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Disha Institute of IT & Management
Disha Institute of IT & Management
Disha Institute of IT & Management
Financial Management Unit I Meaning of Financial Management:Financial Management is such a managerial process which is concerned with the planning and control of Financial resources. It is being studied as a separate subject in 20th century. Till now it was used as a part of economics. Now, its scope has undergone some basic changes from time to time. In present time, it analyses all financial problems of a business. Financial Manager estimates the requirements of funds, plans the different sources of funds and perform functions of collection of funds and its effective utilisation. Finance is such a powerful source that it performs an important role to operate and coordinate the various economic activities of business. Finance is of two types:(1) Public finance. (2) Private finance. 1. Public Finance:means government finance under which principles and practices relating to the procurement and management of funds for central government, state government and local bodies are covered. 2. Private Finance:means procurement and management of funds by individuals and private institutions. Under it we observe as to how individuals and private institution procure funds and utilise it. Scope:What is finance? What are a firms financial activities? How are they related? Firm create manufacturing capacities for production of goods, some provide services to customers. They sell goods or services to earn profit and raise funds to acquire manufacturing and other facilities. Thus, the 3 most important activities of business firm are:(1) Production (2) Marketing I
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There exists an inseperable relationship between finance on the one hand and production, marketing and other functions on the other. Almost, all kinds of business activities, directly or indirectly, involve acquisition and use of funds. For example, recruitment and promotion of employees in production is clearly a responsibility of production department but it require payment of wages and salaries and other benefits and thus involve finance. Similarly, buying a new machine or replacing an old machine for the purpose of increasing productive capacity affects flow of funds. A company in tight financial position will of course, give more weight to financial considerations and devise its marketing and production strategies in light of financial constraint. On other hand, management of a company, which has a regular supply of funds, will be more flexible in formulating its production and marketing policies. In fact, financial policies will be devised to fit production & marketing decision of firms in practice. OBJECTIVES OF FINANCIAL MANAGEMENT:It is the duty of management to clarify the objectives of business so that the departmental objectives could be determined accordingly. Financial objectives of a firm provide a concrete framework within which optimum financial decisions can be made. The main objective of any firm should be to maximise the economic welfare of its shareholders. Accordingly, there are 2 approaches in this regard. (A) Profit maximisation Approach. (B) Wealth maximisation Approach. (A) PROFIT MAXIMISATION APPROACH:According to this approach, a firm should undertake all those activities which add to its profits and eliminate all others which reduce its profits. This objectives highlights the fact that all decisions:- financing, dividend and investment, should result in profit maximisation. Following arguments are given in favour of profit maximisation approach:I
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Profit can be expressed in various forms i.e it can be short term or long term or it can be profit before tax or after tax or it can be gross profit or net profit. Now the question arises, which profits can be maximised under profit maximisation approach. (2) Time Value of Money
This approach is also criticised because it ignores time value of money i.e. under this approach income of different years get equal weight. But, in fact, the value of rupee today will be greater as compared to the value of rupee receivable after one year. In the same manner, the value of income received in the first year will be greater from that which will be received in later year e.g. the profits of 2 different projects are:Example:YEAR 1 2 3 PROJECT1 5,000 10,000 5,000 PROJECT2 10,000 10,000
Both the projects have a total earnings of Rs 20,000 in 3 years and according to this approach both will be considered equally profitable. But Project 1 has greater profits in the initial years of the project & therefore, is more profitable in terms of value of income. The profits earned in initial years can be reinvested and more profits can be earned. (3) Risk Factor:I
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n At = -C t t=1 (1+k) I
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Where W = Net present worth. A, A2--- An= Stream of expected cash benefits from a course of action over a period of time. K = Discount rate to measure risk & timing. C= Initial outlay to acquire that asset If W is positive, the decision should be taken & vice versa. If W is Zero, it would mean that it does not add or reduce the present value of the asset. This approach is considered good for the companies in present situation. This approach gives due consideration to the time value of expected income receivable over different period of time. Under this approach, risk and uncertainty is analysed with the help of interest rate. If uncertainity & time period are greater, higher rate of interest will be used to calculate present value of expected future cash benefits where as the interest rate will be lower for the projects with low risk & uncertainity. Besides, this approach uses cash flows instead of accounting profits which removes ambiguity associated the term profit. On the basis of above explanation, we can conclude that wealth maximisation approach is better to profit maximisation approach to establish mutual relation among the various data. It is possible only through statistics. Cash and inventory management, forecast of financial needs, credit policy decision all are based on the advanced techniques of statistics. Finance is also related to law. Any decision regarding financial policy should be in line with the laws of the country. Organisation of Finance Function The organisation of finance function implies the division and classification of functions relating to finance because financial decisions are of utmost significance to firms. Therefore, to perform the functions of finance, we need a sound and efficient organisation. Although in case of companies, the main responsibility to perform finance function rests with the top management yet the top management (Board of Directors) for convenience can delegate its powers to any subordinate executive I
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Board of Directors
Managing Directing
Finance Committee
Production Manager
Personnel Manager
Financial Manager
Marketing Manager
Treasurer
Controller
Banking Relations
Cash Magt.
Credit Analysis
Assets Protection
Securities Mgt.
Annual Reports
Internal Auding
Statistics
Treasurer performs the functions of procurement of essential funds, their utilisation, investment, banking, cash management credit management, dividend distribution, pension, management etc. Financial, controller is responsible for I
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Functions of the Chief Financial Manager. Chief Financial manager is the top officer of finance department. In America he is known as Vice-president finance and in India he is called Chief Financial Controller. He performs following functions:
(1) Financial Planning :- He determines the capital structure and prepares financial plan. (2) Procurement of Funds:- Financial manager makes the necessary funds available from different sources. (3) Co-ordination:- Financial manager establishes co-ordination among the financial needs of various departments. He is a member of finance committee. (4) Control:- Financial manager examines whether the work is being performed as per pre-determined standards or not. He gets the reports prepared, controls the cost and analyses profits. (5) Business Forecasting:- Financial manager evaluates the effects of all national, international, economic, social and political events on industry and company. (6) Miscellaneous Functions:- It includes the management of assets, management of inventory, arrangement of data and management of bank deposits etc. Functions of Treasurer The following are the functions of treasurer. I
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Time Value of Money:The evaluation of capital expenditure proposals involves the comparison between cash outflows & cash inflows. The pecularity of evaluation of capital expenditure proposals is that it involves the decision to be taken today where as the flow of funds, either outflow or inflow, may be spread over a number of years. It goes without saying that for a meaningful comparison between cash outflows and cash inflows, both the variables should be on comparable basis. As such, the question which arises is that is the value of flows arising in future the same in terms of today. For Example:- if a proposal involves cash inflow of Rs 10,000 after one year, is the value of this cash inflow really Rs 10,000 as on today when capital expenditure proposal is to be evaluated.? The ideal reply to this question is no. The value of Rs 10000 received after one year is less than Rs 10,000 if received today. The reasons for this can be stated as below:-
(i) There is always an element of uncertainety attached with the future cash flows. (ii) The purchasing power of cash inflows received after the year may be less than that of equivalent sum if received today. (iii) There may be investment opportunities available if the amount is received today which cannot be exploited if equivalent sum is received after one year. Time Value of money: Example:- If Mr. X is given the option that he can receive an amount of Rs 10000 either on today or after one year, he will most obviously select the first option why? Because, if he receives Rs 10000 today he can always invest the same say in fixed deposit with the bank carrying interest of say 10% p.a As such, if choice is given to him, he will like to receive Rs 10000 today or Rs 11000 (i.e. Rs 10000 plus interest @ 10% p.a. on Rs 10000) after one year. If he has jto receive Rs 10,000) only after one year, the real value of same in terms of today is not Rs 10000 but something less than that. This concept is called time value of money. I
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(e) What kinds of changes have taken place recently affecting capital market in the country?
(b) Investment decisions:- are decisions regarding application of funds raised by organisation. These relate to selection of the assets in which funds should be invested. The assets in which funds can be invested are of 2 types (a) Fixed assets:- are the assets which bring returns to organisation over a longer span of time. The investment decisions in these types of assets are capital budgeting decisions. Such decisions include 1 How fixed assets should be selected to make investment ? What are various methods available to evaluate investment proposals in fixed assets? 2 How decisions regarding investment in fixed assets should be made in situation of risk & uncertainity? I
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DIVIDEND POLICY Meaning: Dividend is that part of business income which is distributed among share holders. Dividend can be paid in the form of shares or securities or cash. Dividend is given to share holders as a return on their investment in the company. If a company does not pay regular dividend to its share holders, they will not invest in it in future. Dividend is paid on equity as well as preference shares. But it is paid at fixed rate on preference shares where as no rate is fixed for equity shares. Business will either distribute its net profit among share holders or retain it in business. The part of profit which is retained in business is called retained earning & it is source of funds for business. Therefore, there is inverse relationship between the amount to be distributed as dividend and amount of profits to be retained in business. I
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A External factors 1) Phase of Trade cycles 2) Legal Restrictions 3) Tax Policy 4) Investment Opportunities. 5) Restrictions Imposed by Lending Institutions.
B Internal Factors. 1) Attitude of Management 2) Composition of share holding 3) Age of Company. 4) Nature of Business 5) Growth Rate of Company 6) Liquidity Position 7) Customers & Traditions.
A External Factors:1) Phase of trade cycle:During the phase of boom, company may not like to distribute huge amount of profit by way of dividend though earning capacity is more because company will like to retain more profit which can be used during depression. Similarly, during depression company will like to hold dividend payment in order to preserve its liquidity position. 2) Legal Restrictions:I
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Internal Factors:1) Attitude of Management:- If attitude of management is aggressive, it may decide to pay more dividend as the management is interested in increasing income of share holders. Where as if the attitude of management is conservative, company will like to retain more profits to take care of contingencies. 2) Age of Company:- A growing concern will like to retain maximum profit in business in order to raise the funds while old company may follow high dividend policy. 3) Composition of Share Holders:- If a company is private ltd. Company having less number of shareholders, the company having less number of shareholders, the company will like to retain more profits and reduces dividend. If the company is a public limited company, tax brackets of individual shareholders may not have significant impact on dividend policy of company. 4) Nature of Business:- A stable company may follow long term dividend policy where as an unstable company may like to retain its profits during boom to ensure dividend policy is not affected by cyclical variations. 5) Growth rate of Company :- A rapidly growing company may like to retain majority of its profits in order to take care of its expansion needs. However, care I
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Unit III Leverages:The term leverages measures relationships between 2 variables. In financial analysis, the term leverage represents influence of one financial variable over some other financial variable. In financial analysis generally 3 types of leverages maybe computed:1) Operating leverage. 2) Financial leverage. 3) Combined leverage. 1) Operating Leverage:- It measures effect of change in sales quantity on Earning Before Interest and Taxes (EBIT). It is Computed As: Sales- Variable Cost (i.e Contribution) Earnings before interest and tax. Indications:I
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Financial Leverage:It indicates firms ability to use fixed financial charges to magnify effects of changes on EBIT on firms EPS. It indicates the extent to which Earnings per Share (EPS) will be affected with change in Earnings Before Interest and Tax (EBIT). It is computed as:EBIT __________ EBIT- Interest Indications:A high degree of financial leverage indicates high use of fixed income bearings securities in capital structure of the company. A low degree of financial leverage indicates less use of fixed income bearing securities is capital structure of company. For Example I
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Financial Leverage =
High degree of financial leverage is supported by knowledge of fact that in capital structure of A Ltd 90% is the debt capital component, where as in case of B Ltd 10% is debt capital component. It means that in case of A Ltd every 1% increase in EBIT will increase EPS by 1.22% and vice versa. As such, when EBIT is reduced from Rs 5000 to Rs 4000 (i.e. 20% reduction), EPS of A Ltd, gets reduced from Rs 20.50 to Rs 15.50 (i.e.24.40 % reduction) & EPS of B Ltd, gets reduced from Rs 2.72 to Rs 21.6 (i.e 20.40% reduction) Uses of Financial Leverage The degree of financial leverage gives an indication regarding extent to which EPS may be affected due to every change in EBIT. As the use of debt capital in capital structure increase EPS, the company may like to use more & more debt capital in its capital structure by using financial. For Example:EPS in case of A Ltd, is Rs 20.50 when sales are Rs 20000 as 90% of its capital is debt capital. But in case of B Ltd EPS is only Rs 2.72 when sales are I
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Operating leverage X Financial leverage. Sales-Variable Cost _______________ EBIT Sales-Variable Cost = __________________ EBIT- Interest For Example:EBIT X___________ Ebit-Interest
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It Means that in case of A Ltd every IX increase in contribution will increase EPS by 2.44% & vice versa while in case of B Ltd. Every 1% increase in contribution, will increase EPS by 2.04%. As such when contribution gets reduced from Rs 10000 to Rs 9000 i.e. 10% reduction, EPS of A Ltd gets reduced from Rs 20.50 to Rs 15.50 ( i.e. 24.4% reduction) & EPS of B Ltd gets reduced from Rs 2.72 to Rs 2.16 (i.e. 20.4 reduction) Indications:(1) High Operating Leverage, High Financial Leverage:It indicates very risky situation as a slight decrease in sales and contribution may affect EPS to great extant. So, this situation is should be avoided. (2) High Operating Leverage, Low Financial Leverage it indicates that a slight decrease in sales and contribution may affect EBIT to great extent due to existence of high fixed cost but this possibility is already taken care by low proportion of debt capital in overall capital structure. (3) Low Operating Leverage, High Financial Leverage It indicates decrease in sales/contribution will not affect EBIT to great extent. This situation may be considered an ideal situation. I
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Unit II Cost of Capital The projects cost of capital is minimum acceptable rate of return on funds committed to the project. The minimum acceptable rate or required rate of return is a compensation for time and risk in use of capital by project. Since investment projects may differ in risk, each one of them will have its own unique cost of capital. The firm represent aggregate of investment projects under taken by it. Therefore, the firms cost of capital will be overall, or average, required rate of return on aggregate of investment projects. Determining Component Cost of Capital:1) Cost of Debt:A Company may raise debt in various ways. It may borrow funds from financial institutions or public either in form of public deposits or debentures for a specified period of time at certain rate of interest. A debenture or bond may be issued at per or at discount or premium. (a) Debt issued at Par:The before tax cost of debt is rate of return required by lenders. It is easy to compute before tax cost of debt issued & to be redemed at par, it is simply equal to contractual interest. For example, a company decides to sell a new issue of 1 years 15% bond of Rs 100 Each at par. If company realises full face value of Rs 100 bond & will pay Rs 100 Principal to bond holders at maturity, the before tax cost of debt will simply be equal to rate of interest of 15%. Thus:Kd= I= INT ___ Bo Where, I
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Bo =
Where Bn= repayment of debt on maturity and other variable as defined earlier. This equation is used to find out whether cost of debt issued at par or discount or premium. i.e. Bo= f or Bo>f or Bo<F. Tax adjustment:The interest paid on debt is tax deductible. The higher the interest charges, the lower will be amount of tax payable by the firms. This implies that the government indirectly pays a part of lenders required rate of return. As a result the interest tax shield, after tax cost of debt to the firm will be substantially less than investors required rate of return. The before tax cost of debt, kd should therefore, be adjusted for tax effect as follows. After-tax cost of debt = kd (I-T) Where T= Corporate tax rate. 2). Cost of Preference Capital:The measurement of cost of preference capital poses some conceptual difficulty. In case of debt, there is binding legal obligation on the firm to pay interest & interest constitutes basis to calculate cost of debt. However, in case of preference capital, payment of dividends is not legally binding on the firm & even if the dividends are paid, it is not a charge on earnings, rather it is a distribution or appropriation of earnings to preference share holders. Irre Deemable Preference share:The preference share may be treated as a perpetual security if it is irredeemable Thus, its cost is given by following equation:I
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PO
Cost of Preference share is not adjusted for taxes because preference dividend is paid after corporate taxes have been paid. Preference dividends do not save any taxes. Thus cost of Preference share is automatically computed on an after tax basis. Since interest is tax deductible & preference dividend is not, the after tax cost of preference is substantially higher than after tax cost of debt. 3) Cost of Equity Capital:Firms may raise equity capital internally by retained earnings. Alternatively, they could distribute the entire earnings to equity share holders & raise equity capital externally by issuing new shares. In both cases, shareholder are providing funds to the firm to finance their capital expenditures. Therefore, equity shareholders required rate of return will be same whether they supply funds by purchasing new shares or by for going dividends which could have been distributed to them. There is, however, a difference between retained earnings & issue of equity shares from firms point of view. Cost of Retained Earnings:The opportunity cost of retained earnings (internal earnings) is the rate of return on dividends foregone by equity shareholders. The shareholders generally expect dividend and capital gain from their investment. The required rate of return of shareholder can be determined from dividend valuation model. Normal Growth:- A firm whose dividend are expected to grow at a constant rate of g is as follows I
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Super normal growth:Dividends may grow at different rates in future. The growth rate may be very high for a few years & after wards, it may, it may become normal indefinitely in future. The dividend valuation model can be used to calculate cost of equity under different growth assumptions. For example, If the dividends are expected to grow at a super normal growth rates g for n year & there after, at a normal perpetual growth rate of In beginning in year n+1 then cost of equity can be determined by following formula. n DIV0 (1+gs)t Po= __________ t=1 (1+ke)t Pn ________ (1+ke)n
Pn= Discounted value of dividend stream, beginning in year n+1 & growing at a constant, perpetual rate gn, at end of year n and therefore it is equal to :-
Pn
Zero growth DIVl Ke =______ Po The growth rate g will be zero if firm does not retain any of its earnings. I
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Ko= kd (1-T) Wd+kewe Ko= Kd (1-T) D+ + ke S ____ ___ D+S D+S Where Ko= Weighted average cost of capital Kd(1-t) ke are after tax cost of debt & equity D= amount of debt, S= amount of equity. I
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(1) Net Income Approach:The essence of net income approach is that the firm can increase its value or lower the overall cost of capital by increasing proportion of debt in capital structure. The assumption of this approach are:1) The use of debt does not change the risk perception of investors, as a result equity capitalisation rate (kc) & debt-capitalisation rate (kd) remain constant with changes in leverage. 2) The debt capitalisation rate is less than equity-capitalisation rate ( rate (i.e. kd < ke) 3) The corporate income taxes do not exist. The first assumption implies that if ke & kd are constant, increased use of debt by magnifying the shareholders earnings, will result in higher value of the firm via higher value of equity. Consequently, overall or weighted average cost of capital, ko will decrease. The overall cost of capital is measured by EqX Noi Ko= ___ =___ V V
Thus, with constant annual net operating income (NOI) overall cost of capital of capital would decrease as the value of firm, V increases.
Ques6. Write notes on the following. Ans. NET OPERATING INCOME APROACH I
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ke
ko kd
Leverage Figure 18.2 The effect of leverage on the cost of capital (NOI approach) EXISTENCE OF OPTMUM CAPITAL STRUCTURE: THE TRADITIONAL VIEW The traditional view, which is also known as an intermediate approach, is a compromise between the net income approach and the net operating approach. According to this view, the value of the firm can be increased or the cost of capital can be reduced by a judicious mix of debt and equity capital. This approach very clearly implies that the cost of capital decreases within the reasonable limit of debt and then increases with leverage. Thus, an optimum capital structure exists, and it occurs when the cost of capital is minimum or the value of the firm is maximum. The cost of capital declines with leverage because debt capital is cheaper than equity capital within reasonable, or acceptable, limit of debt. The statement that debt funds are cheaper than equity funds carries the clear implication that the cost of debt, plus the increased cost of equity, together on a weighted basis, will be less than the cost of equity which existed on equity before debt financing.2 In other words, the weighted average cost of capital will decrease with the use of debt. According to the traditional position, the manner in which the overall cost of capital reacts to changes in capital structure can be divided into three-stages.3 I
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Thus, so long as Ke and Kd are constant, the value of the firm V increases at a constant rate. (Ke-Kd)/Ke. as the amount of debt increases. When equation(9) is solved for X/V, we get [See equation(6): X = ko=ke-(ke-kd) V V This Implies that, with ke>Kd, the average cost of capital will decline with leverage. Second Stage: Optimum Value Once the firm has reached a certain degree of leverage, increases in leverage have a negligible effect on the value, or the cost of capital of the firm. This is so because the increases in the cost of equity due to the added financial risk offsets I D
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Ko Kd
Leverage 0 L L
The overall effect of these three stages is to suggest that the cost of capital is a function of leverage. It declines with leverage and after reaching a minimum point or range starts rising. The relation between costs of capital and leverage is graphically shown in Figure 18.3 wherein the overall ITS STUDY CENTRE ko is cost of capital curve, SCF-54 (BMNT) is a range saucer-shaped with a horizontal range. This implies that there SECTOR 15 of MARKET, capital structures in which the cost of capital is minimised. ke is assumed to FARIDABAD PH 5002194-95 increase slightly in the beginning and then at a faster rate. In Figure 18.4 the cost of capital curve is shown to be U-shaped. Under such a situation there is a precise point at which the cost of capital would be minimum. This precise point defines the optimum capital structure. I
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Ko
-+
Cost of Capital (Per cent) Figure 18.4 The costs of Capital behavior (traditional view-a variation)
Many variations of the traditional view exist. As indicated in Figures 18.3 and 18.4, some writers imply the cost of equity function to be horizontal over a certain level and then rising, while others assume the cost of equity function rising slightly in the beginning and then at a faster rate. Whether are cost of equity function is horizontal or rising slightly is not very pertinent from the theoretical point of view, as a number of different cost of equity curves can be consistent with a declining average cost of capital curve. The relevant issue is whether or not the average cost of capital curve declines at all as debt is used. 1 All the supporters of the traditional view agree that the cost of capital declines with debt. ILLUSTRATION 18.3 To illustrate the traditional approach, assume that a firm is expecting a net operating income of Rs 1,50000 on a total investment of Rs 10,00,000 The equity capitalisation rate is 10 per cent, if the firm has no debt; but it would increase to 10.56 per cent when the firm substitutes equity capital by issuing debentures of Rs 3.00000 and, to 12.5 per cent when debentures of Rs 600000 are issued to substitute equity capital. Assume that Rs 300000 debentures can be raised at 6 per cent interest rate, whereas Rs 600000 debentures are raised at a rate of interest of 7 per cent. The market value of the firm, value of shares and the average cost of capital are shown in Table 18.6. I
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Table 18.6 MARKET VALUE AND THE COST OF CAPITAL OF THE FIRM (TRADIATIONAL APPROACH) No Debt 6% Rs 3,00,000 Debt 1,50,000 18,000 1,32,000 0.1056 12,50,000 3,00,000 15,50,000 0.097 7%Rs 6,00,000 Debt 1,50,000 42,000 1,08,000 0.125 8,64,000 6,00,000 14,64,000 0.103
Net operating income, X 1,50,000 Total cost of debt, INT = KdD 0 Net income, X- INT 1,50,000 Cost of equity, Ke 0.10 Market value of shares, S= (X- 15,00,000 INT)ke Market value of debt, D 0 Total value of firm, V= S+D 15,00,000 Average cost of capital, Ko = X/V 0.10
Criticism of the Traditional View The validity of the traditional position has been questioned on the ground that the market value of the firm depends upon its net operating income and risk attached to it. The form of financing can neither change the net operating income nor the risk attached to it. It simply changes the way in which the income is distributed between equity holder and debt-holders. Therefore, firms with identical net operating income and risk, but differing in their modes of financing, should have same total value. The traditional view it criticised because it implies that totality of risk is distributed among the various classes of securities.1 Modigliani and Miller also do not agree with the traditional view. They criticise the assumption that the cost of equity remains unaffected by leverage up to some reasonable limit. They assert that sufficient justification does not exist for such and assumption. They do not accept the contention that moderate amounts of debt in sound firms do not really add very much to riskiness of the shares. However, the argument of the traditional theorists that an optimum capital I
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Assumptions The M-M hypotheses can be best explained in terms of their Propositions I and II. It should, however, be noticed that their propositions are based on certain assumptions. These assumptions, as described below, particularly relate to the behaviour of investors and capital market, the actions of the firm and the tax environment. Perfect capital markets Securities (share and debt instruments) are traded in the Perfect capital market situation. This specifically means that (a) investors are free to buy or sell securities; (b) they can borrow without restriction at the same terms ad the firms do; and (c) they behave rationally. It is also implied that the transaction cost, i.e., the cost buying d selling securities, do not exist. Homogeneous risk classes Firms can be grouped into Homogenous risk classes. Firms would be considered to belong to a homogenous risk class if their expected earnings have identical risk characteristics. It is generally implied under the M-M hypothesis that firms within same industry constitute a homogenous class. Risk The risk of investors is defined in terms of the variability of the net operating income (NOI). The risk of investors depends on both the random fluctuations of the expected NOI and the possibility that the actual value of the variable may turn out to be different than their best estimate.1
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Proposition I Given the above stated assumptions, M-M argue that, for firms in the same risk class, the total market value is independent of the debt-equity mix and is given by capitalizing the expected net operating income by the rate appropriate to that risk class.2 This is their Proposition I and can be expressed as follows: Value of the firm = Market value of equity + Market value of debt Expected net operating income = Expected overall capitalization rate X V=(S+D)= ko Where V= the market value of the firm S= the market value of the firms ordinary equity D= the market value of debt X= the expected net operating income on the assets of the firm K0 = the capitalisation rate appropriate to the risk class of the firm. 1. Robichek, A. and S. Myers, Optimal Financing Decisions, Prentice-Hall, 1965, PP. 31-34. 2. Modigliani and Miller op. cit., P. 266. Proposition I can be stated in an equivalent way in terms of the firms average cost of capital which is the ratio of the expected earning to the market value of all its securities. That is: X = (S+D) V X = ko = ko NOI
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ko
Ke
D/V Leverage Figure 18.5 The cost of capital under M-M proposition I Equation (5) expresses Ko as the weighted average of the expected rate of return of equity and debt capital of the firm. Since the cost of capital is defined as the expected net operating income divided by the total market value of the firm, and since M-M conclude that the total market value of the firm is unaffected by the financing mix, it follows that the cost of capital is independent of the capital structure and is equal to the capitalisation rate of a pure-equity stream of its class. The cost of capital function, as hypothesized by M-M through Proposition I, I
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and the value of your investment is: investment = 0.10 (1000-50000)= Rs 6000 You can earn same return at less investment through an alternate investment strategy. This you can do by selling your investment in firm Ls Share for Rs 6000, and by borrowing on your personal account an amount equal to your share of firm Ls corporate borrowing at 6 percent rate of interest 010(50000) = Rs5000. You have Rs 11000 with you. You can now buy 10 per cent of the unlevered firm Us shares. Your investment will be: Investment = 0.10 (1,00,000) Rs= 10,000 And your return will be: Return = 0.10 (10,000) Rs 1,000 I
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Equity return from U Less: Interest on personal borrowing Net Return Note that you are also left with cash of Rs 1,000:
