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Financial Management

K.V.RAMESH Assistant Professor Institute of Public Enterprise

Lay out
 Nature of Financial Management.
 Investment & Financing Decisions.  Dividend Decisions.

 Liquidity Decisions or Working Capital Management.

What is Finance ?
 Finance stands for provision of money as and when required.  Process of raising, providing and administering all money/funds to be used in a corporate enterprise.  Is concerned with the acquisition and conservation of capital funds in meeting the financial need and overall objectives of business enterprise.

.Approaches to finance Providing of funds needed by a business on most suitable terms. Concerned with raising of funds and their effective utilisation. Cash.

.Financial Management  The ways and means of managing money. and utilisation of financial resources with the aim to achieve objectives of the firm.  Is the application of planning and controlling functions to the finance function. acquisition.  Planning. allocation.

Selecting source of finance. Capital structure decisions. Implementing financial controls. .Scope of Finance Function Estimating financial requirements. Proper Cash management. Proper use of surpluses. Selecting pattern of investment.

Increasing profitability. Maximising firm’s value.Aims of Finance function Acquiring sufficient funds. Proper utilisation of funds. .

.  Economy.  Simplicity. Objectives:  Availability of adequate funds.  Liquidity.  Optimum use.  Flexibility.  Long term view.Financial plan Is a statement estimating the amount of capital and determining its composition.  Balancing of costs and risks.

Considerations Nature of Industry. . Future plans. Government control. Availability of sources. Credit rating of the concern.Expansion and diversification. General economic conditions.

. Profitability is essential for fulfilling social goals. Economic and business conditions do not remain the same all the time.Objectives of Financial management Profit: Profit earning. Wealth: Maximizes implies the market value of its shares. Profitability is a barometer for measuring efficiency and economic prosperity of a business. Profits are the main sources of finance for the growth of the business.

(Agencyproblems) Ownership and management are separated. Vs Wealth  Its an prescriptive idea.  Not necessarily socially desirable.  Dividend policy.  Ignores the time value of money.  Ignores Risk factor. .Profit  The term profit is vague.  Controversy objectives Maximize stockholders wealth or wealth of firm.

Acquisition of funds. Maintain proper liquidity. . Investment of funds. Helping in valuation decisions.Functions of a Finance manager Financial forecasting and planning.

C-V-P analysis.Functional areas of FM Determining financial needs. Selecting the source of funds. Working capital management. Capital budgeting. Profit planning and control. Dividend policy. . Financial analysis and Interpretation.

Organization of finance function Board of directors Managing Director/ Chairman Director (F)/ VP (F)/ CFO Treasurer and Controller ( Financial executives) .

. manage and protect the firm’s capital. The basic responsibility of the controller is to check that the funds are used efficiently.Responsibilities of FE The basic responsibility of the treasurer is to provide.

term financing Cash management Credit administration Investments Insurance .Functions of FE Treasurer : Obtaining finance Banking relationship Investor relationship Short.

planning and control Economic appraisal Reporting to Government .Functions of FE Controller: Financial Accounting Internal audit Taxation Management accounting and control Budgeting.

FM Process FM is a dynamic decision-making process include a series of interrelated activities involving: Financial planning Financial decision-making Financial analysis Financial control .

. Money received today can be invested to earn suitable returns. Reasons for Time value Higher preference for present consumption Purchasing power of the currency declines with time.Concept of Time value of money  Value of the money received today is more than the value of the same amount of money received after a certain period.

People generally prefer spending than deferring for future. . Money has time value because of opportunities available to invest.Reasons for Time Preference of Money The future is always uncertain and involves risk.

To move a cash flow forward in time.Timeline and Time travel  Timeline is a linear representation of the timing of the expected cash flows. Rules of Time travel Only cash flows in the same units can be compared or combined at the same point in time. To move a cash flow backward in time. must use discounting.  A series of cash flows lasting several periods as a stream of cash flows. must compound it. . Timelines are an important first step in organizing and then solving a financial problem.

Note: If calculations becomes difficult.n) Where CFi.Techniques of Time Value of Money  Compounding Technique Interest is compounded when the amount earned on an initial deposit becomes part of the principal at the end of the first compounding period. . Vo = Value of money at time 0. Vn = Vo (CFi.n is compound factor at i percent and n periods. Principal refers to the amount of money on which interest is received. the future value of money can be calculated with the help of Compound factor tables. i = Interest rate. n Vn = Vo(1+i) Where Vn = Future value at the period.

Po n .Simple Interest vs Compound Interest Interest paid/earned on original amount or on principal borrowed is called the simple interest. Symbolically Po(1+i) .e. t = 0 i refers to interest rate per period n refers to number of time periods Compound Interest is the interest paid/earned on any previous interest earned as well as on the principal borrowed. Symbolically P0(i)(n) Where P0 refers to deposit today i..

The future value of money in the above said case/cases Vn = Vo ( 1 + i/m) Vn = Future value of money after n years. compounding of interest twice a year say 30th June and 31st December every year. Vo = Value of money at time 0 i = Interest rate m = Number of times of compounding per year mn Where .Multiple Compounding Periods In case the interest is payable on quarterly basis.

Effective rate of interest is calculated with the following formula: ( 1 + i/m) – 1 Where i refers to nominal rate of interest m refers to frequency of compounding per year m .Multi Period Compounding The actual rate of interest realised called effective rate in case of multi period compounding is more than the apparent annual rate of interest called nominal rate.

When cash flows occur at the end of each period the annuity is called a Regular Annuity or Deferred Annuity.n)(1 + i) .Compounded value of Annuity Annuity is a series of equal payments lasting for some specified period. Future value of Annuity: Vn = (R)(ACFi.n) Future value of Annuity Due: Vn = (R)(ACFi. If the cash flows occur at the beginning of each period instead of at the end it is called Annuity Due.

 SFF is the reciprocal of the CVFA. .  The factor used to calculate the annuity for a given future sum is called sinking fund factor (SFF).Sinking fund  It is a fund created out of fixed payments each period to accumulate to a future sum after a specified period.

1000 in an account earning 7% simple interest for two years.a.000 at the end of third year @ 12% rate of interest when interest is calculated on yearly and quarterly basis. . If you deposit Rs. Rate of interest if neither the principal sum of Rs. From the above calculate the value of Rs. 3. What is the accumulated interest at the end of the second year? Calculate the compound value of Rs.100 nor interest is withdrawn at the end of one year. 2.10.100 @ 10% after ten years.Problems 1. 4.100 after two years at 10% p. What will be the value of Rs.

Determine how much money he will have at the end of five years? . Determine how much money he will have at the end of four years. 7.5000 at the beginning of each year for five years in a bank and the deposit earns a compound interest @ 8% p.1000 at the end of every year for four years and the deposit earns a compound interest @ 10% p. quarterly and monthly? 6.a. Mr. A company offers 12% rate of interest on deposits.a. B deposits Rs. What is the effective rate of interest if the compounding is done half yearly. A deposits Rs.5. Mr.

Yes ltd deposits Rs50.8.000 at the end of each year for 4 years at 6 percent rate of interest. . a) How much would this annuity accumulate at the end fourth year? b) Calculate annuity using sinking fund factor.

n . V0 = Vn 1+ i Where Vn is future value for n period Vo is present value Note: When we use discount factors. the present value is calculated by: Present Value = Future Value x DFi.Discounting or Present Value Technique Present value shows what the value is today of some future sum of money. The Present Value Technique is known as discounting because the present value of money to be received in future will always be less.

the present value of an annuity can be calculated with the help of annuity discount factor tables.Present Value of an Annuity If the amount of payment is R.n)(1 + i) Present value of an Infinite Life Annuity: Vo = R/i . Vo = (R)(ADFi. the present value of an annuity due is calculated by using present value tables: Vo = (R)(ADFi.n) Present value of an annuity due: If the cash flows occur at the beginning of each year.

Rs.3000 and Rs.10. Rs. Mr.1000 to be received after one year @ 10% time preference rate.000.10.5000. Rs. 2. Calculate the present value of Rs.2000.5000 after five years @ 10% p.Problems 1. Calculate its present value. X is to receive Rs. 3. . The cash flows for each respective year are Rs. Calculate present value of the following five years cash flows assuming a discount rate of 10%.a.000.

5.1000 received in perpetuity for an infinite period taking discount rate of 10%.10. A has to receive Rs.4.a. Calculate the present value of annuity assuming that he can earn interest on his investment @ 10% p. . 6. Mr. Calculate the present value of annuity due assuming 10% rate of interest.000 at the beginning of each year for five years.2000 per year for five years. Mr. X has to receive Rs. Calculate the present value of Rs.

.  Is the rate of return that a firm requires to earn from its projects.  Is the minimum rate of return which will at least maintain value of the shares.What is Cost of Capital?  Is the minimum rate of return expected by its investors.

Definitions  A cut-off rate for the allocation of capital to investment of projects.  Is the minimum required rate of earnings or the cut-off rate of capital expenditures.  The rate of return the firm requires from investment in order to increase the value of the firm in the market price. . It is the rate of return on a project that will leave unchanged the market price of the stock.

Components of Cost of Capital  The expected normal rate of return at zero risk level (ro).  The premium for financial risk on account of pattern of capital structure (f).  Premium for business risk (b). Symbolically: K = ro + b + f .

Form of Capital  Debt  Preference Capital  Retained Earnings  Equity Capital .

Cost of debt after-tax : Kda = Kdb(1-t) = I/NP (1-t) Where ‘NP’ refers to Net Proceeds ‘t’ refers to rate of tax .Computation of Cost of Capital Debt: Cost of debt is the rate of interest payable on debt. Debt may be irredeemable or redeemable. Cost of debt before-tax: Kdb = I/P Where ‘I’ is interest and ‘P’ is principal.

000 8% debentures: a) at par. . 2.00.Compute cost of debt capital. c) at discount of 5%.50. rate of tax 50% where X ltd issues Rs. L&T Ltd issues Rs. The rate of tax is 60%.000 9% debentures at a premium of 10%.Compute cost of debt. Kdb = I/NP 1.1.Debt issued at a premium or discount Net proceeds received from the issue must be considered and not the face value of securities. b) at premium of 10%. The cost of floatation are 2%.

