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debt, common equity and preferred equity. The capital structure is how a firm finances its overall operations and growth by using different sources of funds. Debt comes in the form of bond issues or long-term notes payable, while equity is classified as common stock, preferred stock or retained earnings. Short-term debt such as working capital requirements is also considered to be part of the capital structure.
Internal Rate Of Return - IRR': The discount rate often used in capital
budgeting that makes the net present value of all cash flows from a particular project equal to zero. Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake the project. As such, IRR can be used to rank several prospective projects a firm is considering. Assuming all other factors are equal among the various projects, the project with the highest IRR would probably be considered the best and undertaken first. IRR is sometimes referred to as "economic rate of return (ERR)". Equity shares : Equity shares are those shares which are ordinary in the course of company's business. They are also called as ordinary shares. These share holders do not enjoy preference regarding payment of dividend and repayment of capital.Equity shareholders are paid dividend out of the profits made by a company. Higher the profits, higher will be the dividend and lower the profits, lower will be the dividend. What is Shareholder Wealth Maximization? When business managers try to maximize the wealth of their firm, they are actually trying to increase their stock price. As the stock price increases, the individual who holds the stock wealth increases. As the stock price goes up, the value of the firm increases and the net worth of the individual who owns the stock increases. Definition of 'Leveraged Buyout - LBO':The acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. Often, the assets of the company being acquired are used as collateral for the loans in addition to the assets of the acquiring company. The purpose of leveraged buyouts is to allow companies to make large acquisitions without having to commit a lot of capital. Working Capital': A measure of both a company's efficiency and its short-term financial health. The working capital ratio is calculated as: Working capital=Current assets- current liabilities Positive working capital means that the company is able to pay off its short-term liabilities. Negative working capital means that a company currently is unable to meet its short-term liabilities with its current assets (cash, accounts receivable and inventory).Also known as "net working capital", or the "working capital ratio".
based upon the number of shares that a shareholder owns. 'Economic Value Added – EVA:A measure of a company's financial performance based on the residual wealth calculated by deducting cost of capital from its operating profit (adjusted for taxes on a cash basis). Capital rationing also could take place if a company has excess production capacity on hand. either by setting a cap on parts of the capital budget or by using a higher cost of capital when weighing the merits of potential investments. however. While this stock action increases the number of shares owned.SVA': A value-based performance measure of a company's worth to shareholders. capital rationing: Limiting a company's new investments. Average Rate of Return: The rate of return on an investment that is calculated by taking the total cash inflow over the life of the investment and dividing it by the number of years in the life of the investment. This might happen when a company has not enjoyed good returns from investments in the recent past. The average rate of return does not . the after-tax cost is seen most often. This is due to the fact that since the total number of shares increases. which also includes the cost of equity. Cost Of Debt: The effective rate that a company pays on its current debt.or after-tax returns.bonus share : Free shares of stock given to current shareholders. Thus. the ratio of number of shares held to number of shares outstanding remains constant. it does not increase the total value. the funding of an independent project does not depend on another project receiving funding first. The basic calculation is net operating profit after tax (NOPAT) minus the cost of capital from the issuance of debt and equity. based on the company's weighted average cost of capital: SVA=NOPAT-Cost of Capital trading on the equity: Borrowing funds to increase capital investment with the hope that the business will be able to generate returns in excess of the interest charges. operating cycle:The average length of time between when a company purchases items for inventory and when it receives payment for sale of the items.(Capital * Cost of Capital) Shareholder Value Added . because interest expense is deductible. Independent Project:A project that is not part of or dependent on any other project. A long operating cycle tends to harm profitability by increasing borrowing requirements and interest expense.) The formula for calculating EVA is as follows: = Net Operating Profit After Taxes (NOPAT) . This can be measured in either before. This is one part of the company's capital structure. (Also referred to as "economic profit".
would be handled as a true lease. it simply guarantees that the return averages out to the average rate of return. it is nothing but internal rate of return . explicit cost of capital: The explicit cost of capital is associated with the raising of funds. Debenture: A type of debt instrument that is not secured by physical asset or collateral. on the other hand. 2. For example. The lease contains a purchase agreement for less than market value. 4. . The lessee gains ownership at the end of the lease period. The choice of lease classification will have important results on a firm's financial statements. but can be a bad thing for consumers if the company starts to use cheaper products or decides to raise prices. Capital Lease/ Financial lease:A lease considered to have the economic characteristics of asset ownership. the best project can be accepted. Both corporations and governments frequently issue this type of bond in order to secure capital.e. or rental. i. other words.. and they are Marginal Cost-Marginal Revenue Method and Total Cost-Total Revenue Method. The company will usually adjust influential factors such as production costs. when choosing between "Mutually Exclusive Projects" more than one project may satisfy the Capital Budgeting criterion. cutoff rate: rate of return that is necessary to maintain market value (or stock price) of a firm.guarantee that the cash inflows are the same in a given year. profit maximization:A process that companies undergo to determine the best output and price levels in order to maximize its return. debentures are documented in an indenture. cutoff rate. The present value of lease payments is greater than 90% of the asset's market value. An operating lease. only one. Thus. There are two main profit maximization methods used. Like other types of bonds. However. it means that company is accepting money at high explicit cost of capital. investor will see which investment provides high internal rate of return but which company gets the money at high internal rate of return. A lease falls into this category if any of the following requirements are met: 1. also called a hurdle rate.. 3. a set of projects which are to accomplish the same task. Profit maximization is a good thing for a company. or minimum required rate of return Mutually Exclusive Projects: Mutually Exclusive Projects are a set of projects from which at most one will be accepted. The life of the lease is 75% or greater of the assets useful life. In capital budgeting In decision. for accounting purposes. and output levels as a way of reaching its profit goal. Debentures are backed only by the general creditworthiness and reputation of the issuer. A capital lease would be considered a purchased asset for accounting purposes. sale prices.
Implicit cost of capital: Implicit cost of capital is opportunity cost. the ease with which assets can beconverted into cash. bid. In other words. either through a friendly acquisition or an unfriendly. This is not in money form because. MVA=Company's Market value.Invested Capital Takeover: General term referring to transfer of control of a firm from one group of shareholders to another group of shareholders. For example: I have Rs. or near-cash assets. my implicit cost of investment in shares will equal to the bank interest. In other words. and withdrawn from in poor years to maintain the dividend amount. But.3500 as bank interest but I did not invested it in saving bank account and invested in the shares of XYZ company. Liquidity " as being on one end of a straight line and ". Change in the controlling interest of a corporation. so I have taken this decision. The Liquidity Versus Profitability Principle:There is a trade-off betweenliquidity and profitability. If you are on the line and move toward one.MVA:A calculation that shows the difference between the market value of a company and the capital contributed by investors (both bondholders and shareholders). A hostile takeover (with the aim of replacing current existing management) is usually attempted through a public tender offer. Profitability " on theother end of the line.000. Alternatively. Liquidity:Having enough money in the form of cash. dividend equalization reserve: Revenue reserve that serves as a buffer between a certain dividend level and profits available. . if money is used one of best alternatives for effective use of resources. after thinking. youautomatically move away from the other. I take the opportunity for getting best reward from investment. it is the sum of all capital claims held against the company plus the market value of debt and equity. 100. hostile. there is the trade-off between liquidity and profitability. tomeet your financial obligations. Profitability:A measure of the amount by which a company's revenues exceedits relevant expenses. So. it is not necessary that XYZ company give me my cost investment in shares. I can deposit it in bank and earn Rs. gaining more of one ordinarily means giving up some of the other. Sums are transferred to this reserve account in good years. Market Value Added .
Financial risk: Financial risk an umbrella term for multiple types of risk associated with financing. meaning the uncertainty of a return and the potential for financial loss. The decision rule is that if the ARR is greater than. ARR uses profit rather than cashflows. expressed as a percentage. The ARR is ratio of the accounting profit to the investment in the project. As a result of this adjustment. a hurdle rate. arbitrary cut-off date.Retained Earnings':The percentage of net earnings not paid out as dividends. investors will adjust their stock holdings accordingly. Risk is a term often used to imply downside risk. some perverse decisions can be made. does not account for the time value of money (TVM). dividend or other policy change affecting the company. ease of understanding and communication.Dividends Paid Clientele Effect: The theory that a company's stock price will move according to the demands and goals of investors in reaction to a tax. Limitation/Disadvantages of accounting rate of return (ARR): it can be calculated in a wide variety of ways. Retained Earnings(RE)=Beginning Retained(BE) + Net Income . but retained by the company to be reinvested in its core business or to pay debt. then accept the project. . and that when a company's policy changes. Financing decisions: Decisions concerning the liabilities and stockholders' equity side of the firm's balance sheet. including financial transactions that include company loans in risk of default. or equal to. accounting rate of return (ARR):The accounting rate of return (ARR) method may be known as the return on capital employed (ROCE) or return on investment (ROI). It is recorded under shareholders' equity on the balance sheet. The clientele effect assumes that investors are attracted to different company policies. managers' performances are often judged using ARR and therefore wish to select projects on the same basis. Advantages accounting rate of return (ARR): familiarity. the stock price will move. such as a decision to issue bonds.
