilities
Accounts payable 150
1500
365
150x

36.5
Net working capital 370
1500
365
370x

90.0

Now assume that for the coming year the sales of the firm are likely to go up by
20% at Rs 1800 lacs. Since operating cycle does not change the working capital
would change in the ratio of sales. Therefore for projected sales of Rs 1800 lacs
the gross and net working capital requirements may be projected as:
Gross working capital =
365
1800
126.5x
=Rs 623.83 lacs
Net working capital =
365
1800
90x
=Rs 443.83 lacs

12.4.3 Using Averages
The working capital projections as shown above are based on the premise that
working capital cycle does not change. It implies that holding periods for
inventory and receivables does not change from period to period even though
12-6
the level of sale does change. However, it may be observed that for newer and
growing firms there is sufficient concern to control the length of the operating
cycle. Over a period of time, firms adopt inventory control measures to
manage with lower levels of holding period. Hence the requirements of working
capital may not rise proportionately with revenue. In order to smoothen out the
variation, sometimes it may not be appropriate to use financial data for end of
the year. An average of opening and closing balances of various components
of working capital would provide a better estimate.

12.5 CONTROLLING WORKING CAPITAL
Working capital management assumes importance and significance because
most analysts and management of the firm believe that investment in working
capital does not yield any return and hence is a necessary evil. It is true that
larger the working capital lesser is the efficiency of capital. It is a drain on
financial resources of the firm and therefore the need to minimise the
investment in working capital.

Investment in current assets improves liquidity of the firm. Liquidity refers to the
ability of the firm to meet its short term obligations from short term assets that
are readily and promptly convertible into cash. Liquidity is necessary for the
sound financial management. If a firm has constrained liquidity, outsiders to the
firm are reluctant to have business, as the fear of non-timely payment
overcomes attractive business propositions. Insiders to the firm such as workers
and managers also tend to link the career prospects and economic welfare
with the liquidity of the firm. Hence it becomes imperative for the firms to have
adequate liquidity.

Adequacy of liquidity comes with a disadvantage attached. Since capital can
be put to several productive uses the emphasis on liquidity without concern for
return on capital employed is misplaced. Excess liquidity in the firm causes
returns on capital employed to fall and is detrimental to the interest of
shareholders. Therefore the endeavour of management is to maintain just
enough liquidity without compromising on returns or profitability.

12.6 EFFICIENCY OF WORKING CAPITAL
How efficiently a firm is using the working capital is measured by turnover ratios.
It is apparent to see that shorter the operating/cash cycle smaller are the funds
blocked in working capital. Turnover ratios also communicate the same.
Turnover ratios mean that how many times in a year the working capital is rolled
over. Larger the turnover ratios better is the efficiency of the firm in managing its
working capital.

Turnover of gross working capital is found by dividing the base figure with the
average level of the working capital component. For example gross working
capital turnover may be found by dividing revenue with the average level of
current assets during the period, usually a year. For example if average level of
current asset is Rs 100 while revenue is Rs 400 it implies that current assets have
been turned over 4 times in a year. Larger the turnover ratio better is the
utilisation and hence lower the amount of funds blocked. Turnover ratio can be
worked out as under:

12-7
Assets Current Average
Sales
= Ratio Turnover Assets Current

Sometimes it is more convenient to express the same figure in terms of number
of days. We may say that when current assets are turned over 4 times in a year
it is equivalent to saying that it takes 3 months to complete one cycle of current
assets. Shorter the time period of holding better is the utilisation and efficiency
of capital. The efficiency of working capital may be expressed either as
turnover ratios or in terms of holding period.

days X 365
Sales
Assets Current Average
= Period Holding Assets Current
We can determine the efficiency of each component of working capital in
similar fashion, with following formulae
Assets Current Net Average
Sales
= Ratio Turnover Assets Current Net
days X 365
Sales
Assets Current Net Average
= Period Holding Assets Current Net

n consumptio of Days 365 x
n Consumptio Material Raw
Inventory Material Raw Average
= Period Holding Material Raw
Inventory Material Raw Average
n Consumptio Material Raw
= Ratio Turnover Material Raw
tion of produc Days 365 x
Production of Cost
Inventory WIP Average
= Period Holding Inventory WIP
Inventory WIP Average
Production of Cost
= Ratio Turnover (WIP) Process - in - Work


sales of Days 365 x
of Sales Cost
Inventory FG Average
= Period Holding Inventory FG
Inventory FG Average
of Sales Cost
= Ratio Turnover ) FG Goods Finished (

Days 365 x
Sales
Debtors Average
= Period Collection Average
Debtors Average
Sales
= Ratio Turnover Debtors

Days 365 x
Purchases
Creditors Average
= Availed Credit Average
Creditors Average
Purchases
= Ratio Turnover Creditors


Usually the turnover ratios or holding periods are compared against some
standard like industry average to make qualitative and quantitative judgment
about the relative performance of the firm under question. Below average
performance would be reflected in lower than average turnover ratios or
higher than average holding periods.

12.8 INVENTORY MANAGEMENT
Inventories of raw materials, work-in-process and finished goods constitute
major proportion of current assets and hence working capital in most
12-8
manufacturing enterprises. The component of inventory is as high as 60-75% in
most manufacturing firms. In contrast for service industry the component of
materials may be as low as 5%.

The need to maintain raw material inventory arises from the desire of the
production function to maintain uninterrupted production. Continued
production is subject to timely availability of raw materials. In firms where batch
production is undertaken full materials requires to process the batch is required.
Adequate and timely availability of materials always remains in doubt due to
several exogenous factors rendering uncertainty. In case the purchase function
or the suppliers of raw material fail to deliver the required raw material in time
the production stops. It is an extremely costly and undesirable situation.
Inventory serves as cushion to absorb uncertainties of supplies. Raw material
inventory decouples purchase function and production function.

Similar arguments may be made for need of inventory of finished goods.
Marketing function would like to meet demands of customers with ready
delivery to gain competitive edge. Finished goods inventory is also required to
meet any unforeseen demand at short intervals of time. Further for economy of
transport cost finished good are despatched only when they constitute a
specific lot such as a truck or container load. Hence finished goods inventory
decouples production and marketing function, much in the same way the raw
material inventory does for purchase and production functions.

Work-in-process inventory is mainly governed by technology/production
methods or batch processing requirements. In case of continuous production
such as steel mills the time taken in processing cannot be controlled. Similarly,
where batch processing is done such as brick production through kilns a full
load is required to save on the energy costs. Of the three components of
inventory the work-in-process inventory is least controllable by management.

12.8.1 The EOQ Model
Because of the cost associated with inventory the firms would like to keep the
stocks at a minimum level that can sustain continued production. The most
popular model used by the firms for controlling inventories is EOQ model. The
objective is to keep minimum level of stock that just suffices for continued
production. To understand we need to understand the consumption pattern
and costs associated with inventories. We do so with the help of an example.

12.8.1.1 Consumption Pattern: Assume that a firm requires 1200 units of an item over a
period of one year. It can place one single order of 1200 units for the entire
year. In most situations one would guess that it would involve large amount in
the order as the consumption does not take place instantaneously. The
consumption pattern in its most simplistic form is uniformly spread over time. As
time elapses, the level of inventory falls. When it reaches a certain level, an
order may be placed again to replenish. Let us assume that quantity ordered is
Q and we now wish to economise on the cost. With ordered quantity arriving at
a time would make inventory rise suddenly. Then it would be consumed
uniformly over a period of time. This is depicted in Figure 12-3.

12-9
12.8.1.2 Carrying Cost: Carrying inventory involves costs such as interest on the capital
locked in the inventory, insurance, rent etc. These costs are normally
proportional to the value of inventory which in turn depends upon the physical
levels. The carrying costs are expressed as percent of the funds blocked the
dominant component of which is the opportunity cost of funds. If consumption
is uniform over a period of time with quantity ordered as Q the average
inventory level would be Q/2. With price of the raw material as p the average
blockage of funds would be Q x p/2. With i as carrying cost the cost of carrying
is Q x p x i/2. Assuming unit price of Rs 10 and carrying cost of 15% the carrying
cost would be Q x 10 x 0.15/ 2.

12.8.1.3 Ordering Cost: With placing an order for the materials there are administrative
costs associated with replenishment of inventory. These costs are more of a
function of the number of orders placed in the inventory rather than the
quantity of order. These costs involve calls to suppliers, placement of orders,
follow-up for speedy delivery, inspection on arrival of materials etc. These costs
are function of number of orders placed in a given period. If we assume total
annual requirements of A units and each order of the size of Q then the number
of orders placed is A/ Q. With each order costs, c then total annual ordering
cost is c x A/ Q. With ordering cost of Rs 100 per order the total order cost would
be 1200 x 100/ Q.
Figure 12-4: Costs of Inventory

Cost

Total Cost



Carrying Cost




Ordering Cost


Q* Order Quantity, Q
Figure 12-3: Depiction of Consumption and Replenishment of Inventory
Level of Inventory


Q


Reorder Level



Time

Lead Time

12-10

Behaviour of costs: The two costs associated with inventory behave in opposite
direction with the order quantity Q. As we increase the order quantity a) the
carrying cost would increase as average investment increases, and b) the
ordering cost decreases as smaller number of orders are placed. The behaviour
of cost is depicted in Figure 12-4. The total cost of the inventory is the sum of
carrying and ordering cost.

12.8.1.4 Optimum Order Quantity: The objective of inventory management is to minimise
the total cost of inventory. With little mathematics we can prove that this would
occur when ordering cost is equal to carrying cost. Therefore, for optimum
order quantity referred as Economic Order Quantity (EOQ), Q* we have
i x p
c x A x 2
* Q
c x
* Q
A
=
2
i x p x * Q
Cost Ordering = Cost Carrying

For A =1200 unit, ordering cost, c =Rs 100, unit price, p =Rs 10 and inventory
carrying cost, i =15% we get EOQ of 400 units.

units 400
0.15 x 10
100 x 1200 x 2
i x p
c x A x 2
Q*
The total cost of the systems is worked out as below:

Number of orders per annum =1200/400 =3
Annual ordering cost =3 x 100 =Rs 300
Average inventory level =400/2 =200 units
Average investment in inventory =200 x 10 =Rs 2,000
Annual carrying costs =0.15 x 2,000 =Rs 300
Total inventory cost =Rs 300 + Rs 300 =Rs 600

Observe that at order quantity of 400 the ordering cost is equal to carrying cost
both at Rs 300 each.

12.8.1.5 When to Order: In order to have timely arrival of stocks the firm would have to
order in advance to allow time for the supplier to make delivery. The time taken
by the supplier between receipt of order and its execution is called lead time.
The firm needs to place order when the inventory level falls to lead time
consumption. If we assume lead time of one month then the firm needs to
place an order when the inventory level falls to 100 units, being equal to
number of unit to be consumed over one month. Hence reorder level would
be:

Reorder level =Lead time consumption =Lead time x consumption rate
=1 month x 1200/ 12 moths =100 units.

12.8.1.6 Safety Stock: The EOQ system of ordering does not provide for a) increased
consumption rate over lead time and b) variation in the lead time. In real life
situations the consumption can increase, which would lead to a situation of
stock out prior to the arrival of fresh stocks. Similarly the supplier may take longer
than the usual lead time again leading to stock out. Usually stock out cost is
12-11
very large although situations have less likelihood of occurrence. Therefore firms
need to have some level of safety stocks to provide of increased consumption
and delays in the lead time or both. Optimum level of safety stock can be
found by balancing the carrying cost and stock out cost. The methods are
statistical in nature.

However, we may decide on optimum level of safety stock based on
experience. Assume that firm feels that stock equal to 15 days consumption is
appropriate level of safety stock. If so the reorder levels and costs would stand
modified as below:

Average level of inventory =Safety Stock + Q/2 =50 + 200 =250 units
Carrying cost =Average investment x % carrying cost
=250 x 10 x 0.15 =Rs 375 p.a.
Ordering cost =Same as before =Rs 300
Reorder level =Safety stock +lead time consumption
=50 + 100 =150 units

EOQ model makes several simplifying assumptions like uniform consumption
rate, fixed per unit price of input independent of quantity etc. However, EOQ
model is fairly robust and is capable of incorporating the changes as may be
desired by the management under real life situations.

12.9 RECEIVABLES MANAGEMENT
Account receivable usually is the second largest component of working capital
in most manufacturing enterprises. In service industry account receivable
remains the dominant constituent of working capital. To promote sales and
gain competitive advantage over competitors firms offer credit periods to their
customers. As we know the money has cost firms believe that the benefits of
increased sales/profit or outperforming the competitors would outweigh the
cost of extending credit.

The key variables in receivables management are a) credit terms; the period
allowed by the firm to its customers for making payment b) cash discount; the
rebate applicable for payment prior to the due date, and c) cash discount
period; the period in which the cash discount is applicable.

There are other costs of extending credit besides opportunity cost of capital
locked in receivables. Extending credit also increases administrative cost in
monitoring and collection. Further it is not necessary that all customers pay on
or before the due date. In such a case the more capital would be locked in
receivables that prescribed by credit terms. Firms also incur cost in collecting
information on the credit worthiness of the customers. Lastly not only the delay
in collection there is a chance that some customers may not pay at all. These
are referred as bad debt costs. All these costs are absent if firms make cash
sales only.