‘RV’ is Redeemable value of debt ‘NP’ is Net proceeds of debentures.Redeemable debt Before Tax Kdb = I + 1/n(RV-NP) ½(RV+NP) Where ‘I’ is Annual Interest ‘n’ is number of years in which debt is to be redeemed. .

3. A company issues Rs.10,00,000 10% redeemable debentures at a discount 5%. The cost of floatation Rs.30,000.The debentures are redeemable after 5 years. Calculate before –tax assuming tax rate 50%. Note: calculate after-tax cost of debt.

After Tax
I(1-t)+ 1/n(RV-NP) Kdb =


Cost of Preference Capital
 It is a function of dividend expected by its investors. Perpetual Kp = D/P D refers to Annual Preference Dividend P refers to proceeds

Issued at a discount or premium Kp = D/NP
Redeemable Kpr = D+MV-NP/n ½(MV+NP)

MV refers to Maturity value of preference shares. NP refers to Net Proceeds of preference shares.

Calculate cost of preference capital if these are issued at par. at a premium of 10% and at a discount of 5%.100 each redeemable after 10 years at a premium of 5%.Problems  Zee ltd issues 10. .  Lakme ltd issues 10.000 10% Preference shares of Rs. Cost of issue is Rs.100 each.000 7% preference shares of Rs.2 per share.The cost of issue is Rs. Calculate the cost of preference capital.  Ponds India ltd issues 1.100 each redeemable after 5years at par.2 per share. Calculate the cost of preference capital.000 10% preference shares of Rs.

Cost of Retained Earnings  It is the rate of return which the existing shareholders can obtain by investing the after-tax dividends in alternative opportunity of equal qualities. D1 Kr = + G NP or MP Where D1 is expected dividend at the end of the year G is Rate of growth .

‘b’ is cost of purchasing new securities or brokerage costs. A firm’s return available to shareholders is 15%. Kr = (D/NP + G) (1-t)(1-b) or Kr = Ke(1-t)(1-b) Where Ke is rate of return available to shareholders. . the average tax rate of shareholders is 40% and it is expected that 2% is brokerage costs.To make adjustment in the cost of retained earnings for tax and cost of purchasing new securities the following formula is adopted. What is the cost of retained earnings.

Cost of Equity It refers to the maximum rate of return that the company must earn on equity finance in order to maintain the present market price of the stock. Dividend yield method: Ke = D/NP or MP Dividend yield plus growth method: Ke = (D1/NP + G) = Do(1+g)/NP+G .

A company issues 1000 equity shares for Rs. Calculate the cost of existing equity share capital. A company has been paying 20% dividend for the past five years and expects the same in near future.160? A company plans to wish you 1000 new shares of Rs. 2. If the current price of an equity share is Rs. The flotation costs are expected to be 5% of the share price.100 each at a premium of 10%. Compute the cost of equity capital.100 each at par. Will it make any difference if the market price of equity share is Rs.150. The company pays dividend of Rs.Problems 1. Compute the cost of new issue of equity shares.10 per share initially and growth in dividends is expected to be 5%. .

 It lies between the least and most expensive funds.  Composite cost of capital or Overall cost of capital or average cost of capital.  It enables the maximization of profits and the wealth of the equity shareholders by investing the funds in projects earning excess of the overall cost of capital.Weighted average cost of capital  Is the average cost of the costs of various sources of financing. .

Capital structure policy Dividend policy Investment policy  Uncontrollable factors Tax rates Level of Interest rates Market risk premium .Factors affecting WACC  Controllable factors.

Add individual source weight cost to arrive cost of capital. Assignment of weight to specific source of funds. Computation of cost of specific source of funds.Steps involved in computation WACC Determination of the source of funds to be raised and their individual share in the total capitalisation. . Multiply the cost of each source by appropriate assigned weights.

D-E ratio Demerits: 1. No relationship between book values and present economic value of various sources of capital.e. when firm is not listed or security are not actively traded.  . Book values provide a usable base. Book value proportions are not consistent with the concept of cost of capital. 3. The book value of the source of fund divided by the book value of total funds. Analysis of capital structure i.. Merits: 1.Assignment of Weights Book value Weights assigned on the basis of values found on the balance sheet. Simple in calculation. 2. 2.

. Very difficult to determine the market values because of frequent fluctuations. If the market value of the share is higher than the book value. 2. representing the true value of the investors. Equity capital gets greater importance. WACC would be overstated and vice-versa.Assignment of Weights  Market value: Weights assigned on the basis of market value of the component of capital. Merits: 1. Market value of the component of capital divided by the market value of all components of capital. Values are closely approximate the actual amount to be received from their sale. 3. Demerits: 1. 2. Prevailing market prices are taken into account.

200 each with a market value of Rs.  10% Preference Shares (10. The term of maturity of debentures is ten years.240. 40. The company is taxed at 30%.000 Equity Shares of Rs.2200.10 is expected to grow at 10% to infinity.2000 each with a market value of Rs.200 each with a market value of Rs. The current dividend of Rs. Additional Information: A flotation cost of 4% was incurred for cash instrument of financing.  Following is the long-term capitalization of a company: .000) of Rs.160.  Retained earnings Rs.20 Lacs.Problems 1. Preference dividend and Interest are payable annually.  9% Debentures 2000 of Rs. Compute Weighted average cost of capital using Market Weights and Book Weights. Redemption premium on debentures is 20%.

The company has the marginal tax rate of 50%.2. You are required to find out the firm’s cost of capital from the above given information. . It is expected to pay a dividend of Rs.  9% Preference shares Rs.  Equity Shares of Rs. 12 Lacs. A company has the following capital structure at the end of March. 2010.10 Lacs.10 each Rs.1.50 per share this year and this dividend is expected to grow at the annual rate of 10% in the future.  12% 2007 debentures Rs.15 Lacs.

 Fails in achieving the wealth maximization objective in the long run. . Demerits:  It ignores the long-term implications of the new financing plans.Marginal Cost of Capital  Marginal Cost of Capital is calculation of the cost of additional funds to be raised.  Marginal Weights represent the proportion of various sources of funds to be employed in raising additional funds.

Sharpe. Relationship between Risk and Return for an individual security.Capital Asset Pricing Model  This model was developed by William F. .  This model explains as to what kind of relationship exists between risk and return namely Relationship between Risk and Return for an efficient portfolio.

.Importance CAPM  It provides a bench mark for evaluating various investments.  It helps us to make an informed guess about the return that can be expected from an asset that has not yet been traded in the market.

    .e. Investors can borrow and lend freely at a riskless rate of interest.  The market is perfect i..  Investors have homogeneous expectations.Assumptions Investors have same information about securities. no transaction costs.  Investors seek to maximize the expected utility of their portfolios over a single period planning horizon. no taxes. There are no restrictions on investments. securities are completely divisible and market is competitive. Security returns are normally distributed.

 It is calculated by discounting the future stream of dividends at the required rate of return called the Capitalization rate.Value of Equity Share  It is a function of cash inflows expected by the investors and the risk associated with cash inflows.  The required rate of return depends upon the element of risk associated with investment in shares and is equal to risk-free rate of interest plus the premium for risk. .

beta co-efficient.CAPM  The premium for risk is the difference between market return from a diversified portfolio and the risk-free rate of return ie.. . Ke = Rf + β(Rm – Rf) Where Ke refers to Cost of equity capital (Rm – Rf) refers to market risk premium β refers to Beta co-efficient of the firm’s portfolio.

7 and the return on market portfolio equals to 14. 2. beta equals 1. The Capital Ltd. .Problems 1.75. Beta co-efficient of the firm is 1.25.5%. You are given the following facts about a firm: Risk-free rate of return is 11%. Compute the cost of equity capital using CAPM assuming a market return of 15% next year. Company’s analyst found that its risk-free rate of return equals to 12%. What would be the cost of equity if beta rises to 1. wishes to calculate its cost of equity capital using CAPM.

R2 ----. 2 & so on.= Annual interest in period 1.n) + (M)(DFi.n) .Valuation of Securities Bonds with a maturity period: n Vd = ∑ Rt + Mn (1+ Kd)t (1+ Kd)n Vd = Value of bond R1. formula is Vd = (R)(ADFi. Kd = Required rate of return M = Maturity value of bond n = Number of years to maturity Note: If n becomes large we use present value tables.

Vd = R Kd Deep Discount Bonds: n Vddb = FV / ( 1 + r ) Or Vddb = (FV) x (DFi.n) Where Vddb = Value of a deep discount bond FV = Face value at maturity r = Required rate of return n = Number of years to mature / Life of DDB .Bonds in Perpetuity/DDBs Bonds which never mature or have infinite maturity period. The value of such bonds is the discounted value of infinite streams of interest (cash) flows.

If an investor has a minimum required rate of return of 12%.Problems 1.1000 bond redeemable after 5years at par.1000 redeemable in equal instalments@14% interest p. Calculate the amount to be paid for bond. Mr.X is considering the purchase of a 8% Rs. . Xltd a company is proposing to issue a 5year debenture of Rs. required rate of return is 10%. calculate the debentures present value. 2.a.

IDBI issued deep discount bond for a maturity period of 20 years and having face value of Rs. .A has a perpetual bond of the face value of Rs. Calculate the value of DDB if the required rate of return is 10%. He receives an interest of Rs.3.600. Calculate the yield to maturity. 5.100000.60 annually. Mr.60 annually.1000.1000. 4.A has a perpetual bond of the face value of Rs. Its current value is Rs. He receives an interest of Rs. What would be its value if the required rate of return is 10%. Mr.

Mr.A is considering the purchase of a 7% preference share of Rs.A has a irredeemable preference share of Rs. ( d/kp) .80 annually.1000.1000 redeemable after 5 years at par. 2. He receives an annual dividend of Rs.Valuation of Preference share 1. What should be the pay now to purchase the share assuming that the required rate of return is 8%. Mr. What will be its value if the required rate of return is 10%.

7.200. . The expected dividend is Rs. D1 Expected dividend P1 Expected price of share ke Required rate of return on equity Mr.X is planning to buy an equity share for 1 year. Note: If in the above case expected dividend and selling price in the second year are Rs. Determine the value of the share assuming the discount rate of 15%.7 and expected sale proceeds Rs. calculate value of share.50 and Rs.Valuation of Equity Share  Short term investor Po = D1/1+ke + P1/ 1+ke where Po refers to Current value of the share.220.

