PERIODICAL TEST 2

UNIT II

PART A:

11. Flotation costs are incurred by a publicly traded company when it issues new securities, and includes
expenses such as underwriting fees, legal fees and registration fees. Companies must consider the impact these
fees will have on how
much capital they can raise from a new issue.

12. Interpret the adjusted NPV with NPV.

ADJUSTED NPV: The adjusted present value is the net present value (NPV) of a project or company if
financed solely by equity plus the present value (PV) of any financing benefits, which are the additional
effects of debt. By taking into account financing benefits, APV includes tax shields such as those provided by
deductible interest.

NPV: Net Present Value (NPV) is the difference between the present value of cash inflows and the present
value of cash outflows over a period of time. NPV is used in capital budgeting to analyse the profitability of a
projected investment or project.

13. How would you use risk free rate of return?The risk-free interest rate is the rate
of return of a hypothetical investment with norisk of financial loss, over a given period of time. Since the risk-
free rate can be obtained with no risk, any other investment having some risk will have to have a higher rate of
return in order to induce any investors to hold it.
14. Determine the payback period from the following cash flows
Year 0 1 2 3 4 5
CFAT 100000 20000 30000 40000 50000 60000
CASH INFLOW IS Rs 100000
YEAR CFAT CCFAT
1 20000 20000
2 30000 50000
3 40000 90000- lower value
4 50000 140000
5 60000 200000 higher value

Payback=year before recover+(amount to be recoverd/cash flow of that year of recovery)

3+10000(100000-90000)/50000 =3.02 years

PAYBACK PERIOD IS 3.02 YEARS

15. Can you apply the payback reciprocal method in decision making ?

No.The payback reciprocal is a crude estimate of the rate of return for a project or investment. The payback
reciprocal is computed by dividing the digit "1" by a project's payback period expressed in years. For
example, if a project's payback period is 4 years, the payback reciprocal is 1 divided by 4 = 0.25 = 25%.

The payback reciprocal overstates the true rate of return because it assumes that the annual cash flows will
continue forever. It also assumes that the annual cash flows are identical in amount. Since these two
conditions are unrealistic you should avoid the use of the payback reciprocal.

16. Classify the various costs in computing the cost of capital?

The various cost involved in cost of capital are

Cost of equity ke

cost of debt ki

Cost of preference share kp

Cost of retained earning kre

17. DEFINE INTERNAL RATE OF RETURN:

Internal rate of return (IRR) is the interest rate at which the net present value of all the cash
flows from a project or investment equal zero. Internal rate of return is used to evaluate the attractiveness
of a project or investment.if any project return is greater than IRR , then accept the project .

18. Compare operating risk and financial risk

Meaning
BASIS FOR
BUSINESS RISK FINANCIAL RISK
COMPARISON
The risk of insufficient profit, Financial Risk is the risk arising to meet out the expenses is due to the use
of debt financing known as Business Risk. in the capital structure.
Connected
BASIS FORwith BUSINESS
leverage
The risk cannot
RISKbe minimized. FINANCIAL
Use of debt capital
RISK
COMPARISON
Minimization Fixed cost If the firm does not use debt
funds, there will be no risk.

19. What are the circumstances NPV & IRR differ?

The NPV and IRR rules will give conflicting ranking to the projects under the following conditions:

• The cash flow pattern of the project may differ. That is the cash flows of one project may increase overtime, while those of others
may decrease or vice versa.

• The cash outlays (initial investments) of the projects may differ

• The projects may have different expected lives.

20. What are the features of ARR method?

ARR method
1. Popular in professional

This method is popular in professional because it is based on accounting profit and professional find it easy to deal with this method.

2. Easy & Understandable

Like payback period it is very simple to calculate and understand. Furthermore, it is easy to calculate due to availability of financial data.

3. Ignore Time Value of money

This method does not take into account the time value of money rather is calculated on the bases of historical data.

4. Does not Absolute measure

This method provides result in % and not in absolute terms therefore some time it is not possible evaluate the project with this method
accurately.

5. Subject to Manipulation

This method base on the accounting profit therefore may be manipulated with the help of accounting policies.

PART B

8⑴.EXPLAIN CONDITIONS THAT ARE REQUIRED FOR OVERALL COST OF CAPIRTAL FOR NEW INVESTMENT: i) Maximum
Return:The financial structure of a company should be guided by clear- cut objective. Its objective can be maximisation of the wealth of the
shareholders or maximisation of return to the shareholders.
(ii) Less Risky:The capital structure should represent a balance between different types of ownership and debt securities. This is essential to
reduce risk on the use of debt capital.
(iii) Safety:A sound capital structure should ensure safety of investment. It should be so determined that fluctuations in the earnings of the
company do not have heavy strain on its financial structure.
(iv) Flexibility:A sound capital structure should facilitate expansion and contraction of funds. The company should be able to procure more
capital in times of need and should be able to pay all its debts when it does not require funds.
(v) Economy:The capital structure should ensure the minimum costs of capital which in turn would increase its ability to generate more
wealth for the company.
(vi) Capacity:The financial structure of a company should be d3mamic. It should be revised periodically depending upon the changes in the
business conditions. If it has surