Sandeep Gokhale

Jamnalal Bajaj Institute

University of Mumbai

1
References
Financial Management

Authors :
• Khan & Jain
• Prasanna Chandra
• I.M.Pandey
• S.C.Kuchhal
• Maheshwari

2
Syllabus
• Ratio Analysis
• Fund & Cash flow analysis
• Cost of Capital
• Working Capital Mgmt.
• Means of Financing
• Capital Budgeting
• Dividend Structuring
• Bonus Shares
• Share Holder Value
Measurement

3
 FINANCIAL MANAGEMENT
Objective: Create share holder value
Methodology: Capturing of value at all Levels.
Business Process restructuring
Enterprise resource management.
Vertically integrated operations.
Customer relationship Management
Sustained up scaling of operations
Effectiveness: Proximity of gross profit to net profit
Maximisation of EVA
4
EV / EBIDTA multiple
 Financial Management – an Overview

Business environment

Planning Policies&Decisions
(Management Accounting)

Restructuring
Financial Investor Wish
Markets Resource Mobilisation List
Treasury

Control&Information
( Audit & Taxation)

5
Valuation Technique
 Environmental scan

Economy: Convertibility of Local Currency

GDP / Industrial growth rate
Scalability of Operations
FDI – Incoming / outgoing
Inflation rate / Fiscal deficit
Trade surplus/deficits
Balance of payment status
WTO Implications
Emerging markets scenario
Gross national income distribution 6
Government Policy: Industrial policy
Government programmes and projects
Tax regime
Subsidies, incentives and concessions
Exim policies / VAT
Government Expenditure
Lending considerations of financial
institutions and commercial banks
Infrastructure Development
Rating of Govt paper
7
Agricultural policies
Technology: Emergence of new technologies.
Access to technical Up gradation
Level of obsolescence.

Socio Demographic: Population trends

Age shifts in population
Educational profile.
Attitudes toward consumption and investment

8
Competition: Number of players in the industry and their
market share.
Duty barrier and status of international cost
and volume positioning.
Degree of homogeneity and differentiation
among products.
Entry barriers for new capacities.
Comparison with substitute products.
Unorganised sector operations.
Marketing polices and practices.
9
 ORGANISATIONAL INTERFACE OF FINANCE

Areas Interface
Corp planning: Long term financial goals in terms of
assets, sales,profits,dividends etc.
Expansion, new projects diversifications
takeovers , mergers,disinvestments.
Internal generation, tax planning.

Operations: Integrating functional plans.

Working capital management

10
Areas Interface
Control: Budgetary control of all divisions
Variance analysis
Marketing: Credit norms
Cost analysis of decisions like discounts ,
premium pricing,product promotion etc.

Manufacturing: Budgeting for manufacturing operations.

Product mix decisions.

Personnel: Budgeting for personnel & administrative

function. 11
 FINANCIAL FUNCTION

Money Mgmt Accounting Control Advisory Role

Resource Financial Budgets Project

Mobilisation Accounting Financing

Working Capital Cost Variance Pricing

Mgmt Accounting Analysis

Investment Mgmt Profit Center Div. Policy

Accounting
Mgmt
Cost Center Valuation of
12
Assets
 Financial Decision Areas
• Investment analysis
• Working capital management
• Sources and cost of funds
• Determination of capital structure
• Dividend policy
• Analysis of risks & returns
• Treasury - interest / exchange rate swaps
• Restructuring of operations / term debt profile
• Equity buyback / Bonus

• To result in shareholder wealth maximisation

13
 PROFIT AND LOSS ACCOUNT

For the Period 1st April to March 31st

Income: Gross sales from Goods & Services

Less: Excise Duty
Net Sales
Other Income
Non operating Income
Total Income

14
Expenditure: Raw materials consumed
Manufacturing expenses
Administrative expenses
Selling expenses
WIP +FG adjustment
PBIDT (Gross Profit)
Less: Interest
Less Depreciation
PBT (Operating Profit)
Less: Tax
PAT (net profit)
Gross cash accruals : PAT + Depn
15
Net cash accruals : GCA - Dividend
 THE BALANCE SHEET
For the year ended March 31st 200...

Liabilities: Equity share capital

Reserves & Surplus
Term loan
Debentures
Fixed deposits
Other unsecured loans
Commercial bank borrowings
Creditors
Other current liabilities 16
Assets: Gross fixed assets
Less: Acc. Depn
Net Block
Investments
Currents Assets: RM Stock
WIP
F.G.Stock
Debtors
Cash in bank
Loans & Advances
Misc.. expenditure
Deferred expenditure 17
 RATIO ANALYSIS

Principal tool for analysis

Inter firm comparison

Intra firm comparison

Industry analysis

Responsibility accounting

18
TYPES OF FINANCIAL RATIOS

Liquidity

Leverage

Turnover

Profitability / Valuation

19
 LIQUIDITY RATIOS

Current Ratio: Current assets

Current liabilities

Acid test ratio: C.A- Inventories

Current liabilities

Cash position ratio: Cash in bank + hand

Current liabilities

Inventory to G.W.C: Inventory

Current assets 20
 LEVERAGE RATIOS

Debt / Equity ratio: Long term debt

Net worth

Borrowing / Assets: 1- Net worth

Total Assets

Fixed asset / Networth: Fixed Assets

Net worth

21
Capital gearing ratio: Capital entitled to fixed return
Capital not entitled to fixed return

Debt. Service coverage ratio: PBDIT - Tax

Interest + Annual installment

Interest coverage ratio: PBDIT - Tax

Interest

F. Asset coverage ratio: Gross fixed asset - Acc. Depn

LT Secured liabilities 22
 ACTIVITY RATIOS

Total asset turnover: Net sales

Total assets

Fixed asset turnover: Net sales

Fixed assets

Inventory turnover: Net sales

Inventory

activity 23
Debtors turnover: Credit sales
Avg. debtor

Collection period: Avg. debtor * 365

CR. Sales

Creditors Turnover: Credit purchase

Avg.. Creditors

Payment period: Avg. Creditor * 365

Net sales 24
 PROFITABILITY / VALUATION RATIOS

Gross profit ratio: PBDIT / Sales

EBITDA / Sales
NOPLAT : Net operating profit less adjusted

Tax
ROSE: PAT - Pref. Div
Net worth

Return on CAP. Employed: PBIT

Total Lia - Creditors – Provisions
25
Book value per share: Net Worth
NO of Equity Shares
EV / EBITDA: Enterprise value / Gross profit

Earning per share: PAT - Pref Div

No. of Equity shares

Price Earning ratio: Market price

Earnings per share

Pay out ratio: Dividend paid

26

Profit after Tax

 USERS OF FINANCIAL RATIOS

Lenders of funds for appraising credit worthiness for long term / short
term lending decisions.

Valuations in investment / disinvestment decisions.

Financial analyst / Mutual Funds / Investment Bankers.

Management for operational short / long term planning.

Credit Rating Agencies

Tax authorities 27
 LIMITATIONS OF RATIO ANALYSIS
A ratio in absolute terms has no meaning. It has to be compared.
•Inter firm comparison.
•Companies resort to window dressing of Balance sheets.
•Operating and accounting practices differ from company to
company.
•Consolidation of group / subsidiary companies figures.
E.G. Changes in Depreciation methods
Inventory Valuation
Treatment of contingent liabilities.
Valuation of investments.
Conversion or transaction of foreign exchange items.
28
 FUND FLOW ANALYSIS
It is a statement indicating the methods by which a company has been
financed and the uses to which it has applied its funds over a period of
time.

It provide an insight into the movement of funds and helps in

understanding the changes in the structure of asset & liabilities.

Provides information as to how funds are raised and utilised.

Determines need for funds and helps in deciding finance mix

Determines financial consequences of business decisions.

Free cash flow generation ability and Utilisation of the same. 29

 FUND MANAGEMENT

Mobilisation Requirement

Quantum Source Cost

Equity Buy
Normal Incremental New
back
Capital Working Investments 30
expenditure capital
 FUND FLOW OCCASIONS
Sources Uses
Funds from operations Loss from operations

Sale of fixed assets Increase in fixed assets

Increase in liabilities Redemption of liabilities

Sale of securities Purchase of securities

Decrease in W.C Increase In W.C

Cash Dividends, Equity buy31 back
 FUND FLOW

Assets Uses of funds

Liabilities Uses of funds

Assets Source of funds

Liabilities Source of funds

Comparison of balance sheets of consecutive years.

32
 TYPES OF FUND FLOW STATEMENTS

OVERALL FUND FLOW

OPERATIONAL FUND FLOW

WORKING CAPITAL BASED FUND FLOW

(ONLY STS/STU STATEMENT)

33
 COST OF CAPITAL
Aggregate of the liabilities raised by a company is the total capital
employed in business.

Different sources have different cost and tax implications.

Cost of capital

It is a single rate (weighted average ) for a finance mix.

It is computed on a post - tax basis since cost of different sources

have different tax implications

E.g.. Interest on debt capital enjoys tax shield while dividend paid
on equity has no tax shield.

COC is used as a discounting rate in DCF analysis. 34

 RELEVANCE OF COC

•Used as a hurdle rate in DCF analysis.

•Wt. Average cost of capital
•Marginal cost of capital

K0 = Ki + Ke

K0 = WT. Average cost of capital

Ki = Cost of debt capital
35
Ke = Cost of equity capital
 COST OF CAPITAL

Consists of three components:

•Risk less cost of a particular type of finance (rj)

•Business risk premium(b)

•Finance risk premium(f)

36
K0 = rj + b + f
RELATIONSHIP BETWEEN WEIGHTED AVERAGE
COST AND MARGINAL COST OF CAPITAL

•Degree of leverage

•Cost of instruments

•Tax Rate / Treatment

WACOC : K0 = Ki1 + Ke1

MCOC : K0 = Ki2 + Ke1

37
 METHODS OF COMPUTATION OF COST OF
EQUITY
ROI approach

Ke = PAT - pref. div + non tax shield portion of depn

Equity block (E + R +S + acc depn)

Market capitalisation approach

Ke = D/P + G
D = Dividend per share G = Growth rate = b*r
P = Market price per share
b= % Retained earnings = PAT - Dividends / PAT
38
r = % Return on “b” = PAT - Pref div / Net worth
Capital Asset Pricing model

Ke = Rf +beta ( Rf – Rm)

Rf = risk free rate of return

Beta = stock relationship with a index
Rm = Market expectations of return ( Bloomberg base )

39
•If ROI approach is used to determine Ke then book value to be
considered as weights.If market capitalization approach is used
then market value to be considered as weights.
•All cost to be considered on a post tax basis.
•The market capitalization approach is superior to the ROI
approach since the parameters are market determined and
futuristic as compared to the ROI approach.
•The CAPM approach is a further refinement which also includes
premium for risk
•In loss making companies minimum cash flow approach is used.
•Cost of equity could be benchmarked with return on
40
guilts,market risk and portfolio risk ( Asset Beta )
 WORKING CAPITAL MANAGEMENT

Objective: Optimise current asset deployment.

Advantages: Lower interest cost.

Inventory holding cost reduced.

Disadvantages: Interruption in production.

Stock out to customers.

41
 ASSET STRUCTURE FOR VARIOUS
INDUSTRIAL SEGMENTS

FA CA

Power Generation 80% 20%

Chemical process plants 50% 50%

Engineering 40% 60%

Service 20% 80%

Trading 10% 90%

42
 WORKING CAPITAL
Current assets comprise of stocks of raw materials, work in progress,
finished goods, and receivables.
Gross working capital = total current assets.
Net working capital = CA - CL
Objective is to optimse asset requirement and funding the same at
minimal cost.

Working capital
Permanent
requirement component

Variable
component) 43
 CONSTITUENTS OF CURRENT ASSETS

Raw material stock

Work in progress

Finished goods stock

Cash in hand / bank

Debtors / Receivables

44
 OPERATING CYCLE TIME
Time required for rolling or rotation of current assets.

Date of receipt RM issued to Throughput time

of RM production Dept

Collection of Despatched to consumers Converted to FG

Receivables 45
 FACTORS INFLUENCING WORKING CAPITAL
REQUIREMENTS
•Nature of business

•Manufacturing process

•Competitive forces in raw material & finished goods segment.

•Infrastructural support.

•Through put time

•Seasonality in demand

•Shelf life of RM / Finished product

•Customer relationship management 46

 CREDIT MANAGEMENT

•Terms of payment Cash against delivery

Consignee basis
Proforma invoice
Letter of credit
Advances
Suppliers / Buyers LOC
•Credit policy variables Credit standards

Credit period

Cash Discounts
47
•Credit evaluation Character
Capacity
Capital
Collateral
Macro conditions

•Control of accounts Days sales outstanding

receivables Ageing schedule (in days)
Collection matrix
Average collection period
48
 RECEIVABLES MANAGEMENT

•Credit standards Collection cost

Average collection period
Bad debts
Level of incremental sale
•Credit terms

•Collection policies

•Factoring 49
 CASH MANAGEMENT
Cash budgets : Quarterly / monthly / weekly

Operating cash inflow/ outflow items:

Cash inflow Cash outflow

Cash sales Accounts payable
Collection of receivables R.M purchase
Salary
factory expense
Administration/selling exp.
Taxes / Duties
50
 WORKING CAPITAL FINANCING

•Cash accruals
•Trade credit
•Commercial bank borrowings
Cash credit limit
WCTL
Bill discounting
Letter of credit
Bank guarantee
•Public deposits 51
•Short term / medium term loans from FI’s Banks
•Debentures for working capital
•Commercial Paper.
•Euro Commercial Borrowings
•Inter Corporate deposits
•Trade credit notes ( commodity exchanges )
•Factors

52
 RBI CREDIT AUTHORISATION SCHEME
1969 Dahejia committee .
. recommended nationalisation of
banks

1974 Tandon committee

To curb excessive credit and inflation

•Industry wise norms for eligible current assets.

•MPBF to be determined on the basis of following:

Method 1: 25% of (CA-CL) to be financed from LTS

Balance would be MPBF.

Method 2: 25% of CA to be financed from LTS from

the balance CL to be deducted to 53
determine MPBF .
Method 3: 25% of core current assets from LTS.

•All borrowers were immediately put under method 1 of lending and

excessive CBB converted into WCTL.

•Structured reporting to banks.

•Penal interest provisions.

54
 FAST TRACK APPROCH

•Credit monitoring arrangement (CMA) instead of CAS.

•Norms for Eligible current assets for computing MPBF will

be the industry average.

•No prior approval of RBI required.

•Lesser dependence on bank finance.

1997: Concept of maximum permissible bank finance (MPBF) 55

abolished to ensure efficient credit delivery mechanism”
Implications:

Banks free to determine credit limits

Consortium finance abolished

Tandon method -2 (CR > 1.33) diluted.

56
 RBI Guidelines
• Working capital credit to be determined by banks according to their
perception of the borrower and the credit needs.Methods followed are :

• Projected balance sheet method

• Cash budget method

• Turn over method ( only for SSI upto rs 200 lacs )

• Other assessment methods.

57
Projected Balance Sheet Method

Applicable to all borrowers engaged in manufacturing,

services and trading activities whose fund based limit is in
excess of rs 25 lacs and below rs 200 lacs.

Under the PBS method ,assessment of working capital will

be carried out in a flexible manner with examination of all
relevant parameters and the borrower will submit the same
as per the following forms:

58
 Projected Balance Sheet Method
• Form 1 : Particulars of existing Long / short term
debts,borrowings from NBFC’S ,ICD’,Leasing etc

• Form 2 : Operating statements

• Form 3 : Analysis of balance sheet

• Form 4 : Comparative statement of CA/CL.

• Form 5 : Fund flow statement.

59
 Cash Budget Method
• Used for assessing WC requirements of seasonal industries and
construction activities.
• The required finance is quantified from the projected cash flows and
not from projected values of assets and liabilities
• Assessment of the cash budget,projected profitability,
liquidity,Leverage and fund flow are done.
• The cash budget analysis is also used to sanction adhoc working
capital limits.
• WC limits are determined on the ‘Cash Gap’ .
• Takes into consideration fluctuations in fund requirement over a
period of time.No strict norms for inventory levels.Temporary
slippage's allowed.
60
 Long Term Financing

Basis of evaluation

Availability

•Flexibility

•Cost

Availability : should be available at the point / time when required

Flexibility : certain instruments are user/ application specific

Cost : to be evaluated on a post tax basis

61
 SOURCES OF TERM FINANCE
•Term loans from all India financial institutions
•State level financial institutions
•Debentures: NCD
PCD
OFCD
•Fixed Deposits
•Equity share capital
•Equity share capital with differential rights as to dividend
,voting or otherwise
•Preference share capital
62
•Mutual Funds
•Retained earnings
•Exchangeables
•Venture Capital
•Deferred payment gurantees
•Leasing
•External commercial borrowings
•Depository receipts
•Floating interest rate Debt.
•Securitisation of future receivables
•Derivative linked bonds
63
 FINANCIAL / INVESTMENT INSTITUTIONS
They are major source of long term debt funds for financing:
•Fixed Assets
•Margin money for working capital
Indian FI’s
IDBI / ICICI / IFCI / IIBI
Foreign Institutions
Sectoral Institutions
HDFC / IL&FS / HUDCO / IDFC
Universal Banks
ICICI Bank
64
Investment institutions
GIC & Subsidiaries
UTI
LIC
Investment Banks
•23 State level financial institutions (IDC’s)
•23 State level financial institutions (MSFC)
SFC’s can fund upto 90 Lacs
SIDC’s can fund upto 150 Lacs