Sale of firm Ls shares, = 0.1 (60,000) Add : Borrowing, 0.1 (50,000) Less: Investment in firm U=0.1 (1,00,000) Remaining cash
Due to the advantage of the alternate investment strategy, a number of investors will be induced towards it they will sell their shares in firm L and buy shares and debentures of firm U. this arbitrage will tend to increases the price of firm Us shares and to decline that of firm Ls shares. It will continue until the equilibrium price for firm Us and firm Ls shares is reached. The arbitrage would work in the opposite direction if we assume that the value of the unlevered firm U (Vu) is greater than the value of the levered firm L (Vl). Let us assume that Vu=Su= Rs 1,00,000 and Vl=Sl+Dt=Rs 40,000+ Rs 50,000 = Rs 90,000. Further, suppose that you own 10 per cent shares in the unlevered firm U: Your return will be: Return= 0.10 (10,000) = Rs 1,000 And your investment will be: Investment = 0.10 (1,00,000) = Rs 10,000 You can design a better investment strategy. You sell your shares in firm U for Rs 10,000. Now you buy 10 per cent of firm Ls share and debt. Your investment in firm L is Rs 9,000. I
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Note that your alternative investment strategy pays you off the same return at a lesser investment. You are left with Rs 1,000 cash. Rs 10,000 (4,000) (5,000) 1,000
Sale of firm Us shares, 0.1(1,00,000) Investment in firm Ls share, 0.1 (40,000) Investment in firm Ls debt, 0.1 (50,000) Remaining cash
Both strategies give the investor same return, but his alternative investment strategy costs him less since Vt<Vu. In such a situation, marginal investors will sell their shares in the unlevered firm and buy the shares and debentures of the levered firm. As a result of this switching, the market value of the levered firms shares will increases and that of the unlevered firm will decline. In the equilibrium Vt=Vu. We can generalize our discussion as follows. 1 In the first instance, let Vt>Vu Both firms earn the same expected net operating income, X. The borrowing and lending Rate is Kd. 1. Modigliani, F and Miller, M.H.,Reply to Heins and Sprenkle, American Economic Review, 59 (Sept 1969), pp.592-95. Assume that an investor hold (alpha) fraction of firm Ls shares. His investment and return will be as follows: Investment I Investment
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The investor in our example can design the following alternative investment strategy: Investment Vu - Dt (Vu-Dt) Investment X -kdDt (X-kdDt)
The investor obtains the same return, (X-Kd D1), in both the cases, but his first investment strategy costs more since V1> Vu. The rational investors at the margin would prefer switching from levered to unlevered firm. The increasing demand for the unlevered firms shares will decreases their market price. Ultimately, market ITS STUDY CENTRE values of the two firms will reach equilibrium, and henceforth, arbitrage will not15 SCF-54 (BMNT) SECTOR be beneficial. MARKET, FARIDABAD PH 5002194-95 Let us take the opposite case where Vu>Vl. Suppose our investor holds fraction of firm Us shares. His investment and return will be as follows:
Investment in Us shares
Investment Vu
Return X
The investor can design an alternate investment strategy as follows: Investment (Vl-Dt) + Dt Vt Return (X-kdDt) + kdDt X
If you can earn the same return with less investment, other can also benefit similarly. Investors will therefore sell shares of firm U and buy shares of firm L. This arbitrage will cause the price of firm Us shares to decline and that of firm Ls shares to increases. It will continue until the price of the levered firms shares equals that of the unlevered firm. Thus, in equilibrium Vl=Vu. On the basis of the arbitrage process, M-M conclude that the market value of a firm (or its cost of capital) is not affected by leverage. Thus, the financing (or capital structure) decision is irrelevant. It does not have any impact on the I
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And Ko and V are constant by definition, the following equation: X=koV=ko(S+D) Substituting Equation (10) into Equation (3), we have Ko(S+D)-kdD Ke = S = S KoS+koD-kdD =Ko+(ko-kd) S D
Equation (7) states that, for any firm in a given risk class, the cost of equity, Ke is equal to the constant average cost of capital, Ko, plus a premium for the financial risk, which is equal to debtequity ration times the spread between the constant average cost of capital and the cost of debt, (Ko-Kd) D/S. the cost of equity, Ke, is a linear function of leverage, measured by the market value I
ke ko kd
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Unit IV I
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Inventories constitutes the most significant part of current assets of large majority of companies in India. On an average, inventories are approximately 60% of current assets in public limited companies in India. Because of the large size of inventories maintained by firms, a considerable amount of funds is required to be committed to them. It is, therefore absolutely imperative to manage inventories efficiently in order to avoid unnecessary investment. A firm nelegecting the management of inventories may fail ultimately. It is possible for a company to reduce its level of inventories to a considerable degree e.g. 10 to 20% without any adverse effect on production and sales, by using simple inventory planning and control techniques. The reduction in Excessive inventories carries a favourable impact on a companys profitability. Nature of Inventories:- Management of inventory constitutes one of the major investments in current assets. The various forms in which a manufacturing concern may carry inventory are: 1) Raw Material: These represents inputs purchased and stored to be converted into finished products in future by making certain manufacturing process of the same. 2) Work in Process: These represent semi-manufactured products which need further processing before they can be treated as finished products. 3) Finished Goods: These represents the finished products ready for sale in market. 4) Stores and Supplies: These represents that part of inventory which does not become a part of final product but are required for production process. They may be in form of cotton waste, oil and lubricants, soaps, brooms, light bulbs etc. Normally they form a very major part of total inventory and do not involve significant investment. MOTIVE/NEEDS OF HOLDING INVENTORY
A Company may hold the inventory with the various motives as stated below: 1) Transaction Motive: The company may be required to hold the inventory in order to facilitate the smooth and unintrupped production and sale operations. It may not be possible for the company to procure the raw material whenever I
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Techniques of Inventory Management (i) A.B.C. Analysis A.B.C. analysis is a selective technique of controlling different items of inventory. In actual practice, thousands of items are included in business as inventories. But all these items are not equally important. According to this technique, only those items of inventory are paid more attention which are significant for business. According to this technique, all items are classified into 3 categories A.B. and C. In A category those items are taken which are very precious and their quantity or number is small. (ii) In B category those items are reserved which are less costly than the items of category A but their number is greater. (iii) In category C all those items are included which are low priced but their number is highest.
The rate of use of items of category A is the highest and that of category C is the lowest. In a manufacturing organisation, the items of inventory can be classified as under:I
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Thus, the number of items of category A are 15% but their value is 70% of total inventory. Therefore, inventory management can be made more effective by concentrating control on this category. Effort are made to minimise investment items of this category. The % of number of items in category B is 30 but their value is 20%. Therefore this category will be paid less attention. The items in category C is 55% but their value is just 10% of total. Therefore, management need not spend much time for control of this class of inventory because very little investment is made in them. These items are purchased in bulk quantity once in 2-3 years. The management must be aware that theses items may be less important in terms of value but their non-availabetety can break down the production process. Therefore, these item should available in time A.B.C. analysis can be presented by following diagram also. % of Costs 0 10 20 30 40 50 60 70 80 90 100 Y
10
20
30 40 50 % of Units
60
70
80
90
100 X
Advantages of ABC Analysis (1) A Close and strict control is facilitated on the most important items which constitute a major portion of overall inventory valuation or overall material consumption & due to this, costs associated with inventories maybe reduced. I
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(3) A strict control on inventory items in this manner help in maintaining a high inventory turnover rates.
2) FIXATION OF INVENTORY LEVELS: Fixation of various inventory levels facilitates initiating of proper action in respect of the movement of various materials in time so that the various materials may be controlled in a proper way. However, the following propositions should be remembered. (i) Only the fixation of inventory levels does not facilitates the inventory control. These has to be a constant watch on the actual stock level of various kinds of materials so that proper action can be taken in time. (ii) The various levels fixed are not fixed on a permanent basis and are subject to revision regularly. The various levels which can be fixed are as below. 1) Maximum level: It indicates the level above which the actual stock should not exceed. If it exceeds, it may involved unnecessary blocking of funds in inventory while fixing this level, following factors are considered. i) Maximum usage. ii) Lead time. iii) Storage facilities available, cost of storage and insurance etc. iv) Prices for material v) Availability of funds.