letter of credit: A letter of credit is a document that a financial institution or similar party issues to a seller of goods or services which provides that the issuer will pay the seller for goods or services the seller delivers to a third-party buyer. It is usually used to get equipment on a short-term basis. The lessee is only required to record the operating expense of the property and it does not affect the balance sheet. any risky asset or investment must compensate the investor for both the time his/her money is tied up in the investment and the investment's relative riskiness. The document serves essentially as a guarantee to the seller that it will be paid by the issuer of the letter of credit regardless of whether the buyer ultimately fails to pay. Cost of preference share capital calculation: If the preference share are redeemable at the end of a specific period. In this way. Capital Asset Pricing Model(CAPM): A model that attempts to describe the relationship between the risk and the expected return on an investment that is used to determine an investment's appropriate price. notably the multifactor CAPM and the two-factor model. A stock split is the same share split into two. then the cost of capital of preference share can be calculated by equation. The assumption behind the CAPM is that money has two values: a time value and a risk value. This type of lease is beneficial for businesses who want to keep their leases out of their financial statements. There are a number of variations on the CAPM. With an operating lease. The CAPM is calculated according to the following formula: ra = rf + Betaa(rm .(Public deposit )Utility of public deposit as a source of fund: "Public deposit" means funds in which the entire beneficial interest is owned by a public depositor or funds held in the name of a public official of a public depositor charged with the duty to receive or administer funds and acting in such official's official capacity. Difference between Bonus issue and Stock Split: A bonus is a free additional share that is given to you without changing any face value. you might have 2 counts now but the worth is same as 100 rs . Operating lease: Operating lease is an operating lease is for part time usage of the property. but in case of Bonus you are given a extra 100rs . the risk that the buyer will fail to pay is transferred from the seller to the letter of credit's issuer. The issuer then seeks reimbursement from the buyer or from the buyer's bank. rf is the risk-free rate of return. only the right to use the property is transferred and not the actual ownership of the asset. The face value never changes for a bonus shares. >In a stock split.so think like this you have 100 rs and then you are taken that 100 rs and given 2 Fifty Rupees . the number of shares increases but the face value drops. Thus. Betaa is the risk premium. This compensation must be in addition to the risk-free rate of return. .rf) where:ra is the asset price. and rm is the market rate of return.
It being measured by the share price of the stock. It offers fixed rate financing. The dividend payout ratio : The dividend payout ratio measures the percentage of a company's net income that is given to shareholders in the form of dividends The dividend payout ratio is a relatively simple calculation:Total Annual Dividends Per Share / Diluted Earnings Per Share Advantages of lease financing 1. you lease and pay for equipment only for the time you need it. Leasing better utilizes equipment. There is less upfront cash outlay. the amount of the returns and the risk or uncertainty of the returns. Shareholders’ Wealth Maximization PROFIT MAXIMIZATION: Simply a single-period or a short-term goal to be achieved within one year Management mainly focus on efficient utilization of capital resources to maximize profits WITHOUT considering the consequences of its actions towards the company’s future performance. 2. Pn = Amount payable at the time of redemption. therefore making your dollar stretch farther.n P o = ∑ PDi / (1+kp)i + Pn / (1 + kp )n i =1 Where Po = Net Proceeds on issue of preference shares. kp = Cost of preference share capital. which in turn is based on the timing of returns. Financial goal of a firm A. There is typically an option to buy equipment at end of lease term. Profit Maximization. As the costs go up over five years. Leasing is inflation friendly. 5. you pay at the same rate monthly. 4. you do not need to make large cash payments for the purchase of needed equipment. and n = Redemption period of preference share. . b. you still pay the same rate as when you began the lease. Maximization of Shareholders' Wealth: The goal is o maximize the shareholders' wealth for whom it is being operated. 3. PD = Annual preference dividend at fixed rate of dividend.
