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Capital Budgeting Decisions
A capital budgeting decision is also called a capital expenditure decision. A capital expenditure is an outlay of cash or commitment of firm’s funds for a project or long term asset that is expected to produce a cash inflow over a period of time exceeding one year.. For example, a machinery worth Rs. 1 crore purchased today might help make cash flows of Rs.1,00,000 , Rs, 2,00,000 , Rs. 3,00,000 etc., in the first, second, third year and so on respectively. . By this decision, a firm decides to invest its current funds most efficiently in the long term assets and the benefit from these assets are expected to flow over a series of years. The firm’s investment decisions generally include expansion, acquisition, modernization, replacement of long term assets besides it also includes divestment (sale of a division or business), undertaking a huge advertisement campaign, research and development etc having long term effects or any other project that requires a capital expenditure and generates a future cash flow. Because capital expenditures can be very large and have a significant impact on the financial performance of the firm, great importance is placed on project selection. This process is called capital budgeting.

FEATURES WHICH DISTINGUISH CAPITAL BUDGETING DECISIONS FROM ORDINARY DAY TO DAY BUSINESS :Importance of Investment decisions 1. Calculation is based on cash flow as it is the cash in hand that is important for immediate investment and not the profit which may not be entirely in cash (Cash flow = Accounting profit before depreciation, interest and tax – depreciation – interest – tax + depreciation) 2. It involves the exchange of current funds for the benefits to be achieved in future.

3. The future benefits are expected to be realized over a series of years.
4. A significant period of time (more than one year) elapses between the investment outlay and the receipt of the benefits.. 5. They influence the firm’s growth in the long run as the effects of investment decision extend into the future. 6. They affect the risk of the firm as the investment is made now but the benefits occur in future and the future is uncertain. 7. The funds are invested in non-flexible and long-term activities 8. They involve commitment of large amount of funds and therefore requires a careful planning to the taken beforehand. 9. It involves a long term and significant effect on the profitability of the concern

Definitions: CHARLES T. HORNGREN," Capital budgeting is long-term planning for making and financing proposed capital outlays". G.C PHILIPPATOS," Capital budgeting is concerned with the allocation of the firm's scarce financial resources among the available market opportunities".

10. They are irreversible, or reversible at substantial loss. Long term assets such as machinery once acquired are not easy to resell (dispose off) them unless otherwise at heavy loses.

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11. They are among the firm’s most difficult decisions. They are based on cash flows occurring in future which are very difficult to predict correctly.

NEED AND IMPORTANCE OF CAPITAL BUDGETING:Capital budgeting decisions are vital to any organisation. The importance of capital budgeting may be well understood from the fact that an unsound investment decisions may prove to be fatal to the very existence of concern. The following are:Growth:- The effects of investment decisions extend into the future and have to be endured for a longer period than wrong decisions can prove disastrous for the continued survival of the firm; unwanted or unprofitable expansion of assets will result in heavy operating cost to the firm. On the other hand, inadequate investment in asset would make it difficult for the firm to compete successfully and maintain its market share. Risk:- A long term commitment of funds may also change the risk complexity of the firm. If the adoption of an investment increases average gain but causes frequent fluctuations in its earnings, the firm will become more risky. Thus, investment decisions shape the basic character of a firm. Funding:-Investment decisions generally involve large amount of funds which make it imperative for the firm to plan its investment programmes very carefully and make an advance arrangement for procuring finances internally or externally.

Irreversibility:- Most investment decisions are irreversible. It is difficult to find a market for such capital items once they have been acquired. The firm will incur heavy losses if such assets are scrapped. Complexity:- Investment decisions are among the firm's most difficult decisions. They are an assessment of future events which are difficult to predict. It is really a complex problem to correctly estimate the future cash flow of an investment. The uncertainty in cash flow is caused by economic, political, social, and technological factors.

TYPES OF INVESTMENT DECISIONS:There are many ways to classify the investment. One classification is as follows:a.)Expansion of existing business. b.)Expansion of new business. c.)Replacement and modernisation. Expansion and Diversification:-A company may add capacity to its existing product lines to expand existing operations. For example:- a fertilizer company may increase its plant capacity to manufacture more urea. Expansion of a new business requires investment in new product and a new kind of production activity within the firm is called diversification. Replacement and modernization:- Assets become outdated and obsolete with technological changes. The firm must decide to replace those assets with new assets

- 3 -Page 3 of 29 that operate more economically. If a cement company changes from semi-automatically drying equipment to fully automatic drying equipment, it is an example of modernization and replacement. area, it may have to invest in house, roads, hospitals, schools, etc. for employees to attract the work force.

INVESTMENT EVALUATION CRITERIA:Three steps are involved in the evaluation criteria of an investment: a.)Estimation of cash flows. b.)Estimation of the required rate of return. c.)Application of a decision rule for making the choice for
I) accepting or II) rejecting Of investment projects

Another way to classify investments is as follows:1.)Mutually Exclusive investments. 2.)Independent investments. 3.)Contingent investments. MUTUALLY EXCLUSIVE INVESTMENTS:- It serves the same purpose and competes with each other. If one investment is undertaken, others will have to be excluded. A company may for example-either use a more labour-intensive, semi-automatic machine or employ a more capital-intensive. INDEPENDENT INVESTMENTS:-It serves different purposes and do not compete with each other. For example-a heavy engineering company may be considering expansion of its plant capacity to manufacture additional excavators and addition of new production facilities to manufacture new product-light commercial vehicles. Depending on their profitability and availability of fund, the company can undertake both investments. CONTINGENT INVESTMENTS:-These are dependent projects; the choice of one investment necessitates under taking one or more other investments. For example ,if a company decides to build a factory in a remote, backward

There is a wide array of criteria for selecting projects. Some shareholders may want the firm to select projects that will show immediate cash inflow, others may want long-term growth with little importance on short-term performance. Ultimately, the goal of the firm is to maximize present shareholder value. A number of capital budgeting techniques are in use in practice. They are grouped in the following two categories:1.)Discounted Cash Flow (DCF) criteria. a.)Net Present Value.(NPV) b.)Internal Rate of Return(IRR) c.)Profitability Index (PI) d.)Discounted Payback Period

- 4 -Page 4 of 29 2.)Non-Discounted Cash Flow Criteria a.)Payback-Period(PB) b.)Accounting Rate of Return(ARR) DISCOUNTED CASH FLOW(DCF):-Sound decision making requires that the cash flows which a firm is expected to give up over period should be logically comparable.In fact, the absolute cash flows which differ in timing, and risk are not directly comparable. Cash flows become logically comparable when they are appropriately adjusted for their differences in timing and risk. The recognition of the time value of money and risk is extremely vital in financial decision making. If the timing and risk of cash flow is not considered, the firm may make decisions which may allow it to miss its objective of maximizing the owner's welfare. The welfare of owners would be maximized when net wealth or net present value is created from making financial decisions. Time preference of money:-If an individual behaves rationally. He would not value the opportunity to receive a specific amount of money now equally with opportunity to have the same amount at some future date. Thus an individual's preference for possession of a given amount of cash now, rather than the same amount at some future time, is called 'time preference money'.
Time preference for money and valuation of cash flows The time preference for money concept puts more value to the cash flow occurring now than later. To measure profitability arising a project, its cash in flows occurring at different time interval need to be added up against cash outflows to determine net gain. Since the cash flows have different preferences attached to them, all are brought to the current preference level. This process of bringing all future cash flows to the current level is known as discounting of cash flows.

Three reasons may be attributed to the individual's time preference for money: a.)Risk b.)Preference for consumption c.)Investment opportunities Finding Present value by discounting:-It is the method by which future cash flows are translated into their present value. The process of determining present value of a future payment(or receipts) or a series of future payments(or receipts) is called discounting. The compound interest rate used for discounting cash flows is called the discount rate. It is also known as OPPORTUNITY COST OF CAPITAL as it is minimum required rate of return expected from a project otherwise investment will flow into the next best alternative left for selecting this very alternative.
I. Discounted cash flow criteria takes into consideration the time value of money ie., a rupee earned today is worth more than the same rupee earned borrow. Further, the decision is based on cash flows accuring during the entire life of the project. (a) Net Present Value method (NPV method) It is the modern method of evaluating investment proposals. Investment involve cash flows. Profitability of an investment project is determined by evaluating its cash

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flows. The NPV method is a process of calculating the present value of project’s cash flows, using the opportunity cost of capital as the discount rate, and finding out the net present value by subtracting initial investment from present value of cash flows. more projects can be added It leads to wealth maximization of shareholders truly

It takes into account the earning over the entire life of project and true profitability evaluated
Illustration: Cash flows of a certain project are as follows given that no project would to accepted if the return is less than 10%. Mears Outflows(Rs) Inflows(Rs) (At 10% discount) Present value factor 1 .909 .826 .751 .683 .620

where

C1, C2, C3 ----- Cn represent cash flows occuring in year 1, 2, 3 ---- n respectively K = opportunity cost of capital assumed to be known (given) and contant. Co = initial investment n = expected life of investment.

Acceptance rule : Accept if NPV>O (i.e., NPV is positive) ; It is going to

increase the wealth.
Reject is NPV<O (i.e., NPV is negative) it is going to

decrease wealth.
Project may be accepted if NPV = O : zero profits. Demerits Requires estimates of cash flows which is a tedious task Requires computation of opportunity cost of capital which is difficult to calculate in practice. The result of NPV changes with change in discounted rates

0 1 2 3 4 5

1,50,000 30,000

20,000 30,000 60,000 80,000 30,000

Merits Considers all cash flows True measure of profitability (as it considers all cash flows)

The savage value (scrap value) at the end of 5th year is Rs 40,000. Calculation of Present value of cash flows
Year PV factor 10% (a) 1 .909 .826 .751 .683 .620 Outflows PV of cash inflows (axb) 1,50,000 27,270 Inflows (c) Present Value of cash inflows (axc) 18,180 24,780 45,060 54,640 18,600

Based on the concept of time value of money It also allows value addivity principle i.e NPV’s of two or

0 1 2 3 4 5

(b) 1,50,000 30,000

20,000 30,000 60,000 80,000 30,000

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5 .620 Total PVP Cash outflow 1,77,270 40,000 Total PV of Cash inflows 24,800 1,86,060

(Salvage value occurs in 5th year hence the Present value of 5th year is used) NPV = Rs. 186,060 – Rs. 1,77,270 = Rs 8790. Since NPV is more than zero hence the investment should be accepted as it will add Rs 8790 to Shareholders wealth (Profits accruing to Shareholders) b)

Internal Rate of Return (IRR) method:
It is also known as Time-adjusted rate of return, discounted cash flow, discounted rate of return, Yield method, and Trial and error yield method. It is discounted at a suitable rate of hit and trial method , which equals the NPV so calculated to the amount of investment.
The IRR is that discount rate at which project’s NPV is zero. In other words, It is the discount rate at which present value of an investments cash inflows is equal to the present value of its cash outflows.

It involves two methods:Ist method:-When net cashflow are equal over the life of the asset than two steps have to be followed:a.)Find present value factor where PVF= initial outflow /annual cash inflow. b.)Consult present value annuity table at the row is equal to life of investment . c) The Vertical column will show the desired IRR. IInd method:-Where annual cashflows are unequal over the life of the asset. IRR is found by the trial and error method.
Required NPV NPV at Lower rate NPV at higher rate XXXXXX C1 XXXXXX XXXXXX C2

IRR = Lower rate +(higher – lower rate)C1/C2 The method is at variously known as yield on investment, marginal efficiency to capital, rate of return over cost, time adjusted rate of internal return and so on.

; where r= rate of return on the investment
Acceptance rule: > Accept if IRR > k > Reject if IRR < k > Project may be accepted if IRR = k ; k=opportunity cost of capital

Merits Considers all cash flows True measure of profitability Based on concept of time value of money

Demerits Requires estimates of cash flows Does not hold the value additivity principle (i.e. IRR = of two or more projects do not add) At times fails to indicate correct choice between mutually exclusive projects.

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Consistent with wealth maximization principle At times yields multiple rates Difficult to compute

evaluate,PI method is most suitable. The other merits and demerits are same as NPV method.
Non Discounted Cash flow Criteria These are traditional method of investment evaluation in which the timing of cash flows is ignored (that some cash flows occur earlier some cash flows occur later, i.e. it ignores time value of money. Though these methods do not help in correctly estimating shareholders wealth creation yet they or popular with business executives (a) Pay back period method : Pay back is the number of years required to recover the initial cash outlay of an investment project. Thus it measures the period of time for

It may be noted that in IRR method ‘r’ has to calculated by trial and error method taking help of extrapolation method. c)Profitability Index: (Benefit cost ratio) The ratio of the present value of the cash flows to the initial outlay is profitability index.

In this method, k is assumed be known (given) It is also manipulation of NPV method in which instead of subtracting Co from cash inflows, the cash inflows are divided by Cash Outflows. Acceptance rule:Accept if PI > 1.0 Reject if PI < 1.0 Project may be accepted if PI = 1.0
Merits • Considers all cash flows • Recognises the time value of money • It is a relative measure of profitability (as it relates cash inflows to cash outflows) • Consistent with the wealth maximization principle Demerits • Requires estimates of the cash flows which is a tedious task • At times, fails to indicate choice between mutually exclusive projects.

the original cost of a project to be recovered from the additional earnings of a project itself. In case of evaluation of a single project, it is adopted if it pays back for itself within a period specified by the management and if the project does not pay back itself within the period then it is rejected. In case of multiple projects: that project is accepted that has the lowest payback period if it is also less than standard payback period. Formula:-PAY BACK PERIOD (PB) = cash outlay or original cost of asset annual cash inflows
Acceptance rule: Accept if PB<standard payback period of an investment. Reject if PB>Std payback Project may be accepted if PB=Std payback period

This method is a slight modification of NPV method. The NPV has one major drawback, it is not easy to rank projects when the costs are differing significantly. To

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Intial cash outlay Annual cash inflow Rs 50,000 Rs 10,000, Rs 20,000, Rs 15,000, Rs 10,000 Rs 10,000 respectively in 1,2,3,4,5th year. Period required to recover Rs 50,000 10,000 – 1st Year 20,000 – 2nd Year 30,000 15,000 – 3rd Year 45,000 5,000 to recover from 4th year to make . Rs 10,000 50,000 3 complete years + 5000 10,000 3½ years


• •

Merits Easy to understand and compute and inexpensive to use Stresses on liquidity Easy and crude way to cope with risk Uses cash flows information (not the accounting profit for decision making as it is the cash in hand that is important not the profit which may not be entirely in cash)


• •

Demerits Ignores the time value of money Ignores cash flows occurring after the payback period. Not a measure of profitability No objective way to determining standard payback No relation with the wealth maximization principle.

Payback Period =

Payback Period =

b)

• It reduces the loss through obsolescence and is more suited to • the developing countries like India. Due to its short term approach, it is particularly suited to a firm which has shortage of cash

It does not take into consideration the cost of capital. It is usually a subjective decision

ba)

Discounted Payback: The number of years required to recover the cash outlay on the present value basis is the discounted payable period. It has our advantage over payback period method that it recognizes time value of money by using discounted cash flows. But it has all the demerits of payback period. Post Payback profitability method: One of the serious limitations of paybacks period method is that it does not take into account cash inflows earned after pay back period and hence the true profitability of the project cannot be assessed. Post payback profitability index helps to select two or more projects having same payback period (mutually exclusive projects)

Illustration 1 Initial cash outlay Life of an asset Estimated Annual cash flow Payback Period = & Uneven cash inflows

Even cash inflows Rs 50,000 5 years Rs 12,500 Investment = Annual Cash flow 50,000 = 4 yrs 12500

Post payback profitability index =

Post Payback Profits x 100 Investment

Accept the project whose post payback profitability index is more in case of mutually exclusive projects having same payback period.

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c)

Accounting rate of return: This method takes
into account the earnings expected from the investment over their whole life. The accounting concept of profit is used rather than cash inflows. The project with higher rate of return is selected as compared to the one with lower rate of return.
Average Profit Average Investment

Total profits (after depreciation before tax) * 100 net investments c.)Return on average investment= Total profits * 100 average investment Average investment=net investment/2 d.)Average Return on Average investment method:(Average annual profits/average net investment)*100.

ARR =

Acceptance rate: Accept if ARR>minimum rate (decided by management) Reject if ARR< minimum rate May Accept if ARR = minimum rate

• • •

Merits Uses accounting data with • which executives are families • Easy to understand and • calculate Give more weightage to future receipts

Demerits Ignore the time value of money Does not use cash flows No objective way to determine minimum acceptable rate of return

Discounting of Cash flows: The time preference for money can be shown quantitatively with the help of compound rate of interest. Hence, Simply. Future Value = Principal + Interest (P) (J) = 100+.10 x 100 = 100 (1+.10) = 100(1.10) = Rs 110 Taking Principal as 100 and interest rate 10% for one year the future value will be

Conclusion: NPV is most superior investment criterion as it is always

The return on investment method can be used in several ways:a) Average rate of return:Average annual profits *100 net investment b.)Return per unit of investment method:-

Juggling the above figures 110 = 100 (1.10) fv = P (1+I) V =P 1+I Principal is alternatively called as present value while dealing with cash flows and ‘I’ as required rate of interest. Required rate of Interest = Risk Free rate+ risk prepium

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This, required rate is the opportunity cost if capital. Which is called so because, the investor would invest money in securities of equivalent risk. Risk Premium is the return over and above the risk free rate which the investor should receive in order to make him forego his principal now. Risk free rate :Risk premium :Compensates him for foregoing the amount now in anticipation of future Compensates him for undertaking risk of uncertainty of income.
PV = 1000 (1+.08)1 + 1500 (1+.08)2 + 1100 (1+.08)3 + 400 (1+.08)4

Compounding for for 1 year for 2 years for 3 years for 4 years Financial Management, Risk and Return and value of the firm Figure (1)

Thus, in the above example, the investor would accept Rs 110 after a year and would readily give Rs 100 now for it. Thus, we can say that he is indifferent between Rs 100 now and Rs 110 after a year. This means – Rs 110 after 1 year is equal to Rs 100 now If FV = Rs 110 Then, PV = Rs 100 If both are equal

110 = (1+1.10) 110 = 100 1.10 FV = PV 1+I (hence, the equation earlier gets formed)

Similarly P.V can be found of Multiple cash flows occurring at different thre Intervals taking the discounting rate into consideration. Consider an investor with an investment opportunity of receiving Rs 1000, Rs 1500, Rs 1100, Rs 400 respectively at the end of one through four year. The Present value of this cash inflows stream taking required interest rate at 81. is:-

Operating & Financial Leverage
When a lever is used, a force applied at one point is transformed into larger force or motion at some other point. In business context. However, leverage refers to the use of fixed costs in an attempt to increase (lever up) profitability. Leverage appears in two forms, in business, as operating leverage and financial leverage.

- 11 -Page 11 of 29 Operating Leverage
In the short run, the costs are of two types, namely, fixed operating cost and variable operating cost. Fixed operating cost do not vary as volume changes. It includes depreciation of building, equipment, insurance etc. variable operating cost vary directly with the level of output. It includes raw material, direct labour costs etc. Fixed operating costs are incurred with the hope that sales volume will produce revenues more than fixed and variable costs. Presence of fixed operating cost is referred to as operating leverage. Due to its presence, a change in volume of sales results in more than proportional change in operating profit (loss). Thus, like a lever, the presence of fixed operating costs causes a % change in sales volume to produce a magnified percentage change in operating profit (or loss). However, leverage is a double edged sword-just as company profits can be magnified, so too can the company’s losses. Table showing the effect of operating leverage an operating profit (EBIT). (EBITt – EBITt-1) EBIT t-1 400% 100%

From the table, it is clear that 50% change in sales lead to 400% change in profits (EBIT) in case of firm A which employed 78% fixed operating costs us compared to 100% change in profits in firms B which employed 22% fixed operating costs.

Degree of Operating Leverage
It measures the sensitivity of a firm’s operating profit to a change in firm’s sales. Degree of operating leverage % change in operating profit (EBIT) at Q units (DOL = % change in output (or Sales) The degree is measured at a units because the sensitivity of the firms to a change in sales as measured by DOC will be different at each level of output (or sales). Equation:Q (P-V) DOL Q units = Q (O-V)-FC OR EBIT +FC DOL S Rs of Sales = EBIT Where Q is quantity, P is Sales Price, V is variable cost, Fc is fixed cost, EBIT is Earning before interest and tax.

Panel A : Two firms before changes in sales
Firm A 10,000 7,000 2,000 1,000 .78 .70 Firms B 11,000 2,000 7,000 2,000 .22 .18

Sales Operating Costs Fixed cost (Fc) Variable Cost (VC) Operating Profit (EBIT) Operating Leverage ratios Fc/ Total costs Fc/ Sales

DOL & Business Risk
DOL is just one component of business Risk whose principle contributing factors are variability in sales and production cost. What it does, is, magnifies their impact on profits.

Financial Leverage (or Trading on Equity)
Financial leverage involves the use of fixed cost financial. Financial leverage is acquired by choice, but operating leverage may not. It may be dictated by physical requirements of firm’s operations. For example, a steel mill by way of its heavy investment in plant and equipment will have large fixed operating cost component consisting of depreciation. Financial leverage is always a choice item, no firms is required to have only long term debt or preferred stock financing. Firms can, instead, finance operations and capital expenditures from internal sources and issues of common stocks.