The best way of explaining the account receivable policy is by way of an
example. Assume a firm has credit policy of 1.00/ 20 net 30 meaning that a
discount of 1% of invoice is available if paid in 20 days else the due date is 40
days. The current revenue of the firm is Rs 730 lacs, with contribution margin of
12-12
25%. Its cost of funds is 15%. Currently 50% of revenue is realised in discount
period and remaining on due date resulting in following costs:

Account receivable collection period =0.5 x 20 + 0.5 x 30 =25 days
Amount of funds in receivables =25 x 730/ 365 =Rs 50 lacs
Cost of funds in receivables =0.15 x 50 =Rs 7.50 lacs

In order to increase sales the firm is considering modifying the credit policy with
either 1.5/15 net 45 (Plan A) or 2.5/10 net 60 (Plan B). With increased discount
the customers likely to avail cash discount would increase to 60% and 70%
under Plan A and B respectively. The plans are expected to result in following
cost and benefits:
Plan A Plan B
Increase in sales 10% 15%
Increase in bad debts of incremental sales 5% 6%
Increase in collection cost Rs 1lac Rs 3 lacs
% sales with availing discount 60% 70%

The adoption of revised credit terms would alter the collection period and with
new plans the average collection period, investment in receivables and cost
thereof would be as follows:

New collection period
(Days)
Revised investment in
receivables
(Rs lacs)
Increase in carrying
cost
(Rs lacs)
Plan A
0.6 x15 +0.4 x 45 =
27 days
27 x 730 x 1.10/365 =
59.50
0.15 (59.50 50.00) =
1.425
Plan B
0.7 x10 +0.3 x 60 =
25 days
25 x 730 x 1.15/365 =
57.50
0.15 (57.50 50.00) =
1.125

The change in credit terms would also change the profit levels too. The current
level of contribution margin is 0.25 x 730 =Rs 182.50 lacs. The revised terms of
increased discount would reduce the margin to the extent of that avails
discount.

Revised revenue
(Rs lacs)
Revised contribution
margin (%)
Increase in contribution
(Rs lacs)
Plan A
730 x 1.10 =
803
0.6 x 24.5% +0.4 x 25% =
24.70%
24.70% x 803.00 182.50 =
15.84
Plan B
730 x 1.15 =
839.50
0.7 x 23.5% +0.3 x 25% =
23.95%
23.95% x 839.50 182.50 =
18.56

Now we may compare the cost and benefits of the Plan A and Plan B.

Rs lacs Plan A Plan B
A) Increase in contribution 15.840 18.560
B) 1)Increase in bad debts 3.650 6.570
2) Increase in funding cost 1.425 1.125
3)Increase in collection cost 1.000 3.000
C) Total increase in costs B) 1, 2, 3 6.075 10.695
Increase in profit (A C) 9.765 7.865

12-13
Since the increase in profit with Plan A is greater than the Plan B firm would be
better off by following Plan A.

SOLVED PROBLEMS

Example 12-1: Finding Operating Cycle from Financial Statement
Following extract of balance sheet is available for beginning and end of year
2010. The firm made sales of Rs 2000 lacs during Year 2010.
Rs lacs
Liabilities Start End Assets Start End
Accounts payable 100 142 Inventories 400 460
Other current liabilities 20 30 Account receivable 240 300
Other current assets incl.
cash and bank balance
12 18

Using average for the period and common denominator of sales find out the
following for projected sales of Rs 2,500 lacs in the next year:
a) the operating cycle
b) gross working capital
c) cash cycle
d) net working capital.

Solution:
All components of working capital with average figures and in terms of revenue
are
days 78 x365
2000
430
x365
Sales
Inventory Average
= Period Holding Inventory
days 4 x365
2000
270
x365
Sales
s Receivable Average
= Period Collection Average 9
days 3 x365
2000
15
x365
Sales
Assets Current Other Average
= Period Holding Asset Current Other
Therefore, Operating cycle =78 + 49 + 3 =130 days of sales
And Gross Working Capital for next year =130 x 2500/ 365 =Rs 890 lacs

days x365
2000
146
x365
Sales
lities OtherLiabi Payables Average
= availed Credit Average 27

Cash Cycle =130 27 =103 days of sales
Net Working Capital for next year =103 x 2500/ 365 =Rs 705 lacs

Example 12-2: EOQ Model
A firm requires and automobile component. The estimated requirement is 2,000
units per month and it costs Rs 15. The carrying cost for the firm is 18% per
annum. The administrative cost attached with processing of the order is Rs 150
per order. If firm decides to retain 750 units as safety stock, find the following:
a) The optimum order size
b) Cost of carrying inventory for the component
c) The reorder level.

Solution
a) The economic order quantity Q* is calculated at 1,633 units as below:

12-14
units 1
0.18 x 15
150 x 24000 x 2
i x p
c x A x 2
Q* 633

b) The total cost associated with inventory is sum of ordering cost and
carrying cost as calculated below:
Ordering cost =24000/ 1633 x 150 =Rs 2,204
Carrying cost =750 x 15 x 0.18 + 1633/2 x 15 x 0.18
=Rs 2,025 +Rs 2,204 =Rs 4,229
Total cost = 2,204 + 4,229 = Rs 6,433

c) Reorder level =safety stock + lead time consumption
=750 + 1,000 =1,750 units

KEY TERMS

Operating
Cycle

The time taken from raw material stage to convert into
finished goods to sales and ultimate realisation of cash is
called operating cycle.

Cash Cycle The time taken from payment of raw material to convert
into finished goods to sales and ultimate realisation of cash
is called cash cycle

Gross Working
Capital
Investment in current assets is called gross working capital.


Net Working
Capital
The difference of current asset and current liabilities is called
net working capital.

Turnover
Ratios
The multiple of value of any current asset/liabilities with an
appropriate annual value are turnover ratios.

Economic
Order
Quantity

An order size that minimises the total cost associated with
inventory is economic order quantity.
Safety Stock The stock retained for the exclusive purpose of preventing
stock out situation is termed safety stock.

Reorder Level The level of inventory where fresh order for replenishment of
stock must be placed is reorder level.

SUMMARY

Working capital is one of the key decision areas of finance function. Unlike
other decisions of finance this decision is repetitive, and offers scope for
corrective actions. Few of the prominent concepts of finance like time value of
money and risk are absent from working capital decisions.

The funds involved in the working capital depend upon operating cycle and
the level of operations. Longer operating cycle and increased level of
12-15
operation demand more investment in working capital. Operating cycle refers
to the time elapsed between obtaining of raw material to its conversion to
finished goods to realisation of sale proceeds. From the date of payment for
raw material to the realisation of sale proceeds is called cash cycle. Shorter the
operating/cash cycle better it is from the perspective of management of
working capital.

Broadly operating cycle represents current assets, while cash cycle refers to the
excess of current assets over current liabilities. Investment in current asset is
gross working capital. Net working capital is the difference of current asset and
current liabilities. Net working capital signifies liquidity of the firm. Excess liquidity
than required is detrimental for the firm as extra liquidity does not earn a return
on the capital. Hence there is a need to keep the working capital at the
minimum as a compromise between liquidity and profitability.

Efficiency of working capital is measured by turnover ratios that represent how
many times the component of working capital is rolled over a year. Larger the
turnover ratio better is the utilisation of working capital.

Inventory of material constitutes the major portion of the current assets and
hence working capital. To economise on the investment in inventories, most
basic model that throws insights to inventory management is used. It is called
EOQ model that provides a formula to arrive at order quantity that minimises
the total costs of inventory.

Similarly, account receivable also forms a significant proportion of working
capital needs to be managed properly. Increasing credit period results in
increase in sales and hence the profit. However, increasing credit period
increases the amount of working capital, increasing the average collection
period. Besides, it also adds to the cost of bad debt and collection. Therefore
decision to increase the credit period must be weighed with net of benefits and
costs associated with a credit policy.

SELF ASSESSSMENT QUESTIONS

1. Define and contrast the terms gross working capital and net working
capital.

2. Differentiate between operating cycle and cash cycle.

3. How working capital management is different from other decisions of
finance function.

4. Given no information about the manufacturing process and the
economic environment in which the firm operates how would you
compute the operating cycle and cash cycle? Illustrate with an
example.

5. How would you comment upon the working capital management of the
firm?

12-16
6. What function inventory serves?

7. Inventory is often said to be necessary evil. Do you agree? Explain.

8. What do you understand by EOQ model?

9. What are the advantages and disadvantages of extending discount
and credit terms?

10. How would you decide of acceptance or otherwise of a particular
credit plan?

FURTHER READINGS

1. Khan and J ain (2004), Financial Management: Text, Problems and Cases
Tata McGraw Hill, Chapter 30
2. Prasanna Chandra (2004), Financial Management: Theory and Practice,
Tata McGraw Hill, Chapter 28
3. I M Pandey (2005), Financial Management, Vikas Publishing House Pvt
Ltd, Chapter 28