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CALCULATION OF VARIOUS LEVELS: The various levels can be decided by using the following mathematical expressions. 1). Re-Order level:Maximum lead time X Maximum usage. 2). Maximum level:Re-order level + Re order Quantity- (Minimum Usage X Maximum lead time) I
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3). INVENTORY TURNOVER: Inventory turnover indicates the ratio of materials consumed to the average inventory held. It is calculated as below: Value of Material Consumed _______________________ Average inventory held Where value of material consumed can be calculated as: Opening stock + purchases- closing stock. Average inventory held can be calculated as: Opening stock + closing stock __________________________ 2 Inventory turnover can be indicated in terms of number of days in which average inventory is consumed. It can be done by dividing 365 days (a year) by inventory turnover ratio. 4. EOQ:- Economic order Quantity as per notes include bills payable, notes payable and miscellaneous accruals. Net working capital is the excess of current assets over current liabilities here. Current assets are those assets which are normally converted into cash within an accounting year; and current liabilities are usually paid within an accounting year. What for is working capital required by firm very much depends on the nature of the business which the firm is conducting. If the firm has business which deals I
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It is the cost of keeping items in stock. It includes interest on investment. Obsolescence losses, store- keeping cost, insurance premium, etc. the larger the volume of inventory, the higher will be the inventory carrying cost and vice versa. II ORDERING COST
It is the cost of placing an order and securing the supplies. It various from time to time depending upon the number or orders placed and the number of times ordered. The more frequently the order are placed and fewer the quantities purchased an each order, the greater will be the ordering cost and vice versa. The economic ordering quantity can be determined by any of the following two methods. 1) FORMULA METHOD I
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EOQ model is based on the following assumptions: I. II. III. The firm knows with certainly the annual usage or demand of the particular item of inventories. The rate at which the firm uses the inventories or makes sales is constant through out a year. The order the replenishment of inventory are placed exactly when inventories reach the zero level.
The above assumption may also be called as limitation of EOQ modes. There is every likelihood of a discrepancy between actual and estimated demand for a particular items of inventory. Similarly, the assumptions as to constant usage or sale of inventories and instantaneous replenishment of inventories are also of doubtful validity. On account of these reasons, EOQ model may sometimes give wrong estimate about economic order quantity. 2. TABULAR METHOD This method is to be used in those circumstances where the inventory carrying cost per units is not constant. This will be clear with the following.: Calculating the Economic Ordering Quantity using Tabular Method on the basis of data given. I
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1600
1 2 3 4 5 6 7 8 9 10
1600 800 533 400 320 267 229 200 178 160
100 200 300 400 500 600 700 800 900 1000
Avg. stock in units (50% of order placed) 800 400 267 200 160 134 115 100 89 80
Carrying costs
6400 3200 2136 1600 1280 1072 920 800 712 640
6500 3400 2436 2000 1780 1672 1620 1600 1612 1640
The above table shows that total cost in the minimum when each is of 200 units. Therefore, economics ordering quantity is 200 units only. As graphic presentation of the economic ordering quantity on the basis of figures given in the above table will be as follows:
_____________ _____________
_________
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0 1 2 3 4 5 6 7 8 9 10
(5) Bill of Materials: In order to ensure proper inventory control, the basic principle to be kept in mind is that proper material is available for production purpose whenever it is required. This aim can be achieved by preparing what is normally called as Bill of Materials. A bill of material is the list of all the materials required for a job, process or production order. It gives the details of the necessary materials as well as the quantity of each item. As soon as the order for the job is received, bill of materials is prepared by Production Department or Production Planning Department. The form in which the bill of material is usually prepared is as below: BILL OF MATERIALS No. Date of Issue Department authorized S. No Description of Material Code No Qty. For Department Use Only Material Requisition No Date Quantity Demanded Remarks Production/Job Order No
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The function of bill of materials are as below: (1) Bill of materials gives an indication about the orders to be executed to all the persons concerned. (2) Bill of materials gives an indication about the materials to be purchased by the Purchase Department if the same is not available with the stores. (3) Bill of material may serve as a base for the Production Department for placing the material requisition slips. (4) Costing/Accounts Department may be able to compute the material cost in respect of a job or a production order. A bill of material prepared and valued in advance may serve as base for quoting the price for the job or production order. (6) Perpetual Inventory System: As discussed earlier, in order to exercise proper inventory control, perpetual inventory system may be implemented. It aims basically at two facts. (1) Maintenance of Bin Cards and Stores Ledger in order to know about eh stock in quantity and value at any point of time. (2) Continuous verification of physical stock to ensure that the physical balance and the book balance tallies. The continuous stock taking may be advantageous from the following angles: (1) Physical balances and book balance can be compared and adjusted without waiting for the entire stock taking to be done at the year end. Further, it is not necessary to close down the factory for Annual stock taking. (2) The figures of stock can be readily available for the purpose of periodic Profit and Loss Account. (3) Discrepancies can be located and adjusted in time. (4) Fixation of various levels and bin cards enables the action to be taken for the placing the order for acquisition of material. I
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The investment decisions of a firm generally known as capital budgeting or capital expenditure decisions. A capital budgeting decision may be defined as the firms decision to invest its current funds most efficiently in the long term assets in anticipation of an expected flow of benefits over a series of year. The long term assets are those which affect the firms operations beyond the one year period. The firms investment decision would generally include expansion, acquisition, modernisation and replacement of long term assets. Sale of a division or business (Investment) is also analysed as an investment decision. Activities such as changes in the methods of sales distribution or undertaking an advertisement compaign or a research and development programme have long-term implications for the firms expenditure and benefits and therefore, they may also be evaluated as investment decisions. Features:1) The exchange of current funds for future lengths. 2) The funds are invested in long term assets. 3) The future benefits will occur to the firm over a series of year.
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(A) Discounted Cash Flow (DCP) Criteria These techniques are considered good because they take into account time value of money. (1) Net Present Value (NPV) This method take into account time value of money. In this method present value of cash flows is calculated for which cash flows are discounted. The rate of interest is called cost of capital and is equal to minimum rate of return which must accrue from the project. Later, present value of cash out flows is calculated in same manner and subtracted from present value of cash inflows. This difference is called Net Present value or NPV. In case investment is made only in beginning of the project, it present value is equal to the amount invested in the project. Taking this assumption, NPV can be calculated as under: NPV = CF1 + (1+k)1 (1+k)2 CF2 +-(1+k)n Cfn -C
n =
Cft -C I
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Where
Cf1, Cf2 represent cash inflows K = Cost of Capital C = Cost of investment proposal n = Expected life of Proposal
If the project has a salvage value also, it should be added in cash inflows of last year. Similarly, if some working capital is also needed, it will be added to initial cost of project and to cash flows of last year. Acceptance Rule:1) Accept if NPV >O (i.e. NPV is Positive) 2) Reject if NPV <O (i.e. NPV is Negative) 3) May accept if NPV= O
Advantage: 1) It takes into account time value of money. 2) It considers cash inflows form project throughout its life. 3) In this method variable discount rates can be used for the projects with longer life period. 4) This method is more closely related to firms objective of maximising wealth of shareholders. 5) True measure of profitability. Disadvantages: (1) Difficult to use, calculate & understand. (2) In calculating NPV, discount rate is most significant because with different discount rates NPV will be different. Thus comparable profitability of projects will change with the change in discount rate. To determine required rate of return which is called cost of capital, is a difficult task. Different authors have their different opinions regarding its calculation.
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PI
MERITS Considers all cash flows. This method considers all benefits during the life time of the project. This method takes into account the time value of money. Pl method is considered better to NPV in case when the initial costs of projects are different for eg. The NPV of two project is equal ie, Rs 5000. The initial cost of project is Rs 40,000 and that of project B Rs 20,000. Project should be selected on the basis of profitability index, whereas under NPV method both the projects will be considered equally profitable. I
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Disadvantages/ Demerits 1). It is difficult to understand and implement this method. 2). The calculations in this method are complex as compared to traditional methods. 3). Requires estimates of the cash flows which is a tedious task. 4). At times fails to indicate correct choice between mutually exclusive projects. 4). Discounted Pay Back Period: This is an improvement over the pay back period method in the sense that it considers time value of money. Thus discounted pay book period indicates that period with which the discounted cash inflows equal to the discounted cash outflows involved in a project. Pay Back Method: Under this method the pay back period of each project/ investment proposal is calculated. The investment proposal, which has the least pay back period is considered profitable. Actual pay back period is compared with the standard one. If actual pay back period is less than the standard, the project will be accepted and in case, actual payback period is more than the standard pay back period, the project will be rejected. Thus, the project with the least payback period is considered profitable. Pay Back Period is the number of year required for the original investment to be recouped. For eg, if the investment required for a project is Rs 20,000 and it is likely to generate cash flow of Rs 10,000 for 5 years, its payback period will be 2 years. It means that investment will be recovered in first 2 year of the project. There are two methods of calculating payback period. First method is used when cash flows remains the same during the life time of the project. In such a case payback (PB) is calculated as under:-
CO =___ C
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MERITS 1. Easy to understand and compute. 2. This method follows short terms view point, as a result, the obsolescence are minimum. 3. Emphasis liquidility, therefore useful for the companies which faces the problem of liquidity. Such companies will invest their funds in such projects in which investment can be recovered in minimum time. 4. Used to find out internal Rate of Return. 5. Suitable for those organisations which emphasise on short-term investments rather than long terms development. 6. Uses cash flow information. 7. Easy and crude way to cope with risk. Demerits 1. Ignores the value of money. 2. Ignores the cash flows occurring after the pay back period. Thus does not take into account the whole profitability of the project. For eg: investment in a project is Rs 50,000. Its life 10 years and cash flows every year are Rs 10,000. Then its Pay back period will be 5 years. But the cash inflows of Rs 50,000 during the last 5 years have been taken into account. 3. No objective way to determine the standard payback. 4. This method also does not take into account the time value of money. The time value of money is the interest on investment. The payback period of two projects may be the same but a project may get more CFAT in the I
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II. Average Rate of Return Method: This method is also called Accounting Rate of Return Method. This method is based on accounting information rather than cash flows. There are various ways of calculating Average Rate of Return. It can be calculated as:Average annual Profit after Tax ARR = ___________________________X100 Average Investment
Average Annual Profit = Total of after tax profit of all the year ___________________________ No. Of years Average Investment = Original Investment + Salvage Value ________________________________ 2 or Original Investment Salvage Value ________________________________ + Salvage Value 2 If working Capital is also required in the initial year of the project, the average investment will be= Net working Capital + Salvage value + (initial cost of Machine- Salvage Value). In another method instead of average investment original cost is used.
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Unit IV MANAGEMENT OF RECEIVABLE Receivables are asset accounts representing amounts owned to a firm as a result of sale of goods or services in ordinary course of business. Receivables are also turned as trade receivables, accounts receivables, customer receivables, sundry debtors, bills receivable etc. Management of I
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Objectives of Receivable Management From creation of receivables the firm gets a few advantages & it has to bear bad debts, administrative expenses, financing costs etc. In the management of receivables financial manager should follow such policy through which cash resources of the firm can be fully utilised. Management of receivables is a process under which decisions to maximise returns on the investment blocked in them are taken. Thus, the main objectives of management receivable is to maximise the returns on investment in receivables & to minimise risk of bad debts etc. Because investment in receivables affects liquidity and profitability, it is, therefore, significant to maintain proper level of receivables. In other words, the basic objectives of receivables management is to maximise the profits. Efficient credit management helps to increase the sales of the firm. Thus, following are the main objectives of receivables management:(1) To optimise the amount of sales. I
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Aspects/Areas/Variables of RM
Credit Analysis
Collection Polices
- Trade References - Bank References - Financials statement Credit Credit Standards- Credit Bureau Report Terms - Past Experience a) Credit period b) Cash Discount c) Cash Discount Period
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Credit Sales during the Year Turnover of Accounts Receivable =________________________ Average Accounts Receivable.
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Period (No of No Days) Accounts 0-20 100 21-40 200 41-60 40 61-80 50 81-100 20 Over 100 10 420
Management Of Cash ITS areas of overall Management of cash is one of most important STUDY CENTRE working SCF-54 is the most liquid type of capital management. This is due to the fact that cash (BMNT) SECTOR 15 MARKET, current assets. As such, it is the responsibility of finance function to see that FARIDABAD PH 5002194-95 various functional areas of business have sufficient cash whenever they require the same. At the same time, it has also to be ensured that funds are not blocked in form of idle cash, because it will effect interest cost & opportunity cost. As such, management of cash has to find a mean between these 2 extremes of shortage of cash as well as idle cash. Motives of holding Cash/ Need:1) Transactive Motive:- Business needs cash for various payments in ordinary course of its operation which includes payment for purchase of material, wages, dividend, taxes etc. Similary business gets cash from its selling activities & other investment. But there is no coordination between inflow and outflow of cash. When expected cash receipt is short of required payment, cash is needed by firm so that liabilities could be paid, if cash receipts match with cash payments business does not need cash for transactional purpose. I
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Objective of Cash Management:1) To make Payment According to Payment Schedule:Firm needs cash to meet its routine expenses including wages, salary, taxes etc. Following are main advantages of adequate cash(1) To prevent firm from being insolvent. (2) The relation of firm with bank does not deteriorate. (3) Contingencies can be met easily. (4) It helps firm to maintain good relations with suppliers.
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Determining Optimum cash Balance:If available cash is more than operating requirements of firm, additional cash should be invested in short-terms securities. Optimum cash balance is that level of cash at which transaction cost & opportunity cost are minimum. If firm maintains more cash than optimum level, opportunity cost increases and transaction decreases and vice versa. Investing Surplus Cash:If nature of surplus cash is permanent, it can be invested in long term assets. While investing cash in securities, their safety, maturity and marketability should be considered. a) Safety:- Cash should be invested in those securities, the prices of which do not change substantially and there is no risk in repayment of its principal & interest. b) Maturity:- more changes take place in long term securities. c) Marketability:- of securities means easiness in converting them into cash. Therefore, the surplus cash should be invested in such securities which can be converted into cash with out much loss.
Unit-II Risk analysis Risk exists because of inability of decision maker to make perfect forecasts. Forecasts cannot be made with perfection or certainity since the future events on which they depend are uncertain. An investment is not risky if, we can I
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Techniques to handle Risk 1) Pay back 2) Risk-adjusted discount rate. 3) Certainty equivalent. 2) Risk-adjusted Discount Rate:To allow a risk, businessman required a premium over and above an alternative which was risk free. Accordingly, more uncertain the returns in future, the greater the risk & greater premium required. Based on this reasoning, it is proposed that risk premium be incorporated into capital budgeting analysis through discount rate. That is, if time preference for money is to be recognised by discounting estimated future cash flows, at same risk-free rate, to their present value, than, to allow for riskiness of those future cash flows a risk premium rate may be added to risk free discount rate. Such a composite discount rate, called risk-adjusted discount rate, will allow for both time preference & risk preference & will be a sum of risk-free rate & risk-premium rate reflecting the investors attitude towards risk. The risk adjusted discount rate method can be expressed as follows: n NPV = t=0 NCFt (1+k)t
Where K= Risk-adjusted rate. That is, Risk-adjusted discount rate= Risk free Rate+ Risk Premium K= kf+kr
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Certainty Equivalent Yet another common procedure for dealing with risk in capital budgeting is to reduce the forecasts of cash flows to some conservative levels. For example, if I
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NCFt= the forecasts of net cash flow without risk-adjustment t = the risk-adjustment factor or the certainty equivalent coefficient kf = risk-free rate assumed to be constant for all periods.
The certainty- equivalent coefficient, t assumes a value between 0 and 1, and varies inversely with risk. A lower t will be used if greater risk is perceived and a higher t will be used if lower risk is anticipated. The coefficients are subjectively or objectively established by the decision maker. These coefficients reflect the decision-makers confidence in obtaining a particular cash flow in period t. For example, a cash flow of Rs 20,000 may be estimated in the next year, but if the investor feels that only 80 per cent of it is a certain amount, then the certainty-equivalent coefficient will be 0.80. That is, he considers only Rs 16000 as the certain cash flow. Thus, to obtain certain cash flows, we will multiply estimated cash flows by the certainty-equivalent coefficients. The certainty-equivalent coefficient can be determined as a relationship between the certain cash flows and the risky cash flows. That is:
t =
NCFt* = NCFt
For example, if one expected a risky cash flow of Rs 80,000 in period t and considers a certain cash flow of Rs 60,000 equally desirable, then t will be 0.75=60,000/80,000. ILLUSTRATION 15.2 A project costs Rs 6,000 and it has cash flows of Rs 4,000, Rs 3,000, Rs 2,000 and Rs 1,000 in year 1 through 4. Assume that the associated t factors are estimated to be: o = 1.00, 1=0.90, 2=0.70, 3=0.50
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NPV = 1.0(-6,000) +
The project would be rejected as it has a negative net present value. If the internal rate of return method is used, we will calculate that rate of discount which equates the present value of certainty-equivalent cash inflows with the present value of certainty-equivalent cash outflows. The ratio so found will be compared with the minimum required risk-free rate. Project will be accepted if the internal rate is higher than, the minimum rate; otherwise it will be unacceptable. Evaluation of Certainty Equivalent The certainty-equivalent approach explicitly recognizes risk, but the procedure for reducing the forecasts of cash flows is implicit and is likely to be inconsistent from one investment to another. Further, this method suffers from many dangers in a large enterprise. First, the forecaster, expecting the reduction that will be made in his forecasts, may inflate them in anticipation. This will no longer give forecasts according to best estimate. Second, if forecasts have to pass through several layers of management, the effect may be to greatly exaggerate the original forecasts or to make it ultra conservative. Third, by focusing explicit attention only on the gloomy outcomes, chances are increased for passing by some good investments. Risk-adjusted Discount Rate VS. Certainty-Equivalent The certainty-equivalent approach recognizes risk in capital budgeting analysis by adjusting estimated cash flows and employs risk-free rate to discount the adjusted cash flows. On the other hand, the risk-adjusted discount rate adjusts for risk by adjusting the discount rate. It has been suggested that the certainty equivalent approach is theoretically a superior technique over the risk-adjusted discount approach because it can measure risk more accurately.1 The risk-adjusted discount rate approach will yield the same result as the certainty-equivalent approach if the risk-free rate is constant and the riskadjusted discount rate is the same for all future periods. Thus, I
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(1+k)t+1 Earlier, we have stated that the values of 1 will vary between 0 and 1. Thus, if Kf and k are constant for all future periods, then K must be larger than Kf to satisfy the condition that t varies. 1. Robichek and Myers, op. cit., pp. 82-86. Unit IV 16 Management Of Working Capital
Working capital management is an important component of overall financial management. Management of working capital like long-term financial decisions affects the risk and profitability of business. In business two types of assets are used. (1) Fixed Assets (2) Current Assets Fixed Assets include land, building, plant and machinery, furniture and fittings etc. fixed assets are used in the business for a long period and they are not purchased for the purpose of selling them to earn profit. Current Assets, on the other hand, are used for day to day operation of business. For the efficient and effective use of fixed assets, there should be adequate working capital in the business. Current assets include cash, bank I
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(ii) Net Concept:- According to the net concept of working capital, net working capital means the excess of current assets over current liabilities. If current assets are equal to current liabilities then according to this concept working capital will be zero and in case current liabilities are more than current assets, the working capital will be called negative working capital. Net Working Capital= Current Assets-Current Liabilities
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Cash Raw Materials Work-in-
Operating Cycle
The greater the period of operating cycle, more will be the requirement of working capital. Business enterprises engaged in manufacturing work have larger duration of operating cycle as compared to those engaged in trading business because in such enterprises cash is directly converted into finished goods. Because no business is able to match its cash inflows and cash outflows, therefore, the business needs to maintain some cash to pay its current liabilities in time. Similarly, to maintain supply of goods to meet the demand in the market, the stock of finished goods has to be kept. For the smooth running of manufacturing work stock of raw material has to be maintained. Firm has to sell on credit due to competition. Thus, business needs adequate working capital. Permanent And Variable Working Capital In business current assets are required because of the operating cycle. But the need for working capital does not end with the completion of operating cycle. Operating cycle goes on continuously and therefore, in order to understand the need for working capital, it becomes essential to distinguish between permanent or regular and variable or seasonal or temporary working capital. (a) Permanent Working Capital:- The requirements for current assets do not remain stable throughout the year and it fluctuates from time to time. A certain minimum amount of raw material, work in progress and finished goods and cash must be maintained regularly in the business so that day to day operation of the business could continue without any obstacles. This minimum I
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Fig. 1. Permanent and Temporary Working Capital From Fig.1 it is clear that the need for regular working capital remains the same for whole the year, whereas variable working capital needs are sometimes high and sometimes low. In a growing concern the need for working capital goes on rising because in the level of business activities. It is presented in Fig. 2)
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X
Factors Affecting Working Capital Business should prepare its financial plan in such a way that it has neither surplus nor inadequate working capital. The needs for every business are different but generally the following factors must be considered while determining the requirement of working capital. (1) Nature of Business:- Nature of business affects the working capital requirements of the business. Railways, transport, electricity, water and other public utilities require relatively lower working capital because the demand for their services is regular and fixed. They also get immediate payment. They need not keep much stock. On the other hand, the trading institutions require more working capital because they have to keep adequate stock, cash and debtors. In financial institutions and banks, the need for working capital is more than permanent capital. (2) Growth and Expansion:- the large sized businesses require more permanent and variable working capital in comparison to small business. If a company is growing, its working capital requirements will also go on increasing. Thus, the growing concerns require more working capital as compared to the stable industries. (3) Production Cycle:- Production cycle means the time period between the purchase of raw material and converting it into finished product. The requirements of working capital in a business depends upon the production cycle. It the period of production cycle is longer, more working capital will be required. If the production cycle is small, the requirements of working capital will also be small. Therefore, business should choose such an alternate method of I
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Debtors may be due to tight credit policy, which would impair sales further. I
Minimum Cost
Total Cost
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Cost Cost of Illiquidity
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Finished material: one months supply: Rs 9,68,000 12= Rs 80,666 The total inventory needs are: Rs 20,667+ Rs 36,867 + Rs 80,666= Rs 138,200 After determining the inventory requirements, projection for debtors and operating cash should be made. Debtors: one months sales: Rs14,48,00012= Rs 1,20,667 Operating Cash: one months total Cost: Rs 9,68,000 12= Rs 80,667 Thus the total working capital required is: Rs 1,38,200+ Rs 1,20,667+ Td 80,666= Rs 3,39,533 Method 2: The average ratio is 30 per cent. Therefore, 30% of annual sales (Rs 14,48,000 is 4,34,400. Method 3. 15% (the average rate) of fixed investment (Rs 16,00,000) is Rs 2,40,000. The first method gives details of the working capital items. This approach is subject to markets are seasonal. As per the first method the working capital requirement is Rs 3,39,533. if this figure is in calculating the rate of return, it is lowered from 33.3% to 27%. On the other hand, the return of firm B drops from 11.1% to 9.9%. the estimated working capital for firm B as per the method is Rs 3,66,200. Rates of return are calculated as follows:
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This model was propounded by Prof. James E. Walter who argues that the choice of dividend policies almost always affect the value of the firm. He shows the importance of relationship between the firms rate of return and its cost of capital (K) in determining the dividend policy that will maximise the wealth of shareholders.
Assumptions:1) Internal financing:The firm finances all investment through retained earnings, that is debt or new equity is not issued. 2) Constant return and cost of capital:The firms rate of return (r ) and its cost of capital (k) are constant. 3) 100% payout or retention:All earning are either distributed as dividends or reinvested internally immediately. 4) Constant EPS and DIV:Beginning earnings and dividends never change. The value of the earnings per share, (EPS) and dividend per share (DIV) may be changed in the model to determine results, but any given values of EPS or DIV are assumed to remain constant forever in determining a given value. 5) Infinite time:The firm has a very long or infinite life. Walters formula to determine the market price per share is as follows:DIV P = K + K r (EPS-DIV)/k
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Equation (1) reveals that the market price per share is the sum of present value of 2 sources of income (i) Present value of infinite stream of constant dividends, (DIV/k) and (ii) Present value of infinite stream of capital gain r (EPS-DIV)/k k When the firm retains a perpetual sum of (EPS-DIV) at rate of return ,its present value will be: R (EPS-DIV)/R This quantity can be known as a capital gain which occurs when earnings are retained within the firm. If this retained earnings occur every year, the present value of an infinite number of capital gains, r (EPS-DIV)/k will be equal to : [r(EPS-DIV)] /k. Thus, the value of a share is the present value of all dividends plus the present value of all capital gain as show in eg (1) which can be rewritten as follows: P= DIV+(r/K) (EPS-DIV) ____________________ K To show the effect of dividend or retention policy on the market value of share, we shall use Eq (2) E.g The effect of different dividend policies on the value of shares respectively for the growth firm, normal firm and declining firm is constructed through given table.
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Dividend Policy and the value of share (Walters Model) Growth Firm (r>k) Basic Data r= 0.15 k=0.10 EPS = Rs 10 Payout Ratio 10% DIV R 50 P= [0+(0.15/0.10)(10-0)] 0.10 = Rs = 150 Payout Ratio 40% DIV = Rs 4 P=[4+0.15/0.10)(10-4) 0.10 =Rs 130 Payout Ratio 80% DIV = Rs 8 P = 110 Payout Ratio 100% DIV = Rs 10 P = Rs 100 Normal Firm (r=k) T= 0.10 K= 0.10 EPS = Rs 10 Declining Firm (r<k) r= 0.08 k = 0.10 EPS = Rs 10
DIV = Rs 0 P = 100
The above table shows that dividend policy depends on the relationship between the firms rate of return and its cost of capital (k). Walters view on the optimum dividend pay out ratio can be summarised as follows.
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Criticism:I
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One very popular model explicitly relating the market value of the firm to dividend policy is developed by Myron Gordon.1 Gordons model is based on the following assumptions:2 o All-equity firm The firm is an all-equity firm, and it has no debt. o No external financing No external financing is available. Consequently retained earnings would be used to finance any expansion. Thus, just as Walters model Gordons model too confounds dividend and investment policies. o Constant return The internal rate to return, r, of the firm is constant. This ignores the diminishing marginal efficiency of investment as represented in Figure 20.1 I
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+ (1+k)2 (1+k)
However, the dividend per share is expected to grow when earnings are retained. The dividend per share is equal to the payout ratio, (1-b), times earnings, i.e., DIVt = (1-b) EPS, where b is the fraction of retained earnings. The retained earnings are assumed to be reinvested within the all-equity firm at a rate of return of r. This allows earnings to grow at the rate of g= br per period. When we incorporate growth in earnings and dividend, resulting from the retained earnings, in the dividend-capitalisation model, the present value of a share is determined by the following formula: DIV(1+g)2 + (1+k) (1+k)2 + (1+k)3 DIV(1+g)3 +.+ (1+k)t
DIV(1+g) Po =
DIV(1+g)
1. 2.
Gordon, Myron J., The Investment, Financing and Valuation of Corporation. Richard D. Irwin, 1962. Francis, op. cit., p. 352. DIV (1+g)t = t=1 (1+k)t I
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Equation (8) shows that regardless of the firms earnings, EPS1, or riskiness (which determines K), the firms value is not affected by dividend policy and is equal to the book value of assets per share. That is, when r=k, dividend policy is irrelevant since b, which represents the firms dividend policy, completely cancels out of equation (8). Interpreted in economic sense, this finding implies that, under competitive conditions, the opportunity cost of capital, k, must be equal to the rate of return generally available to investors in comparable shares. This means that any funds distributed as dividends may be invested in the market at the rate equal to the firms internal rate of return. Consequently, shareholders can neither I
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rA Po = k If r<k then r/k<1 and from Equation (9) it follows that Po is smaller than the firms investment per share in assets. A. It can be shown that if the value of b increases, the value of the share continuously falls. 2 These result may be interpreted as follows: 1. Dobrovolsky, Sergie P., The Economics of Corporation Finance, McGraw Hill, 1971, p.55. 2. ibid., p. 56. (if b=0)
It the internal rate of return is smaller than k, which is equal to the rate available in the market, profit retention clearly becomes undersirable from the shareholders standpoint. Each additional rupee (sic) retained reduces the amount of funds that shareholders could invest at a higher rate elsewhere and thus further depress the value of the companys share. Under such conditions, the company should adopt a policy of contraction and disinvestment, which would allow the owner to transfer not only the net profit but also paid in capital (or a part of it) to some other, more remunerative enterprise.1 Finally, let us consider the case of a growth firm where r>k. The value of a share will increase as the retention ratio, b increases under the condition of r>k. however, it is not clear as to what the value of b should be to maximise the value of the share, P0. For example, if b=k/r, Equation (6) reveals that denominator, kbr=0, thus making P0 infinitely large, and if b=1,k- br becomes negative, thus making P0 negative. These absurd result are obtained because of the assumption that r and k are constant, which underlie the model. Thus, to get the meaningful value of the share, according to Equation (6), the value of b should be less than k/r. Gordons model is illustrated in Illustration 20.2. I
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Table 20.3 DIVIDEND POLICY AND THE VALUE OF THE FIRM (GORDONS MODEL)
Growth Firm (r>k) Basic Data r= 0.15 k=0.10 EPS1 = Rs 10 Payout Ratio, (1-b) =, Retention Ratio, B = 60% g=br=0.6X0.15=0.09 10(1-0.6) P= 0.10-0.09 4 = Rs 400 0.01 Payout Ratio = (1-b) = 60% Retention Ratio, b = 40% g=br=0.4X0.15=0.06 10(1-0.4) p= 0.10-0.06 6 = Rs 150 0.04 Payout Ratio = (1=b) = 90% , Retention Ratio, b =10% g=br=0.10X0.15= 0.015 10(1-0.1) P= 0.10-0.015 = 9 = 0.085 Rs 106 0.09 9 Rs 100 = 0.092 9 Rs 98 Normal Firm (r=k) T= 0.10 K= 0.10 EPS1 = Rs 10 g=br=0.6X0.10=0.06 10(1-0.6) P= 0.10-0.06 4 = Rs 100 0.04 P= 0.010-0.048 4 = Rs 77 0.052 Declining Firm (r<k) r= 0.08 k = 0.10 EPS1 = Rs 10 g=br=0.6X0.08=0.048 10(1-0.6)
g=br=0.4X0.10=0.04 10(1-0.4) P= 0.10-0.04 6 = Rs 100 = 0.06 g=br= 0.10X0.10= 0.01 10(1-0.1) P = 0.10-0.01
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Gordons models conclusions about dividend policy are similar to that of Walters model. This similarity is due to the similarities of assumptions which underlie both the models. Thus the Gordon model suffers from the same limitations as the Walter model. DIVIDENDS AND UNCERTAINTY: THE BIRD-IN-THE HAND ARGUMENT
According to Gordons model, dividend policy is irrelevant where r=k, when all other assumptions are held valid. But when the simplifying assumptions are modified to conform more closely with reality, Gordon concludes that dividend policy does affect the value of a share even when r=k. This view is based on the assumption that under conditions of uncertainty, investors tend to discount distant dividends (capital gains) at a higher rate than they discount near dividends. Investors, behaving rationally, are risk-averse and, therefore, have a preference for near dividends to future dividends. The logic underlying the dividend effect on the share value can be described as the bird-in-the-hand argument. The bird-in-the hand argument was put forward, first of all by Kirshman in the following words: Of two stocks with identical earnings record, and prospects but the one paying a larger dividend that the other, the former will undoubtedly command a higher price merely because stockholders prefer present to future values. Myopic vision plays a part in the price-making process. Stockholders often act upon the principle that a bird in the hand is worth two in the bush and for this reason are willing to pay a premium for the stock with the higher dividend rate, just as they discount the one with the lower rate.1 1. Krishman, Johan, E., Principles of Investment. McGraw Hill, 1933, p. 737; cf. in Mao J.C.T., Quantitative Analysis of Financial Decision, Macmillan, 1969. Where Pb is the price of the share when the retention rate b is positive i.e., b>0. The value of Pb calculated in this way can be determined by discounting this dividend stream at the uniform rate, k. Iz the weighted average of Kt:1 DIV0(1+g) Po = + DIV0(1+g)2 +..+ I DIV0((1+g)t
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Assuming that the firms rate of return equals the discount rate, will Pb be higher or lower than P0? Gordons View, as explained above, it that the increase in earnings retention will result in a lower value of share. To emphasise, he reached this conclusion through two assumptions regarding investors behaviour: (i) investors are risk averters and (ii) they consider distant dividends as less certain than near dividends. On the basis of these assumptions, Gordon concludes that the rate at which an investor discounts his dividend stream from a given firm increases with the futurity of this dividend stream. If investors discount distant dividend at a higher rate than near dividends, increasing the retention ratio has the effect of raising the average discount rate, K, or equivalently lowering share prices. Thus, incorporating uncertainty into his model, Gordon concludes that dividend policy affects the value of the share. His reformulation of the model justifies the behaviour of investors who value a rupee of dividend income more than a rupee of capital gains income. These investors prefer dividend above capital gains because dividends are easier to predict, are less uncertain and less risky, and are therefore, discounted with a lower discount rate.2 However all do not agree with this view. DIVIDEND IRRELEVANCE: MODIGLIANI AND MILLERS HYPOTHESIS
According to Modigliani and Miller (M-M) under a perfect market situation, the dividend policy of a firm is irrelevant as it does not affect the value of the firm. 3 They argue that the value of the firm depends on the firms earnings which result from its investment policy. Thus, when investment decision of the firm is given, dividend decision the split of earnings between dividends and retained earnings is of no significance in determining the value of the firm. A firm, operating in perfect capital market conditions, may face one of the following three situations regarding the payment of dividends: The firm has sufficient cash to pay dividends. The firm does not have sufficient cash to pay dividends, and therefore, it issues new shares to finance the payment of dividends. The firm does not pay dividends, but a shareholder needs cash. I
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Under the M-M assumptions, r will be equal to the discount rate, k and identical for all shares. As a result, the price of each share must adjust so that the rate of return, which is composed of the rate of dividends and capital gains, I
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(14) Since r=K in the assumed world of certainty and perfect markets. Multiplying both sides of equation (14) by the number of shares outstanding. n, we obtain the total value of the firm if no new financing exists: nDIV1+P1) V = nPo = (1+k) (15)
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M-M s valuation Equation (16) allows for the issue of new shares, unlike Walters and Gordons models. Consequently, a firm can pay dividends and raise funds to undertake the optimum investment policy (as explained in figure 20.1). Thus, dividend and investment policies are not confounded in the M-M model, like Walters and Gordons models. As such, M-Ms model yields more general conclusions. The investment programmes of a firm, in a given period of time, can be financed either by retained earnings or the issue of new shares or both thus, the amount of new shares issued will be: mP1=I1-(X1-nDIV1)=I1-X1+nDIV1 (17) where I1 represents the total amount of investment during first period and X1 is the total net profit of the firm during first period. By substituting Equation (17) into Equation (16), M-M showed that the value of the firm is unaffected by its dividend policy, thus, nDIV1 + Pl) + mPl - mPl nPo = (1+k) nDIVl + (n+m) Pl (Il Xl + nDIVl) = (1+k) (n+m) Pl Il + Xl = (1+k) (18)
A firm which pays dividends will have to raise funds externally to finance it investment plans. M-Ms argument, that dividend policy does not affect the wealth of the shareholders, implies that when the firm pays dividends, its advantage is offset by external financing. This means that the terminal value of I
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The price of the share at the end of the current fiscal year is determined as follows: DIVl + Pl Po = (1+k) The value of P when dividend is not paid is: Pl = Rs100(1.10)-0=Rs110 When dividend is paid it is: Pl = Rs 100(1.10)-Rs 5 = Rs 105 In can be observed that whether dividend is paid or not the wealth of shareholders remains the same. When the dividend is not paid the shareholder will get Rs 110 by way of the price per share at the end of the current fiscal year. On the other hand, when dividend is paid, the shareholder will realise Rs 105 by way of the price per share at the end of the current fiscal year plus Rs as dividend. The number of new shares to be issued by the company to finance its investments is determined as follows: mPl = I (X-nDIVl) 105m = 20,00,000 (10,00,000-5,00,000) 105m = 15,00,000 m = 15,00,000/ 105= 14,285 shares I
Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org