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aims at procuring and judiciously utilising the financial resources with a view to maximising the value of the firm thereby the value of the owners i.e., equity shareholders in a company is maximised. Approaches to Finance Function • Providing of funds needed by a business on most suitable terms (This approach confines only to raising of funds • !econd "pproach relates finance function to cash. This approach implies that finance function is related to every activity in the business • Third approach to this function envisages the raising of funds and their effective utilisation. To conclude, finance function covers financial planning, rising of funds, allocation of funds, financial control. Aims of Finance Function "cquiring sufficient funds Proper utilisation of funds Increasing profitability #aximising concern$s value Scope or Content of Finance function %stimating financial requirements &eciding the capital structure !electing a !ource of finance
!electing a pattern of investment Proper cash management Implementing financial controls Proper use of surpluses. Organisation chart of finance function
Financial Management Meaning 'inancial management refers to that part of management activity which is concerned with the planning and controlling of form$s financial resources. It deals with the finding out various sources for raising funds for the firm. Financial management is that managerial activity which is concerned with the planning and controlling of the firm$s financial resources. It is an integrated decision ma(ing process concerned with acquiring, financing and managing assets to accomplish the overall goal of a business organisation. It can also be stated as the process of planning decisions in order to maximise the shareholder$s wealth. 'inancial managers have a major role in cash management, acquisition of funds and in all aspects of raising and allocating capital. "s far as business organisations are concerned, the objective of financial management is to maximise the value of business. Definition: )'inancial management comprises the forecasting, planning, organising, directing, co*ordinating and controlling of all activities relating to acquisition and application of the financial resources of an underta(ing in (eeping with its financial objective.+ This definition of financial management by ,aymond -hambers aptly sums up the vital role played by it in any organisation. SCOPE OF FINANCIA MANA!EMEN" "s an integral part of the overall management, financial management is mainly concerned with acquisition and use of funds by an organi.ation. /ased on financial management guru %.ra !olomon$s concept of financial management, following aspects are ta(en up in detail under the study of financial management0 a# &etermination of si.e of the enterprise and determination of rate of growth. $# &etermining the composition of assets of the enterprise.
c# &etermining the mix of enterprise$s financing i.e. consideration of level of debt to equity, etc. %# "nalyse planning and control of financial affairs of the enterprise.
The scope of financial management has undergone changes over the years. 1ntil the middle of this century, its scope was limited to procurement of funds under major events in the life of the enterprise such as promotion, expansion, merger, etc. In the modern times, the financial management includes besides procurement of funds, the three different (inds of decisions as well namely, investment, financing and dividend. "ll the three types of decisions would be dealt in detail during the course of this chapter. The given figure depicts the overview of the scope and functions of financial management. It also gives the interrelation between the mar(et value, financial decisions and ris( return trade off. The financial manager, in a bid to maximi.e shareholders$ wealth, should strive to maximi.e returns in relation to the given ris(2 he should see( courses of actions that avoid unnecessary ris(s. To ensure maximum return, funds flowing in and out of the firm should be constantly monitored to assure that they are safeguarded and properly utili.ed.
"he $asic o$&ecti'e centers on: Procurement of funds from various sources li(e, %!-, P!-, debentures, term loans and bonds %ffective utilisation of the funds to maximise the profitability of the firm and wealth of its owners. Functions of a Finance Manager : The twin aspects, procurement and effective utilisation of funds are crucial tas(s faced by a finance manager. The financial manager is required to loo( into the financial implications of any decision in the firm. Thus all decisions involve management of funds under the purview of the finance manager. " large number of decisions involve substantial or material changes in value of funds procured or employed. The finance manager, has to manage funds in such a way so as to ma(e their optimum utilisation and to ensure their procurement in a way that the ris(, cost and control are properly balanced under a given situation. 3e may not, be concerned with the decisions, that do not affect the basic financial management and structure. The nature of job of an accountant and finance manager is different, an accountant4s job is primarily to record the business transactions, prepare financial statements showing results of the organisation for a given period and its financial condition at a given point
liabilities. "n assessment has to be made regarding requirements of wor(ing capital involving. 'orecasting the requirements of funds is done by use of techniques of budgetary control and long range planning. investment in fixed assets and so on. each source of funds involves different issues for consideration.of time. " proper mix of the various sources is to be wor(ed out. "sset management policies are to be laid down regarding various items of current assets. . The finance manager or controller has a tas( entirely different from that of an accountant. !ome of the important decisions as regards finance are as follows 0 () Estimating the re)uirements of fun%s : " business requires funds for long term purposes i. "ccountant is not concerned with management of funds that is a specialised tas( and in modern times a complex one. *) Decision regar%ing capital structure : 5nce the requirements of funds is estimated. incomes and expenses are properly grouped. 6ong term funds are used in a project for fixed and also current assets. %stimates of requirements of funds can be made only if all the physical activities of the organisation are forecasted. while (eeping in mind the requirement of production and future price estimates of raw materials and availability of funds. estimation of amount of funds bloc(ed in current assets and that li(ely to be generated for short periods through current liabilities. 3e is to maintain a proper balance between long and short term funds and to ensure that sufficient long*term funds are raised in order to finance fixed assets and other long*term investments and to provide for permanent needs of wor(ing capital. The investment of funds in a project is to be made after careful assessment of various projects through capital budgeting. 3e is to record various happenings in monetary terms to ensure that assets. that the company is able to procure funds at minimum cost and is able to tolerate shoc(s of lean periods. a decision regarding various sources from where the funds would be raised is to be ta(en. " part of long term funds is also to be (ept for financing wor(ing capital requirements. " careful estimate of such funds is required to be made. classified and disclosed in the financial statements. The finance manager has to carefully loo( into the existing capital structure and see how the various proposals of raising funds will affect it.e. In the overall volume of long*term funds. inventory policy is to be determined by the production and finance manager. he is to maintain a proper balance between own and loan funds and to see that the overall capitalisation of the company is such. he is to manage funds. "ll these decisions are (nown as 4financing decisions4. +) In'estment %ecision : 'unds procured from different sources have to be invested in various (inds of assets. They can be translated into monetary terms.
of fun%s to all parts of the organisation or cash management : The finance manager has to ensure that all sections i. units or departments of the organisation are supplied with adequate funds. 3e has to furnish a lot of information to these institutions and persons in order to ensure that raising of funds is within the statutes. 7egotiations for outside financing often requires specialised s(ills. /) E'aluating financial performance : #anagement control systems are usually based on financial analysis.) Di'i%en% %ecision : The finance manager is concerned with the decision to pay or declare dividend. factories. . %ven if one of the many branches is short of funds. " finance manager has to constantly review the financial performance of various units of the organisation. the whole business may be in danger. O67EC"I8ES OF FINANCIA MANA!EMEN" . it involves a large number of considerations. cash management and cash disbursement policies are important with a view to supplying adequate funds at all times and points in an organisation. branches. 3e is to assist the top management in deciding as to what amount of dividend should be paid to the shareholders and what amount be retained by the company. tax position of share holders. It should ensure that there is no excessive cash.. thus.g. 1) 2eeping in touch 3ith stoc4 e5change )uotations an% $eha'ior of share prices : It involves analysis of major trends in the stoc( mar(et and judging their impact on share prices of the company4s shares.5I (return on investment system of divisional control. The principal function of a finance manager relates to decisions regarding procurement. also considerations li(e trend of earnings. "n adequate supply of cash at all points of time is absolutely essential for the smooth flow of business operations. !ections having excess funds contribute to the central pool for use in other sections that needs funds. the trend of share mar(et prices.e. e. and so on to be (ept in mind. ban(s and public depositors. -) Suppl. "nalysis of the financial performance helps the management for assessing how the funds are utilised in various divisions and what can be done to improve it. cash flow situation. 0) Financial negotiations : 'inance manager4s major time is utilised in carrying out negotiations with financial institutions. requirement of funds for future growth. investment and dividends. the amount to be retained or be paid to the shareholders should depend on whether the company or shareholders can ma(e a more profitable use of resources. %conomically spea(ing.
a company cannot survive for long. It is a barometer to measure the efficiency and economic prosperity .ation of ris(s involved. yet if the returns begin to flow say 89 years later. then ris( factor is altogether ignored. society. Proposal " may give a higher amount of profits as compared to proposal /. If profit is given undue importance. is to be seen as to whether or not it gives maximum profit. 3owever. If profit maximisation is the only goal. It is at best a limited objective. %ach alternative. This implies that finance manager will accept highly ris(y proposals also. ris( is very important consideration and has to be balanced with the profit objective. Profit maximisation at the cost of social and moral obligations is a short sighted policy. It does not clarify what exactly it means. proposal / may be preferred which may have lower overall profit but the returns flow is more early and quic(. This implies that the finance manager has to ma(e his decisions in a manner so that the profits of the concern are maximised. #any ris(y propositions yield high profit. "lthough various objectives are possible but we assume two objectives of financial management for elaborate discussion. profit maximisation cannot be the sole objective of a company. Arguments in fa'our of profit Ma5imisation 8. higher is the possibility of profits. There is a direct relationship between ris( and profit.%fficient financial management requires the existence of some objectives or goals because judgment as to whether or not a financial decision is efficient must be made in the light of some objective. Profit maximisation has to be attempted with a reali. 'or example. hence the objective of financial management is also profit maximisation. a number of problems can arise. 3igher the ris(. consumers. if they give high profits. Profit maximisation as an objective is too narrow. however. as well as ethical trade practices. If these factors are ignored. !ome of these have been discussed below0 The term profit is vague. In practice. These are0 (# P9OFI" MA:IMISA"ION It has traditionally been argued that the objective of a company is to earn profit. It fails to ta(e into account the social considerations as also the obligations to various interests of wor(ers. It conveys a different meaning to different people. profit may be in short term or long term period2 it may be total profit or rate of profit etc. Profit maximisation as an objective does not ta(e into account the time pattern of returns. therefore.
dividends and %P! . It helps to achieve social goals =. " firm will be able to survive the adverse business conditions only if it has earnings to face the situation. -redibility of the firm increases ?. The maximisation of wealth is possible by ma(ing decisions of the firm to get benefits that exceed cost. It motivates investment >. .:. It ta(es into consideration the time and the ris( of effected benefits. The 7P@ of a course of "ction is the difference between the present value of its benefits and the present value of its cost.. It facilitates growth <. The wealth maximisation is not only for the shareholders but also for the sta(e holders "he .M goals a%'ocate% on the follo3ing groun%s: It ta(es into consideration the long*run survival and growth of the firm It is consistent with the object of owners economic welfare It suggests the consistent dividend payments to the shareholders The financial decisions result in the capital appreciation It considers ris( and time value of money It considers all future cash flows. !toc( prices will go up in the mar(et Arguments against profit ma5imisation The concept profit is very vague It ignores ris( factor and timing of returns It may allow decision to be ta(en at the cost of 6ong*run stability and profitability of the concern It emphasises more on the short run profitability and short run projects It fails to consider the social responsibility .ealth Ma5imisation It means maximising the 7et Present @alue (or wealth of a course of action.
. The !hare holder wealth is maximised only if mar(et share increases. Profit #aximisation partly enables the firm in wealth maximisation !hareholders prefer A# to P# Criticisms The society$s resources are used to the advantage of a particular firm.or4s< 5f course.h. mar(et share. It facilitates in maximising the value of equity share which serves as an index of the performance of the company. sales.ealth Ma5imisation . hence A# is redefined as value maximisation Other ma5imisation of o$&ecti'es !ales #aximisation Browth #aximisation . retention policies. society welfare is criticised It is a prescriptive idea than a descriptive one .eturn on investment maximisation !ocial objectives Broup of objectives ( Production. hence. profit . level of gearing. there are other goals too li(e0 • "chieving a higher growth rate • "ttaining a larger mar(et share • Baining leadership in the mar(et in terms of products and technology • Promoting employee welfare • Increasing customer satisfaction 8alue ma5imi=ation The primary objective of '# is to maximise the value of the firm. inventory. The maximisation of firm$s value is reflected in the mar(et price of share. ris( dividend. It ta(es into consideration the present and the future earnings.
" part of long term funds is also to be (ept for financing the wor(ing capital requirements. medium and long term objectives "o achie'e 3ealth ma5imi=ation> the finance manager has to ta4e careful %ecision in respect of: ". • In'estment %ecisions "scertainment of the total volume of funds. 'unds procured from different sources have to be invested in various (inds of assets. The investment of funds in a project has to be made after careful assessment of the various projects through capital budgeting.eturn on -apital employed or .5I @alue addition and profitability Browth in %P! and P% ratio Browth in #@ of !hare Browth in &ividends 5ptimum level of leverage !urvival and growth of the firm #inimisation of finance charges %ffective utilisation of !hort. a firm can commit "ppraisal and selection of capital investment proposals #easurement of ris( and uncertainty in the investment proposal . 6ong term funds are used in a project for various fixed assets and also for current assets.pes of %ecisions (# In'estment %ecisions: These decisions determine how scarce resources in terms of funds available are committed to projects which can range from acquiring a piece of plant to the acquisition of another company. The inventory policy would be determined by the production manager and the finance manager (eeping in view the requirement of production and the future price estimates of raw materials and the availability of funds. "sset management policies are to be laid down regarding various items of current assets.Financial o$&ecti'es of a firm: .
reduce or cancel out the ris( in another investment available to him. !uch managers also need to have a very clear understanding as to the difference between profit and cash flow.e. e. 'or example.aising of funds through various instruments "rrangement of funds through various institutions . bearing in mind that profit is of little avail unless the organisation is adequately supported by cash to pay for assets and sustain the wor(ing capital cycle. and the manager must be well aware of the various protective procedures such as hedging (it is a strategy designed to minimi.e. Prioritisation of investment decisions 'und allocation and its rationing &etermination of fixed assets to be acquired &etermination of the level of investments and its management /uy or lease decisions "sset replacement decisions . " major area for ris(*related decisions is in overseas trading. and needs to ensure that the company has a sound capital structure. #T C !T funds . The financial manager needs to possess a good (nowledge of the sources of available funds and their respective costs. • Finance Decisions &etermination of the degree or level of gearing &etermination of the pattern of 6T. mergers and acquisitions !ecurities analysts and portfolio management *# Financing %ecisions: These decisions relate to acquiring the optimum finance to meet financial objectives and seeing that fixed and wor(ing capital are effectively managed. where an organisation is vulnerable to currency fluctuations.estructuring. i. 'inancing decisions also call for a good (nowledge of evaluation of ris(.g. excessive debt carried high ris( for an organisation$s equity because of the priority rights of the lenders. someone who has a shop ta(es care of the ris( of the goods being destroyed by fire by hedging it via a fire insurance contract. reorganisation. a proper balance between equity capital and debt.
-onsideration of cost of capital of individual component and weighted average cost of capital to the firm 5ptimisation of finance mix to improve returns Portfolio management -onsideration of the impact of under capitalisation and over capitalisation -onsideration for foreign exchange ris( exposure /alance between owner$s capital and outside capital %valuation of alternative use of funds . • &ividend decisions &etermination of dividend and retention policies of the firm -onsideration of the impact of the levels of dividend and retention of earnings on the mar(et value of the share and the future earnings of the company -onsideration of possible requirements of funds by the firm for expansion and diversification proposals for financing existing business requirements . -onsideration of interest burden -onsideration of debt level changes and firm$s ban(ruptcy Ta(ing advantage of interest and depreciation in reducing the tax liability of the firm -onsidering the various modes on improving the %P! and mar(et value of the share.ation loo(s for reward for his investment in two ways. The owner of any profit*ma(ing organi. the growth of the capital invested and the cash paid out as income2 for a sole trader this income would be termed as drawings and for a limited liability company the term is dividends.eview of performance by analysis. +# Di'i%en% %ecisions: These decisions relate to the determination as to how much and how frequently cash can be paid out of the profits of an organisation as income for its ownersDshareholders.
-ost of capital includes the cost of debt and the cost of equity. borrowing.e. It can also be said as the required return necessary to ma(e a capital budgeting project * such as building a new factory * worthwhile. It can also be stated as the opportunity cost of an investment.econsideration of distribution and retention policies in boom and recession period -onsidering the impact of legal and cash flow constraints on dividend decisions ( III DEFINI"ION OF COS" OF CAPI"A -ost of capital may be defined as the cut off rate for determining estimated future cash proceeds of a project and eventually deciding whether the project is worth underta(ing or not. the rate of return that a company would otherwise be able to earn at the same ris( level as the investment that has been selected. . heDshe expects to see a return on that investment. since this represents the opportunity cost for investing in assets with the same ris( as the firm. It is also the minimum rate of return that a firm must earn on its investment which will maintain the mar(et value of share at its current level. This is the rate of return that a firm would receive if it invested its money someplace else with similar ris(. !ince the individual expects to get bac( more than hisDher initial investment. The cost of capital determines how a company can raise money maybe through a stoc( issue. or the money that the company misses out on by selling its stoc(. the cost of capital is equal to this return that the investor receives. i. when an investor purchases stoc( in a company. Ahen investors are shopping for places in which to invest their funds. or a mix of the two. they have an . 'or example. "nother way to thin( of the cost of capital is as the opportunity cost of funds.
options. "s a result. If the firm does not achieve the return investors expect (i.opportunity cost. investors will not invest in the firm$s debt and equity. Ec F Aeighted cost of capital for the firm G F &ebt to capital ratio. The cost of capital is given as0 EcF (8*G EeH dEd Ahere. the firm$s value (both their debt and equity will decline. must strive to earn the investor$s opportunity cost. The total capital for a firm is the value of its equity plus the cost of its debt (the cost of debt should be continually updated as the cost of debt changes as a result of interest rate changes .ero*level ris( Premium for 'inance ris( Premium for /usiness ris( (EFroH b Hf Significance of the cost of capital: As an Acceptance criterion in Capital 6u%geting ? the acceptance or rejection of the project is decided by ta(ing into consideration the cost of capital As a %eterminant of capital mi5 in capital structure %ecision * the objective of maximising the value of the firm and minimi. & D (& H % Ee F -ost of equity E& F after tax cost of debt & F #ar(et value of the firm4s debt. the investor$s opportunity cost . including ban( loans and leases % F #ar(et value of all equity (including warrants. . The firm. and the equity portion of convertible securities 6asic aspects of the %efinition -ost of -apital is not a cost as such*it is the rate of return firm needs to earn from its project It is the minimum rate of return* which will at least maintain the mar(et value of shares It comprises of three components* The expected normal rate of return at .e. given its ris(iness.ing the cost of capital results in optimal capital structure As a $asis for e'aluating the financial performance@ the profitability is compared to projected overall cost of capital and the actual cost of capital of funds raised to finance the project.
wor(ing capital. As a $asis for ta4ing other financial %ecisions@ 6i(e &ividend policy..are /oo( cost related to past. "s more than one type of capital is used in a company. the composite cost of capital can be determined after the cost of each type of funds has been obtained. It is the A"--. The explicit cost of any source of capital may be defined as the discount rate that equals that present value of the cash inflows that are . Classification of cost: Aistorical an% future cost: 3. it is the cost foregone in order to ta(e up a particular project. Problems with regard to considering the various costs Problems in computing the cost of equity0 it is a difficult tas( to calculate the expected rate of return on equity. while composite cost is combined cost of various sources of capital. therefore. 'uture cost is the estimated cost related to the future. it is I. Problems in computing cost of retained earnings0 (5pportunity cost of dividends of shareholders is ignored often Problems in assigning weights MEASB9EMEN" OF COS" OF CAPI"A The cost of capital is useful in determining a financial plan. Implicit cost is also (nown as opportunity cost.and increase the value of the firm by debt financing.is the discount rate which equates the P@ of cash inflows in other words.refers to cost of a specific source of capital. recognition should be given to the explicit and the implicit cost. A'erage cost an% marginal cost0 ".is the combined cost of various sources of capital2 #. In order to calculate the specific cost of each type of capital..is the average cost of capital which has to be incurred to obtain additional funds required by the firm. Specific an% composite cost0 !. " company has to employ a combination of creditor$s and owner$s funds. 5thers believe that the cost of capital is unaffected by the changes in the capital structure. the calculation of specific cost which is the minimum financial obligation required to secure the use of capital for a particular source. ma(ing the rights issue. in case of more than one form of source of capital composite cost is resorted to E5plicit cost an% implicit cost: %. capitalisation of profits. Pro$lems in %etermination of COC: -onceptual controversies regarding the relationship between the cost of capital and the capital structure0 few are of the opinion that a firm can minimise the A"-. The first step is.
called maturity period. The explicit cost arises when funds are raised and when funds are used. " bond or debenture is generally issued at a par value of . and interest is paid on face value. 899 or . In the case of a bond or debenture. implicit cost arises. "he chief characteristics of a $on% or %e$enture are as follo3s: 'ace value0 'ace value is called par value. Mar4et 'alue: " bond or debenture may be traded in a stoc( exchange. but they are not free from the ris( of default. " company in India can issue secured or unsecured debentures. %ach source of finance has been discussed in detail. COS" OF ECBI"D It may prima facie appear that equity capital does not carry any cost. The price at which it is currently sold or bought is called the mar(et value of the bond or debenture. -oupons are detachable certificates of interest.: " bond or debenture is generally issued for a specified period of time.s. 9e%emption 'alue0 The value that a bondholder or debenture holder will get on maturity is called redemption or maturity value. 'or capital budgeting decisions. Interest rate: Interest rate is fixed and (nown to bondholders or debenture holders. If . #ar(et value may be different from par value or redemption value. The principal of a redeemable bond or bond with a maturity is payable after a specified period.e. which are also called debentures in India. Interest paid on a bond or debenture is tax deductible. It is repaid on maturity.incremental to the ta(ing of financing opportunity with the present value of its incremental cash outflows. /ut this is not true. The mar(et share price is a function of return that equity shareholders expect and get. The private sector companies also issue bonds. cost of capital is nothing but the explicit cost of capital. The government honour obligations on its bonds. COS" OF DE6" " bond is a long term debt instrument or security.s. The interest rate is also called coupon rate. /onds of the public sector companies in India are generally secured. Maturit. Implicit cost is the rate of return associated with the best investment opportunity for the firm and its shareholders that will be foregone if the project presently under consideration by the firm was accepted. 7ow the different components of cost of capital i. /onds issued by the government do not have any ris( of default. 8. the rate of interest is generally fixed and (nown to investors. " bond or debenture may be redeemed at par or at premium (more than par value or at discount (less than par value .999.
3owever. "ccordingly. This approach also . "lso. The calculation of equity capital cost raises a lot of problems. it is relatively the highest cost of capital. Its purpose is to enable the corporate manager. In theory the management strives to maximi. ($) EarningE Price Approach: The advocates of this approach co*relate the earnings of the company with the mar(et price of its share. &ifferent methods are employed to compute the cost of equity capital. 899. !ince expectations of equity holders are high. whether distributed or not from the company in whose shares he invests. This approach is similar to the dividend price approach2 only it see(s to nullify the effect of changes in the dividend policy. it will have an adverse effect on the mar(et share price. this method cannot be used to calculate cost of equity of units suffering losses.s for each share of . if an investor expects that the company in which he is going to subscribe for shares should have at least a :9I rate of earning.the company does not meet their requirements. Thus.e the position of equity holders and the effort involves many decisions. to ma(e decisions in the best interest of equity holders. higher cost is associated with it.9I the investor will be . -ost of equity capital is the rate of return which equates the present value of expected dividends with the mar(et share price. cost of equity capital is computed by dividing the current dividend by average mar(et price per share. This dividend price ratio expresses the cost of equity capital in relation to what yield the company should pay to attract investors. the cost of ordinary share capital would be based upon the expected rate of earnings of a company. (a) Di'i%en% Price Approach: 3ere. The argument is that each investor expects a certain amount of earnings. !uppose the company is expected to earn . the cost of ordinary share capital can be construed on this basis.s.
rate of growth of dividend subsequently depends on director$s attitude. (e) 9eali=e% Diel% Approach: "ccording to this approach. (c) Di'i%en% Price F !ro3th Approach: %arnings and dividends do not remain constant and the price of equity shares is also directly influenced by the growth rate in dividends. (d Earnings Price F !ro3th Approach: This approach is an improvement over the earlier methods. /ut even this method assumes that dividend will increase at the same rate as earnings. Ahere earnings.ed in the past few years are historically regarded as Jexpected return$ in the future. 3owever. rate of dividend is recommended by the /oard of &irectors and shareholders cannot change it.does not seem to be a complete answer to the problem of determining the cost of ordinary share since it ignores the factor of capital appreciation or depreciation in the mar(et value of shares. the average rate of return . in actual practice. this approach provides a single mechanism of calculating cost of equity. . The dividend method should. be modified by substituting earnings for dividends. it has unrealistic assumptions.eali. this method is not practical. dividends and equity share price all grow at the same rate. therefore. Thus. If the earnings do not remain stable. & F -urrent dividend per share P F #ar(et price per share B F "nnual growth rate of earnings of dividend. The yield of equity for the year is0 Though. the cost of equity capital may be computed as follows0 Ee F (&DP H B Ahere. and the equity share price is the regulator of this growth as deemed by the investor.
Thus. Ee F -ost of equity capital 'or F . The non*diversifiable ris( is assessed in terms of beta coefficient (b or K through fitting regression equation between return of a security and the return on a mar(et portfolio. The diversifiable ris( can be eliminated through a portfolio consisting of large number of well diversified securities. F .ate of return on security b F /eta coefficient #r.(f) Capital Asset Pricing Mo%el Approach (CAPM): This model describes the linear relationship between ris( and return for securities. the cost of equity capital can be calculated under this approach as0 Ee F 'ro H b (#r. L 'ro Ahere. The ris( a security is exposed to be diversifiable and non*diversifiable.ate of return on mar(et portfolio .
the capital asset pricing approach is useful in calculating cost of equity. the whole question of determining the cost . then the investment should not be underta(en.Therefore. If this expected return does not meet or beat the required return. Therefore. The shortcomings of this approach are0 (a %stimation of betas with historical data is unrealistic2 and (b #ar(et imperfections may lead investors to unsystematic ris(. even when the firm is suffering losses. This is calculated by ta(ing a ris( measure (beta which compares the returns of the asset to the mar(et over a period of time and compares it to the mar(et premium. The time value of money is represented by the ris(*free rate in the formula and compensates the investors for placing money in any investment over a period of time. The basic factor behind determining the cost of ordinary share capital is to measure the expectation of investors from the ordinary shares of that particular company. &espite these shortcomings. required rate of return F ris( free rate H ris( premium The idea behind -"P# is that investors need to be compensated in two ways* time value of money and ris(. The other half of the formula represents ris( and calculates the amount of compensation the investor needs for ta(ing on additional ris(. The -"P# says that the expected return of a security or a portfolio equals the rate on a ris(*free security plus a ris( premium.
The cost of capital is the expected return to equity owners (or shareholders and to debt holders.e. a weighted average technique may be used in a quasi* marginal way to evaluate a proposed investment project.of ordinary shares hinges upon the factors which go into the expectations of particular group of investors in a company of a particular ris( class. it can be seen how much interest the company has to pay for every rupee it borrows. represents the investors$ opportunity cost of ta(ing on the ris( of putting money into a company.ACC) "s you (now the capital funding of a company is made up of two components0 debt and equity.EI!A"ED A8E9A!E COS" OF CAPI"A (. the after tax cost of each debt and equity is -alculated separately and added together to a single overall cost of capital. . and bonds. Thus. That is. Thus. Ahat percentage of debt comes from retained earnings. This is the weighted average cost of capital. preference shares. . weighted average cost of capital is the weighted average after tax costs of the individual components of firm$s capital structure. !ince every company has a capital structure i. 6enders and equity holders each expect a certain return on the funds or capital they have provided. equity shares. A"--. so weighted average cost of capital tells the return that both sta(eholders Mequity owners and lenders * can expect. so by ta(ing a weighted average. in other words. such as the construction of a new building. The weighted average cost of capital for a firm is of use in two major areas0 in consideration of the firm$s position and in evaluation of proposed changes necessitating a change in the firm$s capital.
The cost of weighted average method is preferred because the proportions of various sources of funds in the capital structure are different.can be used as a hurdle rate against which to assess return on investment capital performance. A"-. A"-. 6et4s say a company produces a return of :9I and has a A"-. To be representative. !ecurities analysts employ A"-. The A"-. A"-. if the company4s return is less than A"--.serves as a useful reality chec( for investors. Investors use A"-. /y contrast.all the time when valuing and selecting investments. the company is shedding value. In discounted cash flow analysis. therefore. .is used as the discount rate applied to future cash flows for deriving a business4s net present value.represents the minimum rate of return at which a company produces value for its investors. It also plays a (ey role in economic value added (%@" calculations. which indicates that investors should put their money elsewhere. cost of capital should ta(e into account the relative proportions of different sources of finance. Therefore.of 88I.as a tool to decide whether or not to invest.
and that these securities are issued at mar(et value.CA CB A"ION OF .ACC !o the A"-. The validity of the assumption of historical weighting is that choosing between the boo( value weights and mar(et value weights. /ut there are problems in determination of weighted average cost of capital. These mainly relate to computation of equity capital and the assignment of weights to the cost of specific source of financing.of this company is ?. The most serious limitation of marginal weighting is that it does not consider the long run implications of firm$s current financing.N=I. sound and a better indicator of firm$s capital structure. The desirable practice is to employ mar(et weights to compute the firm$s cost of capital. Ahile the boo( value weights may be operationally convenient. not at boo( value. the mar(et value basis is theoretically more consistent. . "ssignment of weights can be possible either on the basis of marginal weighting or historical weighting. This rationale rests on the fact that the cost of capital measures the cost of issuing securities M stoc(s as well as bonds M to finance projects.
sales revenue. Aith fixed costs the percentage change in profits accompanying a change in volume is greater than the percentage change in volume.( I@ e'erage: 6everage refers to the ability of a firm in employing long term funds having a fixed cost. to increase the potential return of an investment. The higher the turnover of operating assets. %arnings before Interest and Tax (%/IT . In other words. Operating le'erage is a function of three factors: (i . The use of assets for which a company pays a fixed cost is called operating leverage. The use of various financial instruments or borrowed capital. leverage is the amount of debt that a firm uses to finance its assets. "DPES OF E8E9A!E The term 6everage in general refers to a relationship between two interrelated variables. %arning per share (%P! etc. These financial variables may be costs. In financial analysis it represents the influence of one financial variable over some other related financial variable. the greater will be the revenue in relation to the fixed charge on those assets. .upee amount of fixed cost. to enhance returns to the owners. output. There are three commonly used measures of leverage in financial analysis. These are0 (i) 5perating 6everage (ii) 'inancial 6everage (iii) -ombined 6everage OPE9A"IN! E8E9A!E 5perating leverage (56 maybe defined as the employment of an asset with a fixed cost in the hope that sufficient revenue will be generated to cover all the fixed and variable costs.
5perating leverage is the ratio of net operating income before fixed charges to net operating income after fixed charges. This can be illustrated graphically as0 .(ii @ariable contribution margin. 5. #ore operating leverage leads to more business ris(. 5perating leverage is directly proportional to business ris(. and (iii @olume of sales. &egree of operating leverage is equal to the percentage increase in the net operating income to the percentage increase in the output. for then a small sales decline causes a big profit.
'inancial leverage involves the use of funds obtained at a fixed cost in the hope of increasing the return to common stoc(holders. . it is the use of company funds on which it pays a limited return.$ In other words. &egree of financial leverage is the ratio of the percentage increase in earnings per share (%P! to the percentage increase in earnings before interest and taxes (%/IT .FINANCIA E8E9A!E: 'inancial leverage ('6 maybe defined as Jthe use of funds with a fixed cost in order to increase earnings per share.
&egree of combined leverage (&-6 is the ratio of percentage change in earning per share to the percentage change in sales. It indicates the effect the sales changes will have on %P!. .estriction from financial instruments DE!9EE OF COM6INED E8E9A!E -ombined leverage maybe defined as the potential use of fixed costs. Significance of financial le'erage: Planning of capital structure Profit planning imitations of F E tra%ing on e)uit. they will get additional earnings without increasing their own investment. which magnifies the effect of sales volume change on the earning per share of the firm. -onsequently. if the firm acquires fixed cost funds at a higher cost than the earnings from those assets then the %P! and return on equity capital will decrease. &ouble*edged weapon /eneficial only to companies having stability in earnings Increases ris( and rate of interest .Impact of financial le'erage: Ahen the dDf bDw the earnings from assets financed by fixed cost funds and costs of these funds are distributed to the equity stoc(holders. 5n the contrary. both operating and financial.ate of return on %!will go up. the %P! and the .
certainty with which the profits will accrue after the underta(ing commences commercial production and the li(ely quantum of return on investment. This is due to varying circumstances of various business underta(ings. internal sources. what should be the proportion of equity share capital. It is thus. important to understand that different types of capital structure would be required for different types of underta(ings.Cuestion : E5plain the concept of capital structure < Ans3er : " finance manager for procurement of funds. . is required to select such a finance mix or capital structure that maximises shareholders wealth. nature of industry. so that the overall cost of capital is minimum. gestation period. -apital structure refers to the mix of sources from where long term funds required by a business may be raised i. preference share capital. -apital structure depends primarily on a number of factors li(e. following must be referred to 0 8 There is no definite model that can be suggestedDused as an ideal for all business underta(ings.e. 'or designing optimum capital structure he is required to select such a mix of sources of finance. debentures and other sources of funds in total amount of capital which an underta(ing may raise for establishing its business. In planning the capital structure.
they assist the management in determining the proportion of funds to be raised from various sources. rules and regulations for capital mar(et formulated by !%/I affect the capital structure decisions. when the company has selected such a combination of equity and debt. . the cost of capital is minimum and mar(et price per share is maximum. capital structure. In reality. that his ris( and cost are least and there is least dilution of control from the existing management. instead of optimum. !imilarly. so that the company4s wealth is maximum. The finance manager attempts to design the capital structure in a manner. : -apital structure should be such that the business does not run the ris( of insolvency.: Bovernment policy is a major factor in planning capital structure.) Sol'enc. "t this. a change in the lending policy of financial institutions may mean a complete change in the financial pattern. it is difficult to measure a fall in the mar(et value of an equity share on account of increase in ris( due to high debt content in the capital structure. mar(etability of the . +) Conser'ation : &ebt content in capital structure should not exceed the limit which the company can bear. The finance managers of business concerns are required to plan capital structure within these constraints. /ut. : The capitals structure should be such that the company is able to raise funds whenever needed. There are also subsidiary factors as. 'eatures of an appropriate capital structure are as below 0 () Profita$ilit. however. : The most profitable capital structure is one that tends to minimise financing cost and maximise of earnings per equity share. *) Fle5i$ilit. Cuestion : E5plain the ma&or consi%erations in the planning of capital structure < Ans3er : The . 'or instance. -) Control : -apital structure should be devised in such a manner that it involves minimum ris( of loss of control over the company. Optimum capital structure : The capital structure is said to be optimum. an appropriate capital structure is more realistic. cost and control. major considerations evident in capital structure planning are ris(.
a company stands committed to pay a higher amount of interest irrespective of the fact whether or not it has cash. Thus. "s compared to debentures. !tructuring capital. if return on investment remains higher than interest rate.is(s are of : (inds vi. the debt content is high in capital structure as the financial leverage wor(s both ways i. i. !uch ris( is absent in case of equity shares. &ebentures also increase the ris( of variation in expected earnings available to equity shareholders through leverage effect i. its ris( of cash insolvency increases. The factors involved in it are as follows 0 () 9is4 : . it enhances shareholders4 returns by a high magnitude or reduces it depending on whether the return on investment is higher or lower than the interest rate.issue. there is relative dispersion of expected earnings available to equity shareholders. even if sufficient cash to do so does not exist. as 0 a the higher proportion of debt in capital structure increases the commitments of the company with regard to fixed charges. 'inancial ris( is of : (inds as below 0 i) 9is4 of cash insol'enc.e. maneuverability and flexibility of capital structure and timing of raising funds. The debenture holders have a charge against the company4s assets and thus. : "s a business raises more debt. financial and business ris(. as the payment of . " company has to pay interest charges on debentures even in case of absence of profits. that would be greater if capital structure of a firm has a higher debt content. is a shrewd financial management decision and is something that ma(es or mars the fortunes of the company.e. shareholders get a high return and vice versa. and b the possibility that the supplier of funds may withdraw funds at any point of time.e. the ris( of variations in expected earnings available to equity shareholders would be higher2 due to trading on equity. There is a lower probability that equity shareholders get a stable dividend if. ii) 9is4 of 'ariation in the e5pecte% earnings a'aila$le to e)uit. long term creditors may have to be paid bac( in installments. In other words. preference shares entail a slightly lower ris( for the company. share@ hol%ers : In case a firm has a higher debt content in capital structure. they can enforce a sale of assets in case of company4s failure to meet its contractual obligations. The financial ris( involved in various sources of funds may be understood with the help of debentures. %ven the principal sum has to be repaid under the stipulated agreement..
This. as a company does not repay equity share capital except on its liquidation and may not declare dividends for years. financial ris( encompasses the volatility of earnings available to equity shareholders as also. preference shareholders can have voting rights and thereby affect the composition of /oard of directors. helps in deciding whether funds should be raised by internal equity or by borrowings. Preference shareholders are also entitled to a fixed rate of dividend. the control aspect is also an important factor for capital structure planning. it automatically dilutes the controlling interest of present owners. In case of . the company is said to trade on equity. . and it is to be (ept in view while deciding on the sources of finance. It is the finance manager4s main objective to see that the return and overall wealth of the company both are maximised.) "ra%ing on e)uit.dividends on such shares is contingent upon the earning of profits by the company. is more than the rate of interest on borrowed funds or rate of dividend on preference shares.e. : " company may raise funds by issue of shares or by borrowings. Thus. thus. It is thus. In the same manner. 'inancial institutions normally stipulate that they shall have one or more directors on the board. dividends are to be paid only in the year in which company earns profits. equity shares are least ris(y. 3owever. the probability of cash insolvency. along with ris(. the finance manager has to consider the cost of capital factor for determination of the capital structure. carrying a fixed rate of interest that is payable irrespective of the fact whether or not there is a profit. as seen here. but dividend payment is subject to the company4s profitability. preference shares increase the variations in expected earnings available to equity shareholders. by implication it agrees to forego a part of its control over the company. Thus. Ahen a company issues equity shares. . Thus. the effect of each proposed method of new finance on %P! is to be carefully analysed. 'rom the company4s view point. Thus. %ven in case of cumulative preference shares. %ven. obvious that decisions concerning capital structure are ta(en after (eeping the control factor in view. if dividends are not paid on such shares for : consecutive years. shareholders4 funds plus long term borrowings. their repayment is made only if they are redeemable and after a stipulated period. *) Cost of capital : -ost is an important consideration in capital structure decisions and it is obvious that a business should be atleast capable of earning enough revenue to meet its cost of capital and also finance its growth. when management agrees to raise loans from financial institutions.5I the total capital employed i. +) Control : "long with cost and ris( factors.
(() "iming : -losely related to flexibility is the timing for issue of securities. : To obtain a balanced capital structure. Proper timing of a security issue often brings substantial savings due to the dynamic nature of the capital mar(et. "lso. 1) Mar4eta$ilit. If it is incurred during the pre*commencement period.-) Corporate ta5ation : 1nder the Income tax laws. dividend on shares is not deductible while interest paid on borrowed capital is allowed as deduction. 5wing to such provisions. #onetary and fiscal policies of government also affect the capital structure decisions. -ost of share issue is allowed as deduction. In other words. -ost of raising finance through borrowings is deductible in the year in which it is incurred. (H) Fle5i$ilit. it is necessary to consider the company4s ability to mar(et corporate securities. 'or instance. a change in the lending policies of financial institutions would mean a complete change in the financial pattern followed by companies. G) Maneu'era$ilit. : It refers to the capacity of the business and its management to adjust to expected and unexpected changes in circumstances. the management would li(e to have a capital structure providing maximum freedom to changes at all times. Intelligent management tries to anticipate the climate in capital mar(et with a view to minimise cost of . it is to be capitalised. 0) egal re)uirements : The finance manager has to (eep in view the legal requirements at the time of deciding as regards the capital structure of the company. /) !o'ernment Policies : Bovernment policies is a major factor in determining capital structure. rules and regulations framed by !%/I considerably affect the capital issue policy of various companies. corporate taxation > plays an important role in determination of the choice between different sources of financing. It enables use of proper type of funds available at a given time and also enhances the bargaining power when dealing with the prospective suppliers of funds. : #aneuverability is required to have as many alternatives as possible at the time of expanding or contracting the requirement of funds.
(/) 9e)uirement of in'estors : &ifferent types of securities are issued to different classes of investors according to their requirement. (. it would be appropriate to raise them by issue of equity shares. they can issue different types of securities. In case funds are required for long term requirements say O to 89 years. it would be appropriate to raise borrowed funds. to some extent affects the capital structure of the company. etc. as they have adequate profits to pay interestDfixed charges. if the funds are required for non* productive purposes.raising funds and the dilution resulting from an issue of new ordinary shares. it would be appropriate to raise borrowed funds. (-) Nature of enterprise : The nature of enterprise to a great extent affects the company4s capital structure. (0) Pro'ision for future : Ahile planning capital structure the provision for future requirement of capital is also required to be considered. 5n the other hand. /usiness enterprises having stability in earnings or enjoying monopoly as regards their products may go for borrowings or preference shares. if the funds are required more or less permanently. hospitals. 3owever. if the funds are required more or less permanently. (*) Si=e of the compan. etc.) Perio% of Finance : The period for which finance is required also affects the determination of capital structure. (+) Purpose of financing : The purpose of financing also. Cuestion : !i'e in %etail the 'arious capital structure theories < . li(e welfare facilities to employees such as schools. the company may rely only on internal resources. : !mall companies rely heavily on owner4s funds while large companies are usually considered. to be less ris(y by investors and thus. 5n the contrary. In case funds are required for productive purposes li(e manufacturing. 3owever. companies not having assured income should preferably rely on internal resources to a large extent. the company may raise funds through long term sources.
Ans3er : " firm4s objective should be directed towards the maximisation of the firm4s value2 the capital structure or leverage decision are to examined from the view point of their impact on the value of the firm. if the degree of financial leverage increases. > There are no corporate or personal taxes. It is based on the following assumptions 0 i There are no corporate taxes. . . "ccording to it. < The operating profit of firm is given and expected to grow. In other words.. a firm can increase its value or lower the overall cost of capital by increasing the proportion of debt in the capital structure.everse would happen in a converse situation. ii The cost of debt is less than cost of equity or equity capitalisation rate. . The approaches are as below 0 () Net Income Approach (NI Approach) : The approach is suggested by &urand. There are no retained earnings implying that entire profits are distributed among shareholders. ? The investors have the same subjective probability distribution of expected earnings. = The business ris( is assumed to be constant and is not affected by the financing mix decision. : The total assets of the firm are given and the degree of leverage can be altered by selling debt to repurchase shares or selling shares to retire debt. There are broadly < approaches in the regard. under the following assumptions 0 8 There are only : sources of funds vi. the weighted average cost of capital would decline with every increase in the debt content in total funds employed. while the value of the firm will increase. a firm would li(e to have a capital structure that maximises the mar(et value of the firm. which analyses relationship between leverage. cost of capital and the value of the firm in different ways. If the value of the firm can be affected by capital structure or financing decision. debt and equity.
! F #ar(et value of equity 7I F %arnings available for equity shareholders E e F %quity -apitalisation rate 1nder. 5verall cost of capital F %/ITD@alue of the firm *) Net Operating Income Approach (NOI) : This approach is also suggested by &urand. according to it. The mar(et value of the firm is determined as 0 @ F %/ITD5verall cost of capital Ahere. the theory suggests total or maximum possible debt financing for minimising cost of capital. 7I approach. The value of the firm on the basis of 7et Income "pproach may be ascertained as follows 0 @ F ! H & Ahere. the mar(et value of the firm is not affected by the capital structure changes. @ F #ar(et value of the firm %/IT F %arnings before interest and tax ! F @ * & Ahere. The mar(et value of the firm is ascertained by capitalising the net operating income at the overall cost of capital. @ F @alue of the firm ! F #ar(et value of equity & F #ar(et value of debt ! F 7IDE e Ahere. which is constant. Thus.iii The use of debt content does not change the ris( perception of investors as a result of both the E d (&ebt capitalisation rate and E e (equity capitalisation rate remains constant. ! F @alue of equity & F #ar(et value of debt @ F #ar(et value of firm -ost of equity F %/ITD(@ * & . the value of a firm will be maximum at a point where weighted average cost of capital is minimum.
"t the optimal capital structure. if financial leverage increases beyond an acceptable limit. 1nder. thus. that the value of the firm can be increased by increasing financial leverage and 75I approach. 3owever. @ F #ar(et value of the firm %/IT F %arnings before interest and tax & F #ar(et value of debt It is based on the following assumptions 0 i The overall cost of capital remains constant for all degree of debt equity mix. the overall cost of capital will be minimum and the value of the firm is maximum. there is no optimal capital structure rather every capital structure is as good as any other and so every capital structure is optimal. Thus. The increasing cost of equity owing to increased financial ris( and increasing cost of debt ma(es the overall cost of capital to increase. also called an intermediate approach as it ta(es a midway between 7I approach. that the value of the firm increases with financial leverage upto a certain point. the advantage of debt is set off exactly by increase in equity capitalisation rate. v The cost of debt is constant. It further states. the overall cost of capital may still reduce. the split between debt and equity is not important. 75I approach since overall cost of capital is constant. The . This causes the equity capialisation rate to increase.Ahere. Thus. "ccording to this approach the firm should strive to reach the optimal capital structure and its total valuation through a judicious use of debt and equity in capital structure. the increase in financial leverage will increase cost of equity. consequently cost of debt also starts increasing. +) "ra%itional Approach : The traditional approach. iv There are no corporate taxes. Thus. ii The mar(et capitalises value of the firm as a whole. /eyond this. the ris( of debt investor may also increase. that the value of the firm is constant irrespective of the degree of financial leverage. as per the traditional approach the cost of capital is a function of financial leverage and the value of firm can be affected by the judicious mix of debt and equity in capital structure. iii The use of less costly debt funds increases the ris( of shareholders.
is determined from the level of shareholder4s expectations. cost of capital is the weighted average of cost of debt and cost of equity. In other words. thus. The total mar(et value of the firm is given by capitalising the expected stream of operating earnings at a discount rate considered appropriate for its ris( class. say 8= I from a particular company. Assumptions : . Thus. They argued. in support of their approach. They ma(e the following propositions 0 i The total mar(et value of a firm and its cost of capital are independent of its capital structure. iii The cut off rate for investment purposes is completely independent of the way in which the investment is financed. financial leverage has no impact on share mar(et prices nor on the cost of capital. they do not ta(e into account the debt equity ratio and they expect 8= I as they find that it covers the particular ris( which this company entails. expect a higher rate of return from the shares of the company. the ris( of the company increases. This is because. The financial ris( increases with more debt content in the capital structure. "s a result. a change in the debt*equity ratio changes the ris( element of the company. The cost of equity. Thus. each change in the debt equity mix is automatically set*off by a change in the expectations of the shareholders from the equity share capital. the total cost of capital of particular firm is independent of its method and level of financing. that as per the traditional approach. a change in the debt equity mix does not affect the cost of capital. since debt is a more ris(y mode of finance. "t this point. which in turn changes the expectations of the shareholders from the particular shares of the company. . that in the eyes of shareholders. ii The cost of equity (Ee is equal to the capitalisation rate of pure equity stream plus a premium for financial ris(. !uppose. this means. etc. That is if. #odigliani and #iller argued that the weighted average cost of capital of a firm is completely independent of its capital structure. #odigliani and #iller.) Mo%igliani an% Miller Approach(MM Approach) : "ccording to this approach. Thus. the debt content in the capital structure of the company increases.increase of financial leverage upto a point favourably affect the value of the firm. shareholders expect a particular rate of return. Ee increases in a manner to offset exactly the use of less expensive sources of funds. the capital structure is optimal C the overall cost of capital will be the least. the shareholders would now. argue that financial leverage has nothing to do with the overall cost of capital and the overall cost of capital is equal to the capitalisation rate of pure equity stream of its class of ris(.
financed by debt and equity. That is. #odigliani and #iller agree that while companies in different industries face different ris(s resulting in their earnings being capitalised at different rates. borrowing money to equate their personal leverage to the degree of corporate leverage in -ompany Q and use them for investing in -ompany P. ## hypothesis argue that through personnel arbitrage investors would quic(ly eliminate any inequalities between the value of leveraged firms and that of unleveraged firms in the same ris( class. it is not possible for these companies to affect their mar(et values. perfect mar(et and arbitrage assumption. while -ompany Q is financed by a combination of debt and equity. * There are no transaction costs. but. iii "ll investors have the same expectations from a firms4 %/IT that is necessary to evaluate the value of a firm. They belong to this class. * They behave rationally. The mar(et price of shares of -ompany Q would be higher than that of -ompany P. They contend that arbitrage will substitute personal leverage for corporate leverage. the total mar(et value must be same irrespective of proportion of debt in company4s capital structure. This means that investors are free to buy and sell securities. equals that of -ompany P. this assumption has been removed. -ompany P is financed by only equity and no debt.i * The capital mar(ets are assumed to be perfect. ii The firms can be classified into 4homogenous ris( class4. iv The dividend payment ratio is 899 I. The support for this hypothesis lies in the presence of arbitrage in the capital mar(et. v There are no corporate taxes. The basic argument . * They can borrow without restrictions on the same terms as the firms do. Criticism : These propositions have been criticised by numerous authorities. * They are well*informed about the ris(*return on all type of securities. there are no retained earnings.e. i. mar(et participants would ta(e advantage of difference by selling equity shares of -ompany Q. their overall capitalisation rate by use of leverage. and thus. financed by only equity. for a company in a particular ris( class. The sale of shares of -ompany Q reduces its price until the mar(et value of the company Q. if their expected earnings have identical ris( characteristics. #ostly criticism is as regards. 'or instance 0 There are : companies P and Q in the same ris( class.
it becomes too ris(y for investors and lenders. beyond a point. through the use of personal leverage can alter corporate leverage. is that individual arbitrageurs. To conclude. after a certain stage. /ut.e. as the company becomes highly geared i. The ## approach assumes availability of free and upto date information. this also is not normally valid. one may say that controversy between the traditionalists and the supporters of ## approach cannot be resolved due to lac( of empirical research. debt content increases. this point indicates the optimal capital structure. Traditionalists argue that the cost of capital of a firm can be lowered and the mar(et value of shares increased by use of financial leverage. as it is extremely doubtful that personal investors would substitute personal leverage for corporate leverage.here. Thus. that in the absence of corporate income taxes. as they do not have the same ris( characteristics. the overall cost of capital begins to rise. overall cost of capital begins to rise. ( III . #odigliani and #iller argues. which is not a valid argument in the practical world.
" part of long term funds is also to be (ept for financing the wor(ing capital requirements. 'unds procured from different sources have to be invested in various (inds of assets. equipment. "he capital $u%geting %ecision means a decision as to whether or not money should be invested in long*term projects such as the setting up of a factory or installing a machinery or creating additional capacities to manufacture a part which at present may be purchased from outside. IN"9ODBC"ION 'inancing and investment of funds are two crucial financial functions # "he in'estment of fun%s also terme% as capital $u%geting requires a number of decisions to be ta(en in a situation in which funds are invested and benefits are expected over a long period. the benefits of investment proposals cannot be directly quantified.In'estment %ecisions: These decisions determine how scarce resources in terms of funds available are committed to projects which can range from acquiring a piece of plant to the acquisition of another company. "sset management policies are to be laid down regarding various items of current assets. The decision in this case will be based on qualitative factors. stoc( and other types of assets must be carefully made. management may be considering a proposal to build a recreation room for employees. 5nce the decision to acquire a fixed asset is ta(en. buildings. The inventory policy would be determined by the production manager and the finance manager (eeping in view the requirement of production and the future price estimates of raw materials and the availability of funds. 3owever. 6ong term funds are used in a project for various fixed assets and also for current assets. -apital /udgeting excludes certain investment decisions. with less consideration on direct financial returns. In any business the commitment of funds in land. The investment of funds in a project has to be made after careful assessment of the various projects through capital budgeting. such as management L employee relations. It becomes a commitment that influences long term prospects and the future earning capacity of the firm. most investment proposals considered by management will require quantitative estimates of the benefits to be . 3owever. it becomes very difficult to reverse that decision. The expenditure on plant and machinery and other long term assets affects operations over a period of years. It includes a financial analysis of the various proposals regarding capital expenditure to evaluate their impact on the financial condition of the company and to choose the best out of the various alternatives. wherein. 'or example. "he term capital $u%geting means planning for capital assets# It involves proper project planning and commercial evaluation of projects to (now in advance technical feasibility and financial viability of the project.
as it is difficult to find a buyer for the second*hand capital items. CAPI"A 6BD!E"IN! P9OCESS The extent to which the capital budgeting process needs to be formali. These decisions not only affect the future benefits and costs of the firm but also influence the rate and direction of growth of the firm.: #ost of the investment decisions are irreversible. The opportunity then enters the planning phase when the potential effect on the firm4s fortunes is assessed and the ability of the management of the firm to exploit the opportunity is determined. The hasty and incorrect decisions would not only result into huge losses but may also account for the failure of the firm. Investment appraisal techniques. . This is because. which in fact is difficult to predict. (# Planning: The capital budgeting process begins with the identification of potential investment opportunities. *# ong time perio%: The capital budgeting decision has its effect over a long period of time. The technique selected .# Comple5 %ecision: The capital investment decision involves an assessment of future events. crucial and critical business decisions due to following reasons0 (# Su$stantial e5pen%iture: -apital budgeting decisions involves the investment of substantial amount of funds.derived from accepting the project. 'urther it is quite difficult to estimate in quantitative terms all the benefits or the costs relating to a particular investment decision. *# E'aluation: This phase involves the determination of proposal and its investments. inflows and outflows. are used to appraise the proposals.e of the organisation2 number of projects to be considered2 direct financial benefit of each project considered by itself2 the composition of the firm4s existing assets and management4s desire to change that composition2 timing of expenditures associated with the projects that are finally accepted. It is therefore necessary for a firm to ma(e such decisions after a thoughtful consideration so as to result in the profitable use of its scarce resources. PB9POSE OF CAPI"A 6BD!E"IN! The capital budgeting decisions are important. 5nce they are ta(en. 5pportunities having little merit are rejected and promising opportunities are advanced in the form of a proposal to enter the evaluation phase. ranging from the simple paybac( method and accounting rate of return to the more sophisticated discounted cash flow techniques. the firm may not be in a position to reverse them bac(.ed and systematic procedures established depends on the si. " bad decision can be detrimental to the value of the organisation over a long period of time. +# Irre'ersi$ilit.
Selection: -onsidering the returns and ris(s associated with the individual projects as well as the cost of capital to the organisation. it is important that the best or most profitable investment projects are selected. the organisation should review the entire project to explain its success or failure. 'urther.e shareholders$ wealth. performance reports comparing actual performance against plans set and post completion audits. purchase the assets. particular care needs to be ta(en with investment project selection and evaluation. Factors influencing capital $u%geting "vailability of funds !tructure of capital Taxation policy Bovernment policy 6ending policies of financial institutions Immediate need of the project %arnings -apital return %conomical value of the project Aor(ing capital "ccounting practice Trend of earnings CAPI"A 6BD!E"IN! "ECANICBESEME"AOD In order to maximi. and begin the implementation of the project. These reports will include capital expenditure progress reports.e the return to the shareholders of a company. This phase may have implication for firms planning and evaluation procedures. or even before. the firm must acquire the necessary funds. Control: The progress of the project is monitored with the aid of feedbac( reports. the review may produce ideas for new proposals to be underta(en in the future. /ecause the results for ma(ing a bad long*term investment decision can be both financially and strategically devastating. Implementation: Ahen the final selection has been made. the organisation will choose among projects so as to maximi. 9e'ie3: Ahen a project terminates.+# .# -# /# should be the one that enables the manager to ma(e the best decision in the light of prevailing circumstances. There are a number of techniques available for appraisal of investment proposals and can be classified as presented below0 .
ations use different methods for different types of projects while others may use multiple methods for evaluating each project.ations may use any or more of capital investment evaluation techniques2 some organi. and accounting (boo( rate of return. internal rate of return. the number of years in the paybac( period can be calculated using the following equation0 . These techniques have been discussed below M net present value. the investor has recovered the money invested in the project. "t that point in time. "s with other methods discussed. paybac( period. profitability index. Ahen the net cash flows are uniform over the useful life of the project. modified internal rate of return. the first steps in calculating the paybac( period are &etermining the total initial capital investment and the annual expected after*tax net cash flows over the useful life of the investment.5rgani. Pa.$ac4 Perio%: The paybac( period of an investment is the length of time required for the cumulative total net cash flows from the investment to equal the total initial cash outlays.
In some industries with high obsolescence ris( or in situations where an organi.ations to place too much emphasis on short paybac( periods thereby ignoring the need to invest in long*term projects that would enhance its competitive position. Accounting (6oo4) 9ate of 9eturn: The accounting rate of return of an investment measures the average annual net income of the project (incremental income as a percentage of the investment. "s long as the paybac( periods for two projects are the same.ation is short on cash.ations prefer the initial investment because it is objectively determined and is not influenced by either the choice of the depreciation . imitations: The major limitation of the paybac( period technique is that it ignores the time value of money. !ome organi. The paybac( period technique focuses on quic( payoffs. use of the paybac( period technique may cause organi. even if one project generates most of its net cash inflows in the early years of the project while the other project generates most of its net cash inflows in the latter years of the paybac( period. the cumulative cash inflow from operations must be calculated for each year by subtracting cash outlays for operations and taxes from cash inflows and summing the results until the total is equal to the initial capital investment. the paybac( period technique considers them equal as investments. The numerator is the average annual net income generated by the project over its useful life. short paybac( periods often become the determining factor for investments.ation to recoup the cash invested. A%'antages: " major advantage of the paybac( period technique is that it is easy to compute and to understand as it provides a quic( estimate of the time needed for the organi. the ris(ier the project as long*term predictions are less reliable. The length of the paybac( period can also serve as an estimate of a project$s ris(2 the longer the paybac( period. 6astly.Ahen the annual expected after*tax net cash flows are not uniform. The denominator can be either the initial investment or the average investment over the useful life of the project. " second limitation of this technique is its failure to consider an investment$s total profitability2 it only considers cash flows from the initiation of the project until its paybac( period and ignores cash flows after the paybac( period.
Net Present 8alue "echni)ue: The net present value technique is a discounted cash flow method that considers the time value of money in evaluating capital investments. depreciation methods. can lead to substantially different amounts for an investment$s net income and boo( values. %ither of these amounts is used in practice but it is important that the same method be used for all investments under consideration. 1sing the same procedure in both decision*ma(ing and performance evaluation ensures consistency. the calculation of the accounting rate of return method considers all net incomes over the entire life of the project and provides a measure of the investment$s profitability. This method may also mirror the method used to evaluate performance on the operating results of an investment and management performance. the discount rate or desired rate of return on an investment is the rate of return the firm would have earned by investing the same funds in the best available . ignores the time value of money and considers the value of all cash flows to be equal. A%'antages: The accounting rate of return technique uses readily available data that is routinely generated for financial reports and does not require any special procedures to Benerate data. Theoretically. "n investment has cash flows throughout its life.. inclusion of only the boo( value of the invested asset ignores the fact that a project can require commitments of wor(ing capital and other outlays that are not included in the boo( value of the project. The method uses net income rather than cash flows2 while net income is a useful measure of profitability. "dditionally. the technique uses accounting numbers that are dependent on the organi. e. The net present value method uses a specified discount rate to bring all subsequent net cash inflows after the initial investment to their present values (the time of the initial investment or year 9 . li(e the paybac( period technique. imitations: The accounting rate of return technique. 'urthermore.method or the estimation of the salvage value. and different accounting procedures. 6astly. and it is assumed that a rupee of cash flow in the early years of an investment is worth more than a rupee of cash flow in a later year. the net cash flow is a better measure of an investment$s performance.g.ation$s choice of accounting procedures.
alternative investment that has the same ris(. The overall cost of capital of a firm is a proportionate average of the costs of the various components of the firm$s financing. +# The net present value can be seen as the addition to the wealth of share holders.e. organi. the investment earns after yielding the desired rate of return in each period. *# The whole stream of cash flows is considered.ations choose to use the cost of capital as the desired rate of return2 the cost of capital is the cost that an organi. expresses cash flows in terms of current rupees. The criterion of 7P@ is thus in conformity with basic financial objectives. "n organi.# The 7P@ uses the discounted cash flows i. .. It implies that each project can be evaluated independent of others on its own merit. . &etermining the best alternative opportunity available is difficult in practical terms so rather than using the true opportunity cost. A%'antages (# 7P@ method ta(es into account the time value of money. imitations (# It involves difficult calculations. (= total the amounts for all years in the life of the project. The net present value of a project is the amount. in current rupees. The 7P@s of different projects therefore can be compared. " firm obtains funds by issuing preferred or common stoc(2 borrowing money using various forms of debt such a notes. (< determine the present values of the net cash flows by multiplying the cash flows by the discount factors.ations often use an alternative measure for the desired rate of return.ation may establish a minimum rate of return that all capital projects must meet2 this minimum could be based on an industry average or the cost of other investment opportunities. (: select the desired rate of return.ation has incurred in raising funds or expects to incur in raising the funds needed for an investment. Net present 'alue I Present 'alue of net cash flo3 @ "otal net initial in'estment The steps to calculating net present value are (8 determine the net cash inflow in each year of the investment. or bonds2 or retaining earnings. loans. The costs to the firm are the returns demanded by debt and equity investors through which the firm raises the funds. (. find the discount factor for each year based on the desired rate of return selected. #any organi. and (> subtract the total net initial investment.
This estimated rate of return is then compared to a criterion rate of return that can be the organi. The procedures for computing the internal rate of return vary with the pattern of net cash flows over the useful life of an investment. 1nli(e the net present value method. the internal rate of return method does not use the desired rate of return but estimates the discount rate that ma(es the present value of subsequent net cash flows equal to the initial investment. The first step is to determine the investment$s total net initial cash disbursements and commitments and its net cash inflows in each year of the investment. 6et us consider two projects involving an initial outlay of .ero. 'or an investment with uniform cash flows over its life.ation$s desired rate of return. 1sing this estimated rate of return. := 6a(hs each with following inflow 0 Internal 9ate of 9eturn Metho%: 6i(e the net present value method. . the following equation is used0 If A is the annuit. the internal rate of return method considers the time value of money.ation has selected to assess the investment$s desirability. the discount rate is the interest rate that has the same discount factor as " in the annuity table along the row for the number of periods of the useful life of the investment. +# The ran(ing of projects depends on the discount rate.ation chooses to use for evaluating capital investments. the net present value of the investment will be . the rate of return from the best alternative investment. This computed discount rate or the internal rate of return will be compared to the criterion rate the organi. Thus accuracy of 7P@ depends on accurate estimation of these two factors which may be quite difficult in practice. or another rate the organi. the initial cash investment.*# The application of this method necessitates forecasting cash flows and the discount rate. and all cash flows from the investment.s. %iscount factor> then 5nce " has been calculated.
It should be noted that there are several spreadsheet programs available for computing both net present value and internal rate of return that facilitate the capital budgeting process. In general terms a project is acceptable if its profitability index value is greater than 8. . 5ne of the methods of comparing such proposals is to wor( out what is (nown as the J&esirability factor$. FactorEProfita$ilit. 5nce a single large project with high 7P@ is selected. possibility of accepting several small projects which together may have higher 7P@ than the single project is excluded. "lso situations may arise where a project with a lower profitability index selected may generate cash flows in such a way that another project can be ta(en up one or two years later. the determination of the discount rate can involve trial and error and interpolation between interest rates.: A%'antages The method also uses the concept of time value of money and is a better project evaluation technique than 7P@. In certain cases we have to compare a number of proposals each involving different amounts of cash inflows. or JProfitability index$. the two alternative proposals for capital expenditure can be compared. In%e50 In above Illustration the students may have seen how with the help of discounted cash flow technique. Desira$ilit. imitations Profitability index fails as a guide in resolving capital rationing (discussed later in this chapter where projects are indivisible. Mathematicall. the total 7P@ in such case being more than the one with a project with highest Profitability Index.Ahen the net cash flows are not uniform over the life of the investment. The Profitability Index approach thus cannot be used indiscriminately but all other type of alternatives of projects will have to be wor(ed out.
interest. If the cash flow is positive. income tax. during the accounting year and also between two accounting periods. It shows inflows and outflows of cash i.iel% : cash flow yield F net cash flow from operating activitiesDnet income ii) cash flo3 to sales : cash flow to sales F net cash flow from operating activitiesDnet sales iii) cash flo3s to assets : cash flow to assets F net cash flow from operating activitiesDaverage total assets *) Free cash flo3 : strictly cash flow is the amount of cash that remains after deducting funds that the company has to commit to continue operating at its planned level. borrow money or issue stoc( in short*term to continue at its planned level. sources and applications of cash during a particular period. : it is the ability of a company to generate cash from its current or continuing operations. !uch commitment has to cover current or continuing operations.e. It is an important tool for short*term analysis. " negative free cash flow means the company will have to sell investments. Two major areas. it means the company has met all its planned commitment and has cash available to reduce debt or expand. that analysts examine while studying a cash flow statement are discussed as below0 () cash generating efficienc. its objectives and requirements are covered in "!*. li(e other financial statements. 'ollowing ratios are used for the purpose. The procedure for preparation of cash flow statement. +) others : besides measuring cash efficiency and free cash flow.sis help a $usiness entit. it is analysed to reveal significant relationships. < Ans3er 0 cash flow analysis is an important tool with the finance manager for ascertaining the changes in cash in hand and ban( balances as from one date to another. the financial analysts also calculates a .Cuestion : ho3 %oes the cash flo3 anal. i) cash flo3 . with the help of cash flow statement.. dividend. net capital expenditures and so on.
information as regards followingare needed which may be obtained from vendors or contractors or by internalestimates 0 i -ost of new equipment2 ii -ost of removal and disposal of old equipment less scrapvalue2 iii -ost of preparing the site and mounting of newequipment2 and iv -ost of ancillary services required for new equipmentsuch as new conveyors or new power supplies and so on. still would not be exact. isalways uncertain and predictions can be made about it only with reference tocertain probability levels. Cuestion : Discuss the estimation of future cash flo3s< Ans3er : In order touse any technique of financial evaluation. 'ollowing are the various stages or steps used indeveloping relevant information for cash flow analysis 0 ()Estimation of costs : To estimate cash outflows. but. /ut. cash flows areat best only a probability. data as regards cash flows from theproject is necessary. thus. iii self*financing investment ratio F internal fundingDnet investment activities it indicates how much of the funds generated by the business are re* invested in assets. 'uture. !ome of which are as below0 i price per shareDfree cash flow per share ii operating cash flowDoperating profit it shows that accrual adjustments are not having severe effect on reported profits. implying that costs of operations and returns from theproject for a considerable period in future should be estimated.number of ratios based on cash figures rather than on earning figures. . The vendor may haverelated data on costs of similar equipment or the company may have to estimatecosts from its own experience.
hence. additional wor(ing capitalrequirements on this account should be shown as cash outflows. must be estimated in view of the changes inprice levels in the economy. etc. may rise due to inflation. -ash inflows are highly dependent on the estimation of production andsales levels. be assessed andestimated in wor(ing out estimated cash outflow. wor(ing capital requirements may riseprogressively eventhough there is increase in activity of a new project. sales are below the brea(*even point. If in a year. 5n the basis of additional production units . 1nlessand until this factor is ta(en into account. The increase in wor(ing capital requirement arises due to the needfor maintaining higher sundry debtors. The impact of inflation is also to be brought intoaccount. etc. The increase would be due to many factors as inflation. Project planners often do notta(e into account the amount required to finance the increase in additionalwor(ing capital that may exceed amount of capital expenditure required. This dependence is due to peculiar nature of fixed cost. treated as cash inflow. etc. the company may even have cash outflows in terms oflosses.cost of a new project specially the oneinvolving long gestation period. -ashinflows tend to increase considerably after the sales are above the brea(*evenpoint. It is imperativethat an estimate may be made regarding the increase in project cost due to delaybeyond expected time. which is quitepossible in a large capital intensive project in the initial year of itscommercial production. "t the expiry ofthe useful life of the project. the wor(ing capital would be released and can bethus. plant and machinery. "s the new capital project commences operation. +)Estimation of pro%uction an% sales : Planning for a new project requires anestimate of the production that it would generate and the sale that it wouldentail. In aninflationary economy. The index is used to estimate the li(elyincrease in costs for future years and as per it. etc. The impact ofpossible inflation on the value of capital goods must thus. "nother adjustment required in cash outflows estimates is thepossibility of delay in the execution of a project depending on a number offactors. 'or instance high rates of inflation has causedvery high increases in the cost of various capital projects. many of which are beyond the management4s control.The finance manager should ma(e a careful estimate of the requirements ofadditional wor(ing capital. the cash outflow will remainincomplete. estimated cash outflows areadjusted. while wor(ing out cash outflows on account of wor(ing capital. *)Estimation of a%%itional 3or4ing capitalre)uirements : The next step is toascertain additional wor(ing capital required for financing increased activityon account of new capital expenditure project.increase in overhead expenditure. cashoutflows requirement should be shown in terms of cash outflows. stoc(*in*hand and prepaid expenses. This is because the valueof stoc(. #any firms wor( out a specificindex showing changes in price levels of capital goods such as buildings.machinery.
possibility of a reduction in sale price. etc. capital cost li(einterest on long term funds and dividends should not be deducted from grossrevenues in order to wor( out cash inflows. !ome accountants suggest that interestbeing a cash expense is to be deducted and dividends to be deducted from cashinflows. The rate of return yielded by a project at acertain rate of return is compared with cost of capital for determining whethera particular project can be ta(en up or not. the fact remains that these constitute cost of capital.In doing so however. this seems to be incorrect. introduction ofcheaper or more efficient product by competitors. on adding interest on long term funds and depreciation to net profitsand deducting liability for taxation for the year. is itself based on the cost of capital. interest on long termfunds and dividends to equity or preference shareholders should not be deductedwhile wor(ing out cash inflows. . recession in the mar(etconditions and such other factors are to be considered. the tax liability of the companymay be wor(ed out. 3owever. fixed costsremains the same. hence. The cash inflow would be revenues less cash expenses andliability for taxation. the amount of cash expenses to be incurred in running the project after itgoes into commercial production are to be estimated. -ash inflows can also be wor(ed outbac(wards. -). It is obvious thatwhichever level of capacity utilisation is attained by the project.)Estimation of cash e5penses : In thisstep. /oth dividends and interestinvolve a cash outflow. variable costs vary with changes in the level ofcapacity utilisation. 5ne problem is oftreatment of dividends and interest. ifdiscounting rate.or4ing out cash inflo3s : The difference between gross revenues and cash expenses hasto be adjusted for taxation before cash inflows can be wor(ed out. Thus.that can be sold and priceat which they may be sold. 3owever. . the comparison becomes vitiated. In view ofdepreciation and other taxable expenses. If the cost of capital becomespart of cash outflows. the gross revenues from a project can be wor(ed out.
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