(iv) if debt capacity is lowand (v) dilution of control isn't a problem or does not rise. Generally a company cannot buy its own shares but it can buy its own debentures. any amount of money is worth more the sooner it is received. This core principle of finance holds that. iii. Financing Through Equity Shares and Debentures Comparison A company may prefer equity finance (i) if long gestation period is involved. Shareholders' wealth maximization can be achieved by considering the present and potential future earnings per share. A company may prefer debenture financing compared to equity shares financing for the following reasons: i. This is done by placing call option in the debentures. v. Debentures can be redeemed in case the company does not need the funds raised throughthis source. Profit maximization ignores risk.It also means maximizing the total market value of the existing shareholders' common stock. (iii) if financial risk perception is high.since they do not have voting rights. Main component of Cash-outlay • • • • Operating (functional activities)Investing (Outflows of expenditures and applicable returns on short-term and long-term investments)Financing activities (revolving door assets/liabilities)Implementation of any non-cash changes 'Time Value of Money . timing of returns.deductible. . Profit maximization does not consider the timing of returns. Debenture financing is cheaper since the rate of interest payable on it is lower than thedividend rate of preference shares. dividend policy and other factors that affect the market price of the company's stock. provided money can earn interest. Drawbacks of Profit Maximization Profit maximization is a short-term concept. (ii) if equity is preferred by the market forces. iv. All financial decisions will affect the achievement of this goal.Generally the debenture-holders cannot interfere in the management of the company.Debentures offer variety and in dull market conditions only debentures help gainingaccess to capital market. ii. vi.TVM': The idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity. Also referred to as "present discounted value". Interest on debentures is allowed as a business expense and it is tax.
you pay interest out to your investors .this interest is tax deductible. you pay out dividends. When you issue debt in the form of bonds. sold. bought. Also called operation gearing. See also financial leverage and investment leverage. rent. such as for energy. they lie with the lessor in case of an operating lease. On the other hand. It is a measure of leverage. and Extent to which a firm commits itself to high levels of fixed operating costs (which vary with time. salaries but not interest) as compared with the levels of variable costs (which vary with volume. In case of finance lease. material).Because debt circumvents taxation at the corporate level. an operating lease is shown as operating expense in profit and loss statement. Whereas risk and rewards are with the lessee in case of finance lease. asset is shown on the asset side of the balance sheet. and traded like other negotiable instruments. and is offered generally at a discount instead of on interest bearing basis. When you issue equity. labor. the corporation. You. It is also called a scrip dividend. . the cost of debt is less than the cost of equity. A stock dividend may be declared when the company is cash poor and cannot afford a dividend otherwise. 2 to 30 days. and secured only by the reputation of the issuer. Another difference is the manner in which the lease gets reported in financial statements. See also: Payment-in-kind bond.What is the difference between Finance Lease and Operating Lease? • Major difference between a finance lease and operating lease lies in the ownership of the asset. commercial paper is a popular means of raising cash. Operating leverage : Operating leverage is a measure of how revenue growth translates into growth in operating income. They are generally not considered desirable because one must pay capital gains tax on stock dividends. it is one of the major components of operating risk. This is called the DTS (Debt Tax Shield) commercial paper: Promissory note (issued by financial institutions or large firms) with very-short to short maturity period (usually. and not more than 270 days). Rated. pay taxes once. Stock Dividend: A dividend that is paid in stock or bonds rather than cash. such as insurance. even though there is no cash gain for the shareholder. • Why cost of equity capital is higher than that of debt capital. Firms with high operating leverage have high breakeven points but (when the breakeven point is crossed) they show a greater increase in operating income with every increase in sales revenue (and greater losses with every drop in sales revenue) in comparison with firms with low operating leverage. and the equity holder pays taxes another time. and are subject to double taxation. These dividends represent corporate income. whereas rentals are shown on the side of the liabilities of the balance sheet.
it is known as acquisitions. he/she expects to see a return on that investment. Low levels of uncertainty (low risk) are associated with low potential returns. The risk-free rate represents the expected return from an absolutely riskfree investment over a specified period. Also known as "investment appraisal". Among the two. and controlling of the monetary resources of an organization. In this process of restructuring. Risk-Free Rate of Return :The theoretical rate of return for an investment that has zero risk. The weighted average cost of capital (WACC) : The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets. Capital Budgeting:The process in which a business determines whether projects such as building a new plant or investing in a long-term venture are worth pursuing. that is. whereas high levels of uncertainty (high risk) are associated with high potential returns. The WACC is the minimum return that a . In such a case the deal gets finalized on friendly terms and both the companies share equal profits in the newly created entity. directing. the one that is financially stronger and bigger in all ways establishes it power. one company overpowers the other company and the decision is mainly taken during downturns in economy or during declining profit margins. or the money that the company misses out on by selling its stock. the cost of capital is equal to this return that the investor receives. Oftentimes. Risk-Return Tradeoff': The principle that potential return rises with an increase in risk. organizing. The combined operations then run under the name of the powerful entity who also takes over the existing stocks of the other company. When one company takes over the other and rules all its business operations. Financial Management: The planning. cost of capital : The opportunity cost of an investment.Difference between merger and acquisition(takeover) Though there is a thin line difference between the two but the impact of the kind of completely different in both the cases. Merger is considered to be a process when two or more companies come together to expand their business operations. when an investor purchases stock in a company. invested money can render higher profits only if it is subject to the possibility of being lost. For example. a prospective project's lifetime cash inflows and outflows are assessed in order to determine whether the returns generated meet a sufficient target benchmark. According to the risk-return tradeoff. the rate of return that a company would otherwise be able to earn at the same risk level as the investment that has been selected. monitoring. Since the individual expects to get back more than his/her initial investment.
it increases its chance of going bankrupt as it loses the ability to service its debts. the purchase price is paid on or about the average maturity date of the accounts being purchased in the batch. This can occur when the company is not generating enough cash flow or is unable to access forms of financing such as debt or equity. General Reserve and Specific Reserve Factoring :Factoring is a financial transaction whereby a business sells its accounts receivable (i. or they will invest elsewhere.. buying back shares and restructuring the company are possible solutions to this problem. it is where costs to acquire an asset are included in the price of the asset.e. An overcapitalized company might be paying more than it needs to in interest and dividends. the factor makes no advance on the purchased accounts. Rd = cost of debt . In "maturity" factoring. If a company can't generate capital over time. better known as "market capitalization". and other providers of capital. The sum of a corporation's stock. Undercapitalized companies also tend to choose high-cost sources of capital. Over Capitalization: When a company has issued more debt and equity than its assets are worth. In "advance" factoring. Tc = corporate tax rate Types of Reserves: Revenue Reserve. invoices) to a third party (called a factor) at a discount. over lower-cost forms such as equity or long-term debt." often 70-85% of the purchase price of the accounts. Definition of 'Capitalization' • • • In accounting. with the balance of the purchase price being paid. rather. D/V = percentage of financing that is debt . . E = market value of the firm's equity . Where: Re = cost of equity . Under Capitalization: When a company does not have sufficient capital to conduct normal business operations and pay creditors. Also known as "invested capital". such as short-term credit. owners. V = E + D . D = market value of the firm's debt . net of the factor's discount fee (commission) and other charges. A company's outstanding shares multiplied by its share price. Reducing debt. the factor provides financing to the seller of the accounts in the form of a cash "advance. long-term debt and retained earnings. upon collection.company must earn on an existing asset base to satisfy its creditors. E/V = percentage of financing that is equity . Capital Reserve.
In contrast to return on investment and net present value methods. dividend policy: A company's stance on whether it will pay out profits as dividends or keep them as retained earnings.payback period method: Method of evaluating investment opportunities and product development projects on the basis of the time taken to recoup the investment. and unpaid taxes. current liabilities/ current debt: Obligations such as deferred dividend. however. or if the dividend payout will be infrequent. the cash inflows occurring after the payback period are not included in this method. also called leverage. retained earnings: retained earnings refers to the portion of net income which is retained by the corporation rather than distributed to its owners as dividends. the policy will outline whether or not the dividends will be issued on an ongoing basis. Gross working capital does not account for current liabilities. . they may also be unable to find new lenders in the future. financial leverage: The degree to which an investor or business is utilizing borrowed money. trade credit. If the company decides to issue dividends. This period is compared to the required payback period to determine the acceptability of the investment proposal. Gross Working Capital: Cash and short-term assets expected to be converted to cash within a year. Formula: Payback period (in years) = Initial capital investment ÷ Annual cash-flow from the investment. Also called current debt. Companies that are highly leveraged may be at risk of bankruptcy if they are unable to make payments on their debt. Financial leverage is not always bad. it can increase the shareholders' return on investment and often there are tax advantages associated with borrowing. Gross working capital tends not to add much to the business' assets. but helps keep it running on a day-to-day basis. but is simply the measure of total cash and cash equivalent on hand. arising in the normal course of a business and due for payment within a year. Businesses use the calculation of gross working capital to measure cash flow.
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