65
Features: Interest rate is based upon the prime
lending rate + project risk.
Basic interest rate linked to inflation rate
Project risk / company risk depends on the credit-
rating.

Security Hypothecation & mortgage

Collateral
Covenants
Moratorium period
Repayment schedule / Amortisation schedule
Convertibility option only in the event of default. 66
GUIDE LINES FOR KEY RATIOS

DCSR > 1.8 TIMES

D/E 1:5:1
Promoters contribution : 20 - 25%
CR: > 1.33

Banks

Participate in Long term financing on conditions similar to FI’s

however are able to offer funds at lower cupon rates.
67
Debentures:

•Approval from SEBI mandatory if public issue is proposed

•Debentures used to finance margin money not to exceed more than

20% of N.W.C

•Convertibility clause terms to be specified at issuance time.

•Credit rating mandatory

68
•Types of Debentures:
NCD
FCD
PCD
OCD
•Coupon rate depends on terms of issue.

Other features
•No TDS for interest paid upto Rs 2500 per annum
•Redemption premium
•Listing on stock exchanges
•Fully secured
•Call and put options
69
Advantages from Issuer’s point of view:
•Lower cost due to low risk and tax deductibility of interest
payment.
•No / limited dilution of control
•Offer stable return to investors having fixed maturity
and subsequently redemption/ conversion to equity
•No increase in equity base during non conversion period

Fixed deposits
•Limit on quantum : 25% of networth
•Cost : 8-11% depending on maturity period & risk
•unsecured 70
 EQUITY SHARE CAPITAL

•Authorised , issued, subscribed and paid up

•Par value, issue price, book value, market value
•Residual claims on Income /Assets
•No upper limit
•Costliest sources of finance
•Entails permanent servicing by way of dividends without tax
shield
•Voting rights/ Control in management/ Limited liability
•Under preview of SEBI and SEB guidelines
•Buy Back allowed 71
•For Listing on BSE/ NSE the paid up Equity capital should
be atleast Rs 10 Cr. and for the other exchanges atleast Rs5 Cr

Equity investments in foreign cos allowed to resident indian

shareholder in the event foregin co has 10% stake in indian co.
•For Listing on exchanges atleast 10% to be offered to the public
by way of a prospectus
Issuance of Non-Voting & differential rights shares allowed
•Debentures on conversion becomes equity share capital.

72
 EVALUATION OF ESC
Company’s point of view
Advantages
Represents almost permanent capital
Does not involve any fixed obligation for servicing
Enhances credit worthiness of the company to secure additional
debt.
Disadvantages
High cost of capital
Dividends paid on profit after tax further subjected to dividend
distribution tax of 12.5%
High flotation cost
73
Dilution of control (Treasury issue)
Investors point of view
Advantages
Enjoy voting right in the company with limited liability.
Short term capital gains tax reduced to 10%
Long term Capital gains tax abolished. ( Exchange traded
securities )
Indexation benefit available under 54E.
Disadvantages
Controlling power could be notional
Turn over tax at 15 basis points on sale of the security on an
exchange
Have residual claim to income / assets
Vide fluctuations in stock price
Dividend’s subjected to distribution tax of 12.5% 74
Retained earnings

Made up of Accumulated depreciation and retained profits.

Represent the internal sources of finance available to the

company.

Availability : Level of profitability / payout ratio

Cost : Identical to ESC.
Flexibility : High
75
Advantages
Reinvestment of profit may be convenient to many shareholders.
No dilution of control since Co. Relies on retained earnings
No flotation cost/ Losses on account of underpricing.
Proceeds could be used in a subsequent buyback.
Disadvantages
High opportunity cost

. Limitation on amount
Bonus issue may capitalise
reserves 76
Preference share capital

Fixed minimum dividend rate

No voting rights
Prior claim on income / assets
Redeemable at issuer’s & investor’s discretion

Features:
No dilution of control
Provision to skip dividend in absence of profits
77
Leasing

Ownership of asset with lessor (depreciation to be claimed be

lessor)
Wet lease
Promoters contribution not necessary
Off balance sheet item (borrowing power unaffected)
Flexibility in lease rentals
Lease rent (principle + interest) is tax deductive).

78
CAPTAL BUDGETING

79
•Capital investment decision
Capital investments involve increase in the fixed assets of a
company.
(Expansion / diversification / Green field / takeover / merger)
•Characteristics of investments
Capital outlay needs to be made up front returns come later
Certain amount of risk is involved
Capital investment tend to be indivisible. (difficult to phase out).
•Financial techniques
The purpose of financial techniques is to enable the making of
investment acceptance / rejection decisions.
80
Non financial factors in project appraisal
Market
Technical
Infrastructure
Ecological
Economic
Influence of non - financial factors
Financial projections
Gestation period
Profitability
Life of project / Terminal value
Sensitivity analysis 81
 NON FINANCIAL FACTORS DETERMINING
FINANCIAL VIABILITY OF PROJECTS

Market factors
Present and future size of the market
Present and future demand and supply situation
Achievable market share
Selling & distribution channels

Technical factors
Level of Technological obsolence
Plant location
Scales of operation
82
Raw material & utilities consumption norms
Ecological factors
Pollutant levels
Treatment of effluent
Environmental impact of the project

Economic factors
Social cost benefit analysis
Economic rate of protection
Domestic resource cost
Protection enjoyed by industry.
83
 FINANCIAL TECHNIQUES IN CAPITAL
BUDGETING
Return on investment
AVG ROI = PBIT
(over 10 yrs) Total Inv.
Advantages
Simple to calculate and easy to understand
Maximisation of shareholders wealth and maximising the market
value of investments.
.Disadvantages
Time value of money not considered
It is a concept based on profit and not cash
84
No objective criterion for acceptance / Rejection decision.
Payback period

It is the time required to get back the original investment

companies going through liquidity crisis /for small investments will
use the pay back period method.

Disadvantages
Cash inflows / Outflows after payback Period are ignored.
Time value for money is ignored

85
Discounted cash flow (DCF)
Cash inflow and outflow for the entire life of the project is
considered.
It considers time value for money as a result earnings in earlier
years have higher value than earned in later years.
IRR Method
IRR is that rate of discount at which the net present value of cash
flows equals net present value of cash outflows.
If IRR > COC Investment is support worthy.
NPV method
Using COC discount the netflows
If NPV is + VE investment is support worthy..
86
 Comparison of elements
Elements Payback NPV IRR

Net investment. Comparable comparable Comparable

Subsequent Possible to use Exact timing Exact timing

investment rough approx.

Recovery of Not Possible Specific Specific

terminal value economic impact economic impact

Accounting Rough Not relevant Not Relevant

profit approximation

Operating cash Approximation Not relevant Not relevant

flow of pattern
87
 Comparison of elements
Year by year Cannot Exact economic Exact Economic
operating cash accomodate impact impact
flow pattern

Economic Life Not considered Integral to Integral to

analysis analysis

Result Years to cover Net Balance of Yield rate of

the initial equivalent cash discount equating
investment inflows and inflows and
outflows outflows.

88
 CONCEPTS IN CAPITAL BUDGETING
•Life of project
Physical
Market
Techno efficient
•Incremental principle
Sunk / Allocated costs to be ignored
Only incremental cash flows to be considered
•Evaluation of post tax basis since COC is on a post tax basis
•Principle of separation of “Finance” from “Investment “ decision.
Financing cost (interest) to be ignored.
•Effect of tax shield on the company as a whole to be considered
89
 PROJECT COST COMPONENTS
Land
Civil Construction
Plant & Machinery
Misc Fixed Assets
Erection and commissioning
Technical Know how fees
Preliminary & preoperative expenses
Contingencies
Total Capital Cost
Margin money for working capital
Total project cost 90
 PROJECT CASH FLOWS
Cash outflows Capital expenditure
Margin money
Normal capital expenditure

Cash inflow Net cash accruals

Salvage value
Recovery of WC

91
 NPV vs IRR conflict
• NPV is technically superior to IRR and is also able to handle
selection of mutually exclusive projects.
• The decision rule for the NPV assumes that cash flows resulting
during the life cycle of the project have an opportunity cost equal to
the discount rate used.
• The decision rule for the IRR assumes that such resulting cash flows
have an opportunity cost equal to IRR which generated them.
• NPV approach provides an absolute measure that fully represents the
value from the project to a company.
• IRR by contrast provides a % figure from which the benefits in
terms of wealth creation cannot be grasped.

92
 Capital Budgeting Sensitivity Analysis

• Monte Carlo Simulation

• Break even analysis

• Decision tree analysis

• Expected value Criterion

• Under different scenarios

93
 Share holder value creation
• Cash Dividends
• Stock Dividends
• Bonus Shares
• Bonus Debentures-issued from free reserves
• Equity Buy back / Secondary Listing
• Stock Split
• Synergic Investments
• Synergic Acquisitions
• Disinvest out of unrelated businesses
• Shares of holding co. with fungibility

94
 DIVIDEND STRUCTURING

Appropriation of PAT towards Dividend pay out and Reserves

Payout ratio = Dividend paid / PAT

Retention ratio = PAT - Dividend paid / PAT

Dividend rate (%) could be high but payout could be low.

Dividend rate will be depended upon the PAT, Payout ratio and 95
Equity base.
 Dividend Structuring
100% retention scenario
For some shareholders dividend acts as a regular income source
EX: investor’s for whom it is a regular source of income, mutual
funds, investment companies.
Declaration of dividend is perceived as an indication that the
companies operations are profitable.
100% payout scenario
Repeated raising of capital increases floatation cost
Companies requirement for expansion / margin money / new
investment.
Tax inefficient due to 12.5% distribution tax. 96
Factors influencing dividend policy

•If the appetite for funds is high due to increase in level of exsisting
operation or due to major capital investment plan then a high
retention policy will be adopted.

•A closely held company having major capital investment plans

will follow a low pay out policy so that internal accruals could act
as a major source of finance in the future thereby reducing
dependence on infusion of fresh equity.
•Tax implications
Company has to pay 12.5% distribution tax.Recipient of dividend
tax exempted in the shareholders hands.. 97
•Restriction in loan agreement / government regulations / FI’s on
on payment of dividend during the currency of the loan.
•Legal requirement under Companies act.
•Liquidity position : Higher PAT does not necessarily mean
healthy liquidity. A strained liquidity position would force a policy
of low payout.
•Stability in the rate of dividend : companies usually follow a
policy of gradually rising or stable dividend policy and not directly
link it with PAT.
•Generally the Indian corporate sector follows a payout policy of
30% . The retention ratio keeps increasing so as to counter
inflation, floatation cost, help in Equity buyback etc.
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 BONUS SHARES
Bonus share are issued to existing share holders as a result of
capitalization of reserves.
In the wake of a bonus issue
The shareholders proportional ownership remains unchanged
The book value, market price, E.P.S decreases.
Fallout of a bonus issue
•Normally the Ex-bonus price comes down by the proportion of
bonus given with a mark up of approximately 30 - 35%
•More active trading in stock exchanges.
•The nominal rate of dividend tends to decline this may dispel the
impression of profiteering.
•Shareholders regard a bonus issue as a firm indication that the
prospects for the company are good.
•Capital gains tax exemptions with indexation available for bonus
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issue
 GUIDELINES FOR ISSUE OF BONUS SHARES
Issuer : Security exchange board of India
Bonus issue should be made from capitalisation of free reserves
built out of genuine profits and share premium.Reserves created by
revaluation of assets, statutory reserves etc. are not allowed for
capitalisation
Bonus issue greater than 1:1 allowed
Residual reserve test: residual reserves after the proposed
capitalisation should be at least 40% of the increased capital For
computation all contingent liabilities, statutory reserves and
revaluation reserves to be excluded.
Yield test: 30% of the average P.B.T for the last 3 years should
give a return of at least 10% on the enhanced capital.
Bonus in lieu of dividend is not permitted
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If R = Reserves before bonus issue
S = Share capital before bonus issue
B = Bonus Quantum
PRT = Average PBT for last 3 years
RPT = .4 (S + B) > (R - B)
YIELD TEST = .3 (PBT) > (.1) (S+B)

Bonus issue also to be given to debenture holders if there is an

impending conversion.

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