80 at the end of ten years. Calculate the present value of share if his required rate of return is 12%. Po = (D) (ADFi.n) + (Pn ) (DFi. .5 per share for each of ten years and a selling price of Rs.X expects a dividend of Rs.n) Mr.D is constant  The value of share shall be calculated by using annuity discount factor tables.

Dividend Valuation Model  The concept of this model is that many investors do not contemplate selling their share in the near future.g Where Do is current dividend D1 is expected dividend Do(1+g) Ke .g Ke is required rate of return on equity g is expected percent growth in dividend . ∞ t Po = Σ Dt / (1+ke) t=1 No growth: Po = D/Ke Constant growth: Po = D1 = Ke .

Problems 1. What is the value of its share. Calculate the dividend growth rate . . The company is expected to pay a dividend of Rs.200.5. should he buy the share? The current price of a company’s share is Rs. A company is expected to pay a dividend of Rs. If an investor’s required rate of return is 12%.6 per share. The dividends are expected to grow perpetually at a rate of 9%. 2. if the required rate of return is 15%? The current price of a company’s share is Rs. if its capitalisation rate is 12%. 3.75 and dividend per share is Rs.5 per share with an annual growth rate of 10%.

g OR D1 Ke = Po + g .Rate of Return on Equity Share Po = D1 Ke .

can be calculated with the following formula: D1 re = + P1-P0 Po P0 The market price of a share is Rs.88.4 and the share can be sold at Rs. The company is expected to pay a dividend of Rs.The expected rate of return re. Advise the investor to buy or not if his capitalisation rate is 10%. . Calculate return on share.80.

It is that expenditure incurred at one point of time whereas benefits of expenditure are realised at different points of time in future. .Unit.2 Investment Decisions Capital budgeting is the process of making investment decisions in capital expenditures. It is concerned with the allocation of the firm’s scarce financial resources among the available market opportunities.

.  Are strategic investment decisions.  Funds invested are in non-flexible and long term activities.  Future benefits are expected to be realised over a series of years.  Involve huge funds and are irreversible decisions.Distinction of capital budgeting decisions  Involves the exchange of current funds for the benefits to be achieved in future.

Difficulties of Investment decisions. Long-term effect on profitability. Long-term commitment of funds.Nature of Investment decisions Large investments. . National importance. Irreversible in nature.

Evaluation of various proposals. Final approval and preparation of capital expenditure budget. Fixing priorities.Capital budgeting process Identification on Investment proposals. Performance review. . Implementing proposal. Screening the proposals.

Net present value.Techniques of Financial Evaluation       Pay-back period. Internal rate of return. . Discounted pay-back. Profitability Index. Accounting rate of return.

Advantages:  Simple to understand and easy to calculate.  A project with a shorter pay-back period is preferred to the one having a longer pay-back period.  This method is suited to a firm which has shortage of cash. .PAY-BACK PERIOD This method throws light on the length of the period by which the entire investment would be recouped from out of the future cash flows. Cash flow means net profit after tax before depreciation.

 It treats each asset individually in isolation with other assets.  It does not take into consideration the cost of capital. Cash outlay of the project PB = Annual Cash inflows .Disadvantages  It does not take into account the cash inflows earned after the pay-back period and hence true profitability of the projects cannot be correctly assessed.  Ignores the time value of money.

Rs. Rs. Calculate discounted pay-back period from the following information: Cost of project Rs. . There are two projects X and Y. You are required rank these projects according to PB method. The following are the net profit before depreciation and after tax of the two projects for their respective years.000. Project Y.2 Lacs. Cut off rate 10%.1000.8000.6 Lacs.4000. Annual Cash inflow Rs. Rs.2000. 2. 5000 and Rs. Rs. Life of project 5 years. Rs.4000. Each project requires an investment of Rs. Project X Rs.Problems 1.8000. Rs.2000. 20. Rs.6000.

Average annual profit ARR = Net investment in the project . The project with higher rate of return is selected.Accounting Rate of Return This method takes into account the earnings expected from the investments over their whole life. Under this method concept of profit is used rather than cash inflows. The term profit refers to net profit after tax and depreciation.

Demerits:  Does not take into account time value of money.  This method takes calculations of average rate of return for the entire life of the project by taking the terminal salvage / scrap value.  It does not take into account the quickness or the rapidity with which the investment is recouped. .Merits / Demerits Merits:  This method is fairly a simple calculation of averages.

000 and Rs.000 Expected Life (Years) 4 5 Projected net income after tax and depreciation: Years 1 2. Rs. Calculate the average rate of return for projects A and B from the following: Project B Investments (Rs.5 Lacs and has a scrap value of Rs.500 3. Rs.20.000. A project requires an investment of Rs.000 If the required rate of return is 12%. It is expected to yield profits after depreciation and taxes during the five years amounting to Rs.Problems 1.000 3 1.000. .40. Calculate the average rate of return on the investment.50.000 30.000.000 5 1.) 20.60.000 3.000 after five years. Rs.000 1.500 2.000 4 1.000. which project should be undertaken? Project A 2.000 2 1.70.20.