Panel B : Two firms after 50% increase in sales
Sales Operating Costs Fixed cost (Fc) Variable Cost (VC) Operating Profit (EBIT) Percentage change in EBIT Firm A 15,000 7,000 3,000 5,000 Firms B 16,500 2,000 10,500 4,000

Degree of financial leverage (DFL)

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It measures the sensitivity of a firm’s earnings per share to a change in firm’s operating profit. DFL = % change in earnings per share (EPS) % change in operating profit (EBIT) Effect of financial leverage on level and variability of earnings per shares
Firm A (100% equity 80,000 — 80,000 32,000 48,000 4,000 (fig in Rs) Firm A (50% equity 80,000 30,000 50,000 20,000 30,000 2,000 where I = PD = t= NS =

A company can raise additional funds from various sources such as (a) all common stock (b) all debt or (c) all preferred stock. The indifference analysis is used to determine EBIT level which EPS is same for two (or more) alternatives. This analysis is also referred to as Break Even analysis. Following formula is used:EPS = (EBIT – I) (I – t) – PD NS

Panel A: EBIT Interest (I) Profit before tax (PBT) Expected taxes (t) @ 40% PAT Number of shares of common stock outstanding (NS) Expected earnings per share (EPS)

annual interest paid annual preferred dividend paid corporate tax rate Number of shares of common stock outstanding

for example : indifference point between the common stock and all debt financing alternatives given t=40% Interest rate is 12% additional finance required is Rs 50,00,000. Given 20,000 shares outstanding. Share price is Rs 50. Which translates into additional 1,00,000 shares

Firm A (100% equity Panel B: Risk Components Degree of financial leverage EBIT [ EBIT – I – PD/ (I0T) ] 1.00

Firm A (50% equity

Common Stocks
(EBIT – 0) (1-.40) – 0 3,00,000 =

All debts
(EBIT – 6,00,000) (1-.40) – 0 2,00,000

1.60

PD = Preferred dividend t = tax rate I = Interest amount Mence, it is clear than EPS is more in case of firm B which also earns same EBIT as firm A due to the use of financial leverage. Total Leverage: When financial leverage is combined with operating leverage the result is referred to as total or combined leverage. The result of combined leverage is that a small change in firms sales leads to a much greater change in EPS due to Play of both the leverages.
Degree of total leverage = DTC = DOL x DFL % Change in EPS % change in output (sale)

Indifference Analysis:

NS is case of common stocks is 3,00,000 shares (i.e. 200000 + 1,00,000) 2,00,000 an already outstanding and 1,00,000 shares are additionally raised) NS in case of all financing is 200000 Shares Since no additional shares are issued only debt is raised to finance additional requirement. I in case of common stock is zero since no interest arises due to non usage of debt. I in case of all debt financing is calculated as t = 40% in both the cases PD = 0 Since no preferred stocks is used for financing Solving the equation further by cross multiplication: (EBIT) (.60) (2,00,000) = (3,00,000) (EBIT) – 6,00,000) (.60) = EBIT (1,20,000) = (1,80,000) (EBIT – 600000) = EBIT (1,20,000) = (1,80,000) (EBIT)) – (1,80,000) (6,00,000) bringing EBIT from RHS to Left hand side

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EBIT (1,20,000) – (1,80,000) (EBIT) = - (1,08,00,00,00,000) EBIT (1,20,000 – 1,80,000) = - 1,08,00,00,00,000 60,000 (EBIT) = 1,08,00,00,00,000 1,08,00,00,00,000 EBIT = = 18,00,000 60,000 At EBIT = Rs 18,00,000 whether the firm uses all debt or all common stock. EPS will remain same (or indifferent to EBIT) The indifference point can also be found out graphically

Financial management refers to that part of the management activity which is concerned with the planning and centrolling of firm’s financial resources. Evolution of Corporate finance/financial management The evolutionary stages of corporate finance are studied as follow: 1. Traditional approach: the traditional approach relates to the initial stages of its evolution during 1920s and 1930s. Financial management was known as ‘Corporate finance’ then; According to this approach the scope of finance function was limited to only procurement of funds needed by a business on most suitable terms. It completely ignored the efficient use of funds in the business and day to day financial problems of an organization. 2. Modern Approach: According to this view, finance function deals with not only finding out sources of raising funds, but also their proper utilization. Finance is treated as on integral part of management and the finance function covers financial planning, raising of funds, financial control etc. The techniques of simulation, mathematical programming, financial engineering are used in financial management to solve day to day financial problems. Chronology of evolution 1. In the initial stages of evolution of corporate finance, emphasis was placed on the study of sources and forms of financing the large sized business.

The higher the EBIT than indifference point, the use of debt would result in higher EPS and lower the EBIT than indifference point the valuable is the use of common stock for greater EPS to occur.

Nature and Scope of Financial Management
Finance is as important to a business as the blood for life. Every enterprise, whether big, medium or small needs finance to carry on its operations. Without adequate finance, no business can achieve its objective.

- 14 -Page 14 of 29 2. The grave ECONOMIC RECESSION of 1930’s rendered difficulties in raising finance from banks and other financial institutions. Thus, emphasis was on improved methods of planning and control, sound financial structure of the firm and concern for liquidity - Thus, ways and means of evaluating the CREDIT WORTHINESS of firm were developed. 3. Late 1950’s, the Post world war era – saw reorganization of industries and need for selecting sound financial structure. Emphasis shifted from profitability to liquidity and from institutional finance to day to day operations . Techniques of analyzing capital investment in the form of CAPITAL BUDGETING were also developed. Scope of financial management widened to include the process of DECISION MAKING WITHIN THE FIRM. 4. Modern Phase began in mid-fifties, the discipline of CORPORATE FINANCE OR FINANCIAL MANAGEMENT became more ANALYTICAL AND QUANTITATIVE 5. 1960’s saw advances in the thory of ‘PORTFOLIO ANALYSIS’ by Markowitz, Sharpe, Litner etc., Modern concept like CAPM, OPTION PRICING THEORY, BINOMIAL MODEL were developed. 6. In 1980’s , role of taxation in personal and corporate finance was emphasized. Further, newer avenues of raising finance with the introduction of new capital market instruments such PCD’s, FCD’s PSB’s and CPP’s were introduced. 7. Globalisation of markets has witnessed the emergence of FINANCIAL ENGINEERING, which involves the design, development and implementation of innovative financial instruments and the formulation of creative optimal solution. The techniques of models, mathematical programming and simulations were used. Thus, we can say that Financial Management has evolved from a branch of economics to a distinct subject of detailed study of its own. Traditional approach Modern approach 1. It relates to initial stages It relates to late 1950’s of evolution during 1920’s were the concept of and 1930’s when the term MANAGEMENT OF CORPORATE FINANCE WORKING CAPITAL was was used used. 2. The scope was confined It views finance function in to only procurement of broader sense funds on most suitable term 3. Utilisation of funds was It includes both raising of considered beyond its funds as well as their purview utilization 4.It was felt that decisions Finance function does not regarding applications of only stop at finding out funds are taken somewhere sources but also their else in organization proper utilization ( of funds) 5. Institutions and Finance function involved instruments for raising decision making relating to funds were considered to utlisation of funds so that be a part of finance returns generated should be function more than costs of procuring them 6. Scope fo finance Scope covered financial function, evolved around planning, raising of funds, the study of capital market allocation of funds and

- 15 -Page 15 of 29 institutions, instruments of financial control raising external funds Using techniques of mathematical programming, simulation , financial engineering etc Limitations of traditional approach 1. It is outsider looking in approach that completely ignores internal decision making as to the proper utilization of funds. 2. The focus of traditional approach was on procurement of long term funds. Thus it ignores the important issue of working capital fiancé and management. 3. the issue of allocation of funds , which is so important this approach ignores it completely 4. It does not lay focus on day to day financial problems of an organization. Financial Decision The modern approach considers four basic management decision (i) Investment decision/ capital budgeting decision (ii) financing decision/ capital structure decision (iii) Liquidity decision/ working capital decision (iv) dividend decision/ distribution decision 1. Investment decision: Investment denotes expenditure made now whose benefits will be received over a number of y ears in the future. In simple terms, it refers to determination of total amount of assets to be held in the firm. The profitability of various investments is assessed by finance manager in term of expected return, costs involved and risk associated with future. These decisions relate to setting up of new unit, expansion, replacement, research and development projects, mergers, acquisitions and also spin offs etc. Financing Decision: Once a firm decides to make an investment, it must decide on the best source of financing that investment. It can raise funds from various sources such as debentures, preference capital, equity capital etc. The financing decision is concerned with how best to finance new assets that would reduce the overall cost of raising the funds and would also minimize risk associated with financing. Liquidity decision: The amount of current assets to be held in the business is known as liquidity decision. Such as decision is influenced by trade off between liquidity and profitability. The higher the amount of liquid assets such as stock, debtors, cash etc the higher the liquidity i.e. ability to pay off short term debts but lower would be profitability as the amount keep in the form of current assets gets blocked in the business and thus fails to earn any return that would have been possible had it been invested somewhere else. Dividend Decision: It is another important financial decision. The financial manager must decide whether the firm should distribute all profits, or retain them fully a part of it. The higher rate of dividend may raise the market price of shares and thus, maximize the wealth of shareholders. The firm should also consider the question of dividend stability, stock dividend and cash dividend.

2.

3.

4.

Financial Goal

- 16 -Page 16 of 29

The decision that a finance manager makes must be guided by a goal. The goal can be: (i) Profit Maximization goal: Profit earning is the main aim of every business. No business can survive and grow without earning profit, besides, profit is a measure of efficiency of a business enterprise. The arguments favouring this objective are as follows: (a) when profit earning is the main aim of business then profit maximisation should be obvious objective. (b) Profitability measures efficiency of a business. (c) Profit enables a firm to survive adverse conditions. (d) Profits are main source of financing the firm’s growth (e) Profits are essential for fulfilling social goals also. Arguments against profit maximization goal: (i) The term ‘profit’ is ambiguous. Does it mean profit before tax & after tax? Does it mean operating profit or profit available for share holders is not clearly defined. (ii) This objective ignores time value of money is it does not recognize that a rupee earned today is worth more than a rupee earned after a year. (c) It ignores the risk element associates with projects. A project may involve more risk than another project to make it unacceptable due to inadequate risk bearing capacity of the firm. (d) It also does not take into account the effect of dividend policy on the market price of shares

II.

Wealth Maximisation Objective: Shareholder’s wealth is measured by the product of no. of shares owned, multiplied with the current market price per share theoretically, wealth maximisation objective s claimed superior to profit maximisation objective on the following grounds: (i) It provides on urambiguous objective to seek when making investment and financing decisions. (ii) It takes into account the time value of money as the cash flows occurring later are adequately reduced to bring them to present level. (iii) It also provides for adjustment of risk factor during cost - benefit analysis in decision making. (iv) It saves the interests of suppliers of funds, employees, management and society as all of them desire an increase in the market price of shares hold in their hands.

Limitation of this objective : (i) It is a prescriptive idea and does not describe what firms should actually to. (ii) The objective of wealth maximisation may not necessarily be socially desirable. (iii) There is some controversy as to whether the objective is to maximise shareholder’s wealth or the wealth of the firm which include debenture holders, preferred shareholders etc., (iv) The objective may not be realizable when there is a separation of ownership and management in company from of

- 17 -Page 17 of 29 organisation. Shareholders interest conflict with manages interest. many directors or a highly placed official. All important financial decisions are taken by the committee or executive but routine decisions are left to the lower level of management. In still larger concerns, two more officer — controller and treasure - may be appointed under the direct superrison of chief financial officer (CFO). the controller is concerned with planning and controlling the finance, preparing reports, estimating the requirement of funds, capital budgeting etc whereas treasure deals in raising of long term finds, working capital (short term firms), protection of funds etc. In India, controller is generally termed as finance controller or the management accountant. But the designation of treasure is not very popular as some of his functions are performed by company secretaries, chartered accountants etc. Functional Areas of Financial Management The scope of financial management is getting enlarged day by day spanning from routine function of record keeping to giving strategic direction to the organisation for outdoing the competitors. Some of the functional areas are stated as follows: 1. Preparing books of accounts : The basic functions of the finance function is to record daily transactions properly with documentary evidence and enable the preparation of Trading account, profit and loss account and balance sheet. Financial analysis Y Interpretation: Finance manager tries to draw of out critical information

In spite of the conflicts, shareholders wealth maximisation objective is more logical and operationally feasible than the profit maximisation objective. Organisation of Finance function
Board of director Managing Director

Vice President Production

Vice President Finance

Vice President Marketing

Controller Planning & Control Accounting Preparation financial reports Reporting and Interpreting Internal audit Tax administration Economic appraisal & reporting to Government

Treasurer Provision of both Long term & short term capital Relations with banks & financial institute are Cash Management Receivables management Protection of funds & securities Investor relations Audit

Organisation of finance function varies from enterprises, enterprise, depending upon is nature, size and other requirements. In small concerns, the owner himself handles finance function. In medium and large scale concerns, a separate department looks after all the finance functions. This department is headed by a committee or executive under the direct supervision of board of

2.

- 18 -Page 18 of 29 about liquidity, profitability and efficiency of the concern by analysis of the financial statements. Financial forecasting: Determining the financial needs of a concern in advance is another important function of the finance manager. The requirement of funds for long term and short term needs varies from industry to industry, scale of operations, economic conditions etc. Selecting the source of funds: Estimated needs of funds are then to be fulfilled by raising of adequate funds. The finance manager has to evaluate various sources of funds so that the cost of raising them is minimised. Profit planning & Control: Profit is a function of cost and volume. Given the amount of profits should be earned, the finance manager calculates the volume of sales to achieve the said profitability. Cost-Volume-Profit analysis tool devised to help the finance manager in profit planning and control. Capital Budgeting: Investment of procured funds among various projects that would yield maximum profits and maximise the market price of firms share is another important functional area of finance. Working Capital Management: Working Capital is the portion of total funds lying with the business that are kept as cash, debtors, stocks for carrying on daily operations smoothly. Adequate amount of working capital should be kept in the business as its scarcity such as mad-equate cash to pay for purchases or loans in time may tarnish the image of concern and in most situation may lead to bankreptsy also whereas WC is also bad as it does not earn any return. Devising Dividend Policy: Dividend is the portion of profits distributed to the shareholders. This profit can be kept (retained) in the business also if it needs cash for growth. Shareholders desire dividends whereas the concern wants to keep profits with itself to finance its needs. The finance manager should decide how much to keep and now much to distribute to keep both the parties satisfied. Valuation decision: Financial management is also concerned with evaluation of sale/purchase value of a firm in case of mergers, acquisitions, spin offs, demurrers etc. Corporate risk Management: Every business decision involves risk whether it is a merger or outsourcing and so on. The finance function aims to effectively assess the riskiness of every project, and looks for strategies to manage or mitigate the risk associated with it. International financial management: The business now a days are transcending boundaries making the finance function more complex. The funds can now be raised from any country and invested at different places. The tax laws relating to different countries have to be complied with, there is problem of consolidation of books of accounts, risk of operating in different countries also critically influences the financial decision making.