This method attempts to calculate the return on investments by introducing the factor of time element.    .Net Present Value A rupee in hand today is certainly more valuable than the rupee which is received after a period of time. Merits: It recognizes the time value of money It takes into account the earnings over the entire life of the project and true profitability of the investment proposal can be evaluated. The NPV method is based on the fact that the cash flow arising at different periods of time differ in value and are not comparable unless there equivalent present values are formed. It takes into consideration the objective of maximum profitability.

NPV may not give good results.Demerits  More difficult to understand and operate.  While comparing projects with unequal investment of funds. .  It is not easy to determine the appropriate discount rate.

20. Cash inflows of a certain project along with cash outflows are give below: Years 0 1 2 3 4 5 Outflows Rs.000 80. No project is acceptable unless the yield is 10%.000 30. .000 Inflows Rs.000.000 30. Calculate NPV.40.Problems 1. 1.000 60.000 The salvage value at the end of the fifth year is Rs.000 30.50.

000. The project has an expected life of five years and zero salvage value.000 respectively. A company is considering investment in a project that costs Rs. The company’s rate of tax is 40%. You are required to calculate the net present value at 10% and advise the company. 1. 80.20.2 Lacs.2. The company uses straight line method of depreciation. The estimated earnings before depreciation and before tax from the project are Rs.70.000.000 and 60.000. . 90.

. select the proposal with the highest rate of return as long as the rates are higher than the cutoff rate.Internal Rate of Return  Time adjusted rate of return or discounted cash flow or discounted rate of return or trial and error yield method.  In case of alternative proposals.  It is defined as the rate of discount at which the present value of cash inflows is equal to the present value of cash out flows.  Accept the proposal if the IRR is higher than or equal to the minimum required rate of return.

Net cash inflows are estimated future profits before depreciation but after taxes. a) When annual cash flows are equal: Calculate PV factor = Initial outlay / annual cash flow Refer PV annuity tables and find out the rate at which the calculated PV factor is equal to the PV given in the table.Steps  Determine the future net cash flows during the entire economic life of the project.  Determine rate of discount at which the PV of cash inflows is equal to PV of cash outflows. .

apply higher rate of discount.  Prepare the cash flow table using an arbitrary assumed discount rate to discount the net cash flow to the PV.  If the NPV is negative at this higher rate.  If higher discount rate still gives a positive NPV increase the discount rate further until NPV becomes negative. .  Find out the NPV by deducing the PV of total cash flows.  If NPV is positive.Steps b) When annual cash flows are unequal over the life of the asset. the IRR must be between these two rates.

It is difficult method of evaluation of investment proposals. which is not justified.Merits / Demerits     Merits: It takes into account time value of money. It considers the profitability of the projects over its entire life. It is method which ensures reliable technique of capital budgeting. This method assumes that the earnings are reinvested in the project. Demerits: It is difficult to understand.    . It provides for uniform ranking of various proposals.

.Differences between NPV & IRR  Size disparity  Time disparity  Projects with unequal lives  Re-investment rate assumption NPV method is a superior to that of IRR.

Profitability Index OR Benefit-Cost Ratio  It is the relationship between present value of cash inflows and Initial outflows. A proposal is acceptable if the PI is greater than one .

000 and 1. The machine has life expectancy of five years and has no salvage value.2. NPV and profitability index at 10% discount rate.000.000.Problems 1. 70. 1. Calculate pay-back period.000.50.50. The firm uses straight line method of depreciation.00.000. . 90. average rate of return. The estimated cash flows before tax after depreciation are as follows: Rs.000. The company’s tax rate is 40%.60. A company is considering an investment proposal to purchase a machine costing Rs.

000 7. A company has investment opportunity costing Rs.000 15.000 Using 10% as the cost of capital.000 10.000 7.000 with the following expected net cash flow after taxes and before depreciation. . NPV and PI at 10% discount factor.000 8.2.000 7.000 4. determine the following: Pay-back period.40. IRR with the help of 10% and 15% discount factor.) 7. Year 1 2 3 4 5 6 7 8 9 10 Net Cash flow (Rs.000 10.000 7.

400 It is estimated that each of the alternative proposals will require additional networking capital of Rs.3.2. Assuming required rate of return @ 10% per annum. A company can make either of two investments at the beginning of 2012.500 3. . PI and discounted pay-back period.400 End of 2015 2. End of 2012 500 Nil End of 2013 2.000 3.1 to be received at the end of each year.400 End of 2014 3. at 10% and 14% may be utilized.000 28. Evaluate the investment proposals under pay-back period. IRR.500 3. The forecast particulars are given below: Proposal A Proposal B Cost of Investment (Rs.000 which will be received back in full after the expiry of each project life. The present value of Re. NPV.) 20. Depreciation is provided under straight line method.400 End of 2016 3.000 Life (Years) 4 5 Scrap Value Nil Nil Net Income (after dep & tax) Rs.

Financing decisions .

 Capitalisation refers to the total amount of securities issued by a company. It is a quantitative aspect of the financial planning. .Capital structure  It refers to the relationship between the various long-term forms of financing and is a qualitative aspect.

Control and flexibility. Requirements of investors. . Nature and size of a firm.Factors influencing capital structure         Financial leverage. Growth and stability of sales. Risk. Cash flows. Cost of capital.

Factors continues         Capital market conditions. Legal requirements. . Personal considerations. Costs of floatation. Period of finance. Corporate rate of tax. Purpose of financing. Assets structure.

Principles of capital structure decisions
 Cost  Risk

 Control
 Flexibility  Timing

Changes in capital structure
To restore balance in the financial plan. To simplify the capital structure. To suit investor’s needs. To fund Current liabilities. To write off the deficit. To capitalise retained earnings. To fund accumulated dividend. To facilitate merger and expansion.

Optimal capital structure
 Defined as that capital structure or combination of debt and equity that leads to the maximum value of the firm.
 It maximizes the value of the company and hence the wealth of its owners and minimizes the company’s cost of capital.

Points to make optimal Capital structure Prefer to raise funds having a fixed cost. Should avoid undue financial risk associated with the use of increased debt financing. Should be flexible. if the ROI is higher than the fixed costs of funds. . Tax advantage (if any) must be availed.

The use of long-term fixed interest bearing debt and preference share capital along with equity shares. the percentage change in operating revenue will be more than the percentage change in sales.associated with employment of fixed costs.Leverages Leverage refers to an increased means of accomplishing some purpose. The fixed costs remaining same. Financial leverage. Operating leverage. .

Formula  Financial leverage EBIT EBT  Operating leverage Contribution EBIT  Combined leverage FL*OL .

Compute the following: i. A company which has operating income (EBIT) of Rs. The degree of financial leverage at the present level of operating income. .Problems 1.000 has the following capital structure: 10% Debentures Rs.100 each Rs.00.6 lakhs 12% Preference capital Rs.3. The percentage change in EPS associated with 20% increase in EBIT and 20% decrease in EBIT. iii.2 lakhs Equity capital of Rs. Earnings per share ii.4 lakhs The company is in 30% tax bracket.

The degree of operating leverage.000 of 10% Debentures.100 each and Rs. EPS in 2010 and 2011. The income tax is assumed to be 30%. The degree of financial leverage.00. The capital structure of a Zee Ltd consists of an ordinary share capital of Rs.000 units in the year 2010 to per unit.2.000.000 units in the year 2011. .00. of Rs. iii.00. The sales of the company increased by 20% from 2.40. Variable costs Rs. The selling price is Rs.00. Calculate the following: i. ii.2.20.6 per unit and the fixed expense Rs.

term borrowing at 9% interest p.15 lakhs. Rs. 4.3. Rs.000 equity shares of Rs. 1.30 lakhs to finance a major project expansion The finance manager has identified four possible financing plans. The company’s expected EBIT Rs. Assuming corporate tax rate 30%. .a.10 lakhs in equity shares of Rs.100 each and the balance through long .100 each and the balance through preference shares with 10% dividend.40 lakhs consisting of 40. 2.100 each. X company is having an equity capital of Rs. 3. Rs.100 each and the balance through 8% debentures.15 lakhs in equity shares of Rs.15 lakhs in equity shares of Rs. you are require to determine EPS and Financial leverage that will help the firm by your expert advice on selecting the best option for financing. The management is planning to raise another Rs. through equity shares.

 At this point EPS equals Zero.Financial Break-even point  The level of EBIT which is just equal to pay the total financial charges.  If EBIT is less than the financial break even point. more of such fixed cost funds may be inducted in the capital structure. the EPS shall be negative suggesting fixed interest bearing debt or preference capital should be reduced in the capitalization of the firm.  If EBIT exceeds the financial break even point. .

t refers to fixed interest charges. I DP Preference dividend. t refers to tax rate. FBEP = Fixed interest charges When Capital structure consists of Equity. DP FBEP = I + 1. Preference and Debt. .When Capital structure consists of Equity and Debt only.

level at which EPS remains the same irrespective of different alternatives of debt-equity mix.  At this level of EBIT. the rate of return on capital employed is equal to the cost of debt and this is also known as breakeven level of EBIT for alternative financial plans. .Point of Indifference  Refers to that EBIT.

I1 = Interest under alternative financial plan 1. I2 = Interest under alternative financial plan 2. . S2 = Number of equity shares or amount of equity share capital under alternative 2.PD = S2 X = Equivalency point or point of Indifference or Break even EBIT level.Formula (X-I1) (1-T) – PD S1 (X-I2 ) (1-T) . T = Tax rate. S1 = Number of equity shares or amount of equity share capital under alternative 1. PD = Preference dividend.

Honest company ltd has the choice for raising an additional sum of Rs. At what level of earnings before interest and tax after the new funds are raised. .00. would earnings per share be the same whether new funds are raised either by raising debt or issue of equity shares.100 each at par. tax rate 30 percent.20 lakhs either by raising a 10% debt or by issue of additional equity shares of Rs.000 equity shares of Rs100 each and no debt. The existing capital structure of the company consists of 2.

Theories of Capital structure Net Income approach Net operating approach Traditional approach Modigliani and Miller approach .

 The risk perception of investors is not changed by the use of debt.Net Income approach A firm can minimise the weighted average cost of capital and increase the value of the firm as well as market price of equity shares by using debt financing to the maximum possible extent. .  There are no taxes. Assumptions:  Cost of debt is less than cost of equity.

Net Operating Income approach Change in the capital structure of a company does not affect the market value of the firm and the overall cost of capital remains constant irrespective of the method of financing. The market capitalises the value of the firm as a whole. There is nothing as an optimal capital structure and every capital structure is the optimal capital structure. iii. The business risk remains constant at every level of debt-equity mix. Reasons for the above assumptions: Increased use of debt increases the financial risk of equity shareholders and hence the cost of equity increases. ii. Assumptions: i. . The cost of debt remains constant with the increasing proportion of debt as the financial risk of the lenders is not effected. There are no corporate taxes.

. remains more or less unchanged for moderate increase in debt thereafter. The overall cost of capital decreases up to a certain point.Traditional approach Compromise approach Proper debt equity mix leads to a optimum capital structure. and increases beyond a certain point.

the cost of equity increases. A firm’s operating income is a determinant of its total value.Theory of Irrelevance-MM approach  The cost of capital is not affected by changes in the capital structure or  The debt-equity mix is irrelevant in the determination of the total value of a firm. Reasons: 1. . Two identical firms in all respects except their capital structure cannot have different market values or cost of capital because of arbitrage process. 2. Though debt is cheaper to equity. 4. with increased use of debt as a source of finance. 3. Increase in cost of equity offsets the advantage of the low cost of debt.

All earnings are distributed to the shareholders. Risk to investors depends upon the random fluctuations of the expected earnings and the possibility that the actual value of the variables. Investors act rationally. The cut-off point of investment in a firm is capitalisation rate. There is a perfect market. .Assumptions There are no corporate taxes. The expected earnings of all firms have identical risk characteristics.

Theory of relevance-MM When the corporate taxes are assumed to exist the value of firm will increase or the cost of capital will decrease with the use of debt on account of deductibility of interest charges. Optimal capital structure can be achieved by maximising the debt mix in the equity of a firm. .

Dividend decisions

Determinants of Dividend policy
           Legal restrictions. Magnitude and trend of Earnings. Desire and type of Shareholders. Nature of Industry. Age of the company. Future financial requirements. Taxation policy. Inflation. Control. Stability of dividends. Liquid resources.

Schools of thought

 Theory of Irrelevance.

 Theory of Relevance

rational investors. absence of tax discrimination between dividend income and capital appreciation.  MM observed “Under conditions of perfect capital markets.Modigliani and Miller approach  The dividend policy has no effect on the market price of the shares and the value of the firm is determined by the earning capacity of the firm or its investment policy.” . given the firm’s investment policy. its dividend policy may have no influence on the market price of the shares.

Investors behave rationally. There are either no taxes or there are no differences in the tax rates applicable to dividends and capital gains. . The firm has a rigid investment policy. Information about the company is available to all without any cost.Assumptions There are perfect capital markets. No investor is large enough to effect the market price of shares. There are no floatation and transaction costs.

I is Investment required. .(E – nD1) P1 Value of the firm ( nPo ) = (n+m) P1 – (I – E) 1+ke Where n refers to number of shares outstanding at the beginning of the period.Arguments for Market price of a share (P1) = Po (1+ke) -D1 Number of shares to be issued (m) = I . ke refers to cost of equity capital. E refers to Total earnings of the firm during the period.

The company expects to have a net income of Rs 50. the payment of dividend does not affect the value of the firm.000.Problem Carewell ltd.It has outstanding 5. the rate of capitalisation rate is 10%.. .1.100 each.000 shares selling at Rs. Show that under the MMhypothesis. The firm is contemplating the declaration of dividend of Rs.00.6 per share at the end of the current financial year.000 and has a proposal for making new investments of Rs.

• The firm has a very long life. .Theory of Relevance  Walter’s approach Dividend decisions are relevant and affect the value of the firm. • The IRR and the cost of capital of the firm are constant. Assumptions: • The investments are financed through retained earnings only and the firm does not use external sources of funds. The relationship between the IRR earned by the firm and its cost of capital is very significant in determining the dividend policy to sub serve the ultimate goal of maximising the wealth of the shareholders. • Earnings and dividends do not change while determining the value.

E is EPS. . r is IRR.Walter’s formula Market price of a share: D+r/k ( E – D ) k Where D is dividend per share. k is cost of capital or capitalisation rate.

k is capitalisation rate.  Uncertainty of future and the shareholders discount future dividends at a higher rate. b is retention ratio. .br Where E is EPS.  The market value of a share is equal to the present value of future stream of dividends. r is rate of return. Market price of share: E (1.b ) k.Gordon’s approach  The value of a rupee of dividend income is more than the value of a rupee of capital gain.

Rs. Rate of return on investment 15%. 2.Problems 1. What is the market value of share under the Gordon model. if the payout is 40% and 80%. 60% and 90%. 3. earns Rs. XYZ Ltd..8 per share and is capitalised at a rate of 10%.20. if the retention rate is 40% and 60%. It has 20% rate of return on investment.) 10 10 10 Capitalisation rate ( % ) 10 10 10 IRR ( % ) 15 10 8 What is the market value of share under Walter’s model. The following information relates to three companies: A Ltd B Ltd C Ltd EPS (Rs. Cost of capital is 10% and EPS Rs. What should be the price per share at 20% dividend pay out ratio according to Walter’s formula? What is the market price per share at the optimum payout ratio. a) b) . From the following information calculate the value of the share of the firm according to Gordon’s model if the payment ratio is 40%.