3.

9.

4.

10.

5.

11.

6.

7.

Capital Structure
Theories and factors A firm uses different sources to raise funds for its long term needs. These sources are debt, preference capital and equity capital. On debt fixed rate of interest in payable and on preference capital a fixed rate of dividend (not legally obligatory); if declared, is payable whereas equity Shareholders receive their share from profits after paying all

8.

- 19 -Page 19 of 29
the above and further it is also not obligatory; sources that of preference dividend. A mix of debt and equity capital used in the business is referred to as its capital structure. Why Debt is used The interest amount payable on debt is fixed say interest payable on 10% debentures of Rs 10,00,000 is Rs 1,00,000 every year till the debt is repaid. If the firm is able to earn more than 10% (say 15%) from the use of these funds, the difference will increase in profits:Income earned = Rs 15/100x10,00,000 Interest payment Addition to profits made by the use of debt = = Rs 1,50,00 Rs 1,00,000 50,000

At the same time, own funds may be used anywhere else more profitably. This use of debt and preference capital can which only a fixed amount is payable) as a source of finance, along with equity capital is known as FINANCIAL LEVERAGE or TRADING ON EQUITY. Optimum Capital Structure: A firm may use debt in different proportion debt and equity parts to the total funds raised. Say, if total funds are 100; may be;’ 50 debt, equity 50 equity or debt 60 and equity 40 and 50 on there can be different mixes of both the sources. That mix of debt and equity that minimises the total cost of capital is known as OPTIMUM CAPITAL STRUCTURE. An optimum Capital Structure thereby increase the market value of the firm by decreasing the cost of capital. Controversy Regarding Optimum Capital Structure

There are different views on whether an optimum capital structure exists or not these views are given in the following approaches: 1. Net Income Approach : (NI) approach: According to this approach, overall cost of capital (CWACC) declines with the increase in the use of debt (or ___ leverage). As a result, value of the firm rises with leverage. And Optimum Capital Structure exist at 100% debt usage and no equity usage. 2. Net Operating Income Approach: Not approach: According to this approach, overall cost of capital remains unchanged by the use of leverage. Reason being; whatever benefit or addition to profit is gained by the use of leverage the same is eaten away by the increase in the cost of equity which now feel the existence of increased risk than before. As a result, no optimum capital structure is said to exist and therefore 100% equity is as good as 100% debt or any combination of them. 3. Traditional Approach As per this approach, the cost of capital falls initially with the increase in use of debt upto a certain level and after reaching the optimum capital structure it begins to rise with the increase in the use of debt. It is a combination of NI approach and NOI approach. Hence, According to this approach, Optimum capital Structure exists. 4. Modigliani and Miller (Mm) Approach: If can be studied under two situations:(a) In the absence of taxes; it supports NOI approach and denies the existence of optimum capital structure. (b) In the presence of corporate taxes; the use of debt ads to the value of firm (this addition is known as interest tax shield). This advantage is however reduced with the inclusion of personal income

- 20 -Page 20 of 29
taxes payable on dividends and the financial distress costs. Net Income Approach: OPTIMUM CAPITAL STRUCTURE = 100% debt. It is based on the following assumptions: (*) The use of debt does not change the risk perception of investors as such Ke and Kd remains constant with change in Leverage. * Kd < Ke (i.e. debt capitalisation rate is loss than equity capitalisation rate) * Corporate income taxes do not exists. Graphically, it can be shown as Kd = Cost of debt is interest rate is taken as 6% Ke = dividend and growth expectations by equity share holders is taken as 10% representing cost of equity. : where = Proportion of debt in total funds

I.

= Proportion of equity in total of funds

illustration, Assume a firm has an expected annual net operating income of Rs 1,00,000, an equity rate, Ke, of 10% and Rs 5,00,000 of 6% debt. The value of the firm and overall cost of capital change can be studied as :
Case I (using 5,00,000 debt Net operating Income X Total cost of debt i.e., Interest = Rs. Rs 1,00,000 Case II (using 7,00,000 debt Rs 1,00,000 Change 12,00,000 increase in debt

30,000 —

— 42,000 58,000

Ko = overall cost of capital measured as NOI= X = net operating income before interest and taxes (i.e.; EBIT) V = value of firm which is sum of value of equity ‘S’ and value of debt ‘D’ i.e., V = S+D Ko can also be measured as :

Net income (NI) available to equity shareholders

70,000

NOI V

Market value of Equity(s) NI/ke = 70,00/10 , 58,000/10 7,00,000 5,80,000 Market value of Debt 5,00,000 7,00,000 IWT/Ko Value of firm v=SID 12,00,000 12,80,000 Rs. 80,000 increase in value of firm Case I Case I Change (using 5,00,000 debt) (Using Rs 7,00,000 debt) Rs. 2,00,000 increase in debt

- 21 -Page 21 of 29

X Ko = V

1,00,000 12,00,00 0 = 8.33%

x 100

1,00,000 12,80,00 0 = 7.81%

x 100

Fall in the overall cost of Capital (i.e. ko) from 8.33% to 7.81%

II.

NET OPERATING INCOME APPROACH (No optimum capital structure exists a firm’s market value is not affected by capital structure) Assumptions of NOI approach are as follow: The market value of the firm is found by the following equation; V=D+S = NOI/Ko = X/Ko . This equation is stated as capitalising the net operating income of the firm (ie. X or NOI) at overall or weighted overage cost of capital (i.e Ko) where Ko is not affected by the amount of debt used. Ko depends on the business risk i.e. risk of not able to the same NOI as before from the investment due to market conditions. The use of less costly debt increases the risk of shareholders. This causes cost of equity to risk and as a result the advantage given by use of debt is taken away by the increase in cost of equity. (Equity shareholders demand higher return compensation for bearing higher risk) Cost of debt i.e. kd is constant The corporate income tax as do not exist. It can be graphically represented as :If is clearly visible from the graph that with increase in leverage Ke rises and this makes Ko to remain constant at all levels. Degree of leverage III. TRADITIONAL APPROACH or INTERMEDIATE APPROACH - Existence of Optimum Capital Structure It is a compromise between not Income approach and net operating income approach. According to this approach, The value of the firm can be increased or the cost of capital can be reduced by the correct mix of debt and equity. According to this approach, the overall capital structure movements due to change in capital structure can be divided into three stages shown graphically as under :

-

-

- 22 -Page 22 of 29

Third Stage : Declining Value Beyond the acuptable limit of leverage, the value of the firm decreases or cost of capital increases with leverage. As is indicated by rising Ko in the third stage. After L2 mix at any addition of debt in the capital debt holders also start feeling the risk and this leads to increase in their cost in the form of agency cost (interference of debt holders in decision making, asking for more stricter contract stipulations and so on) along w\with further increase in the risk perception of equity shareholders. Both these costs together pull up the overall cost of capital. IV MM hypothesis : 1. Absence of Corporate Taxes: Irrelevance of Capital Structure Assumptions:- Perfect capital market exists i.e i) securities are freely bought & sold ii) investors can freely borrow at the same terms as firms can iii) they are rational. iv) Transaction costs do not exist i.e. the cost of buying & selling securities - Homogeneous risk classes: Firms within same industry will have more or loss same risk about the earnings to occur as per expectation. - Risk: The risk of investors is defined as the variability (i.e. changes) of the not operating income the greater the variability from the previous record the greater the risk. - No corporate taxes exist - Full payout: firms distribute their entire earnings to the investors.

First Stage: Increasing Value In the first stage, Ke remains constant as equity share holders do not perceive increase in risk due to increase in the use of debt. This causes an addition to profits because of the use of debt which adds to the value of the firm and reduces the overall cost of capital as indicated in the graph when Ko falls with increases in Leverage. Second stage: Constant Value: Optimum Capital Structure The fall in Ko continues fill a particular limit the mix of debt and equity) after that the equity share holders start fearing more risk due to debt obligations (i.e. bankruptry due to default in payment of interest) and ask for more returns (i.e. Ke, rises) for their investment. This offsets the debt advantage. As such Ko remains constant. Any mix of debt and equity in stage II (between L1 & L2) optimum capital structure.

- 23 -Page 23 of 29
Preportion I : Under prepositino I value of firm is Independent of the debt equity mix and the value of the firm is computed as: Value of the firm = Market Value of + Market Value of Equity Debt = Expected overall cost of capital Expected overall cost of capital Ke = Cost of equity or equity capitalisation rate (i.e. it is the rate by which we divide Net Income available to shareholders to find out market value of equity)

According to Preposition I, Since total market value of the firm is unaffected by financing mix, it follows that the cost of capital will not change with change in the degree of leverage and the WACC will be equal to cost of equity (ke) Arbitrage Process or Switching Process :

According to preposition I it is the NOI, that is look upon by investors in calculating the risk associated with the firm and not separately the earnings available to equity shareholders as the interest expenses. It is the variability or flluctuations in NOI that affects the investors not the amount of debt used. The Preposition I can be expressed as:

MM hypothesis staes that two firms identical in all respects (i.e. in the same risk class) exept for capital structures cannot have different market values of their firms. If they have different market values, arbitrage or switching will take place. In arbitrage, investors use personal or home-make leverage (i.e. undertake personal loans is the purpose of investments) as against corporate leverage to restore the equilibrium. Illustration :- Suppose 2 firms: unlevered firm U and levered firm L - have identical NOI at Rs 10,000.
Unlevered firm U Rs, 10,000 Rs 1,00,000 Rs1,00,000 Levered firm L Rs. 10,000 Rs. 60,000 Rs. 50,000 Rs 1,10,000 [ 6% debt]

NOI = X Expected S=Value of Equity Share D=Value of debt V=S+D

Ko D V S

= = = =

WACC = weighted average cost of capital Debt S+D = Value of the firm Equity capital

Suppose a person sums = 10% of the levered firm L. Return on investment = .10 (X-INT) = .10 (10,000 - 6/00x50,000) = .10 (10,000-3000) = Rs 700 Value of Investment = .10 (S) .10 (60,000) = Rs 6000

- 24 -Page 24 of 29

The person can earn the same return of Rs700 through an alternative strategy by following the following steps: Step 1: Sell your investment in firm L for Rs 6,000 Step 2: Borrow on your personal account an amount equal to your share of firm L’s following @ 6% of 10% share, .10 (50,000) = Rs 5000 Your have 6000+5000 = Rs 11000 with your Step 3: Buy 10% of un_____ firm ‘U’s shares Investment = .10 (v) =.10 (1,00,000) = Rs 10,000 Return = .10 (NOI) = .10 (10,000) = Rs 1000 However, you have borrowed Rs 5000 at 6% therefore you will have to pay Rs 300 as interest. Interest = 6/100 x 5000 = Rs 300 Your net return is Rs 700 as shown below: Equity return firm U Less : Interest on personal borrowing Net return Rs 1000 300 700

With decrease in demand for L’s shares its value would decrease; and increase in demand for firm ‘U’s shares its value would increase. Till they become equal. Hence, Preposition 1 is proved. Preposition II:- Preposition II states that cost of equity, Ke, would increase with increase in leverage, that would exactly offset any increase in earnings per share consequently firm’s market value would remain unchanged. It can be newed graphically as:

Note: that you are also left with cash Rs 1000 as follows :Equity return firm U Less : Interest on personal borrowing Net return Less investment in firm U = .10 (1,00,000) Remain in a Cash Rs 6000 5000 11000 10,000 1,000

This graph follows NOI approach upto stage I. IN stage II when Kd increase due to increase in risk perception of debt holders Ke start falling down as a part of their risk has been transferred to debt holders. Consequently, any increase in Ko by increase in Kd is brought down by fall in Ke by same extent keeping Ko again constant as before. Hence, them is no Optimum capital structure Criticism of M-M hypothesis : The shortcomings of MM hypothesis are as follow : 1. The assumption that individuals (i.e. common investors) and firms can borrow and lend at the same rate of interest does not hold good in practice. 2. It is incorrect to assume that corporate leverage (i.e. debt raised by firms) and home made leverage (i.e. personal

Due to this advantage of alternative investment strategy, a number of investors will sell their shares in firm L and buy the shares of firm ‘U’.

- 25 -Page 25 of 29
loans taken by individuals) are exact substitutes firms have limited liability whereas individuals have unlimited liability. 3. The transaction of buying and selling of securities involves costs as such non existence of transaction cost cannot be said to be practically applicable. 4. Working of orbitrage in also influenced by institutional restrictions. At times institutional investors may not able to use personal leverage in place of corporate leverage simply because they are not allowed to do so. Existence of corporate taxes & MM hypothesis Evidence of corporate taxes (i.e. the taxes firms pay on their profits) further strengthans the MM hypothesis. The existence of corporate tax gives a tax advantage to the firm on its interest payments which is an expenses allowed to be deducted from profits and on the remaining profits taxes are computed. This yields greater income for its investors for example:X = NOI = Rs 10,000 Kd = 0.06 or 6% D = Rs 20,000 Corporate tax = 50% Unlevered firm will have Rs 5000 [ 10,000 - 50/100x10,000] for distribution to its equity share holders worked out as follows for both L & U firms.
Unlevered firm (U) Rs 10,000 – 10,000 5000 Levered firm (L) Rs 10,000 1,200 8,800 4400 (Income tax liability) Amount available to equity share holders Total returns available to debt holders as well as equity share holders 5000 4400

5000

1,200 4,400

as interest income for debt holders earnings available to equity show holders

Total

5000

5,600

Earning increase due to the USE OF DEBT & EXISTENCE OF CORPORATE TAXES. Note that income tax liability of firm L is Rs 44000 where as that of firm U is Rs 5,000. The difference of Rs 600 which firm ‘L’ is saving or paying less by way of income tax is known as “Interest tax Shield”. If Interesting to watch out that the total return available to firm ‘L’ is Rs 5600 & firm ‘U’ is Rs 5000 i.e.Rs 600 less (Rs 5600 - Rs 5000). This difference is same as saved by way of taxes of Rs 600. This savings has increased the total returns of the firm by Rs 600. It can be computed following method also: Interest tax shield INTS = Tax rate X Interest = .50 x Kd D = .50 x (.06x20,000) = .50 x 1200 = Rs 600

NOI – Interest Profit before tax Less taxes @ 50%

(

x20,000)

Thus, the value of a Levered firm is equal to value of unlevered firm plus the present value of interest tax shield : VL = VU+TD ; [5600 = 5000 (Vu) +600(Interest tax shield)]

- 26 -Page 26 of 29
Vi = Value of levered firm VU = Value of Unlevered firm T = Tax rate D = Value of debt TD = Interest Tax shield The above discussion imphes that when corporate tax rate i.e. T is positive i.e. T>o, the value of levered firm will increase continuously with debt. Thus, theorefically the value of the firm will be maximum when it employs 100% debt. This is shows as follows : VU T Tpe Tpb = Value of Unlevered firm = Corporate tax rate = Personal tax rate on equity = Personal tax rate of debt

The objective of a firm would be to minimise the total taxes (both corprate and personal) while deciding on how much to borrow as the existence of personal taxes reduce the interest tax shield advantage available to the firm. Suppose in the previous illustration both the debtholders and equity shareholders may personal income tax of 40% on their income
Unlevered firm (U) Rs 5000 2000 3000 – – Levered firm (L) Rs 4400 1760 2640 1200 480 720 3000 Equity Debt – 3000 2640 720 3360 Difference in Levered firm is 3360-3000=Rs 360 =D

Existence of Personal taxes: Investors pay personal taxes on the income earned by them. Therefore, from investors point of view, taxes will include both corporate and personal taxes Hence, the value of levered and unlevered firms would now equate as follow :

Earning available to Equity share holder before personal taxes Less Personal tax @ 40% = Tpe After tax earning available to equity share holder Earning Interest Income of debt holder personal taxes Less personal taxes @ 40% = Tpb Interest income after personal taxes Total returns available after corporate & personal taxes Total

Where, VL

= Value of levered firm

Interest tax shield has reduced from earlier Rs 600 to Rs 360 due to the existence of personal taxes.

- 27 -Page 27 of 29
2. The personal tax rate on equity cannot be zero as firms pay dividends 3. Investors in high tax bracket may indirectly invest in debt securities by investing in those institutions wherefrom income is tax exempt. These institutions, in turn, invest in corporate bonds. Financial Distress & MM Hypothesis If a firm can have an optimum capital structure at 100% debt then why don’t firms in practice borrow 100%? The answer lies in the fact that as the amount of debt is increased, certain disadvantages due to the use of debt also increase simultaneously. These disadvantages are grouped under the term FINANCIAL DISTRESS. Financial distress occurs when a firm is unable to pay its interest and principal repayment obligations as and when they became due. This may, in extreme cases, push a firm into banks uptry which involve distress sale of its assets at throwaway prices to settle the claims of creditors, incuring legal costs etc. It may involve many indirect costs as well. Management may avoid investment in profitable projects if they are risky under insolvency or financial distress. Financial distress reduces the value of the firm. The value of a levered firm is given as: VL = Vu+TD-PVFD VL = Value of levered firm VU = Value of unlevered firm TD = TAX shield on Interest PVFD = Present value of financial distress PVINTS = Present value of interest tax shield Graphically it can be shown as:

Putting the values in egn (1) the get Vc = 3000 + = 3000 + [ 1-(1-(1-.50) 720 = 3000 + .50 x 720 = 3000 + 360 = Rs 3360 as calculated above firms save their taxes by having interest as part of their expenses. But this interest income is taxed in the hands of debt providers even if they receive it or not. Whereas, equity shareholders are taxed on their dividend income only when they receive it in their hands or sell their shares and get cpaital gains (selling shares at a price higher than their purchase price) The above fact, induces companies to go for debt but demotivates debt holders. Hence, the firms have to induce debt holders to provide more debt by paying them higher rate of interest. Firms will keep increasing the rate of interest until the corporate tax savings are greater than personal tax 1oss. Thereafter they will stop. This impolies :1. There exists an optimum capital structure 2. There is no optimum capital structure for a single firm but for the whole economy. Limitations :1. If implies that investors would keep on investing in securities and debt holders in debt. But in p;ractice, investors hold a mix of debt and quity securities (shares) known as portfolio

- 28 -Page 28 of 29

Short Notes Capital budgeting (or investment appraisal) is the planning process used to determine whether a firm's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is budget for major capital, or investment, expenditures Cash Flow Vs Accounting Profit Acounting profit would be the reported amount of "Profit" after calculating books against sales and operational expenses. Once you have figured in all associated cost to a service or product, paid the overhead bills, insurances and such; the remainding revenue would be reported as profit ACCOUNTING RATE OF RETURN METHOD:ADVANTAGE:i.)It is very simple to understand and easy to operate. ii.)It uses the entire earnings of a project in calculating rate of return and not only the earnings upto payback period and hence gives a better view of profitability as compared to pay back period method. iii.)As this method is based upon accounting concepts of profits, it can be readily calculated from the financial data. DISADVANTAGE:-

The figure shows that present value of Interest tax shield increases with increase in borrowing but 50 does the present value of financial distress. However, the cost of financial distress are quite insignificant at moderate level of debt, therefore the value of the firm increase with debt. With more an dmore debt, the cost of financial distress increases and therefore, tax benefit shrinks. The optimum point is reached when the Present Value of the tax benefit becames equal to the present value of the costs of financial distress. The Value of the firm is Maximum at this point.

- 29 -Page 29 of 29 i.)This method also like pay back method ignores the time value of money as profits earned at different points of time are given equal weight by arranging the profits. ii.)It does not take into consideration the cash flows which are important than the accounting profits.
Is Equity Capital without Cost: Equity shareholders are the real risk bearers of a firm. They are the residual holders of all the profits of a firm and they have got voting rights still distributing dividends to them is at the discretion of the company management. But it does not mean that they need not be given dividend. The reason being, if they are not given dividend or regularity is not maintained in distributing dividend to them, they may not be interested in their investment in the company and may shift their investment to other companies. Hence, it is in the interest of maintaining the wealth of the company shareholders intact that they are distributed dividends at least equal to opportunity cost of capital. This becomes a cost to the company. There are various measures of cost: Earnings model Dividend model at normal growth Supernormal growth model Average residual income model CAPM model Also the value of retained earnings should be calculated as it is the undistributed income which actually belongs to equity shareholders. AGENCY COSTS Company form of organization involves separation of ownership and control. Shareholders are scattered at distant places far and wide and the actual management is entrusted to the managers of the firm. This becomes the cause of conflict between both the parties. Due to distance from the managerial activities shareholders lack trust on the managers regarding their truthfulness in managing the affairs of the firm and feel that they might be using resources to their own benefit. Debtholders also feel the same way. This distrust causes repeated checking on the affairs of the company which involves cost titled as agency costs. The term agency is used since managers act as agent of the shareholders and debtholders of the firm in managing the affairs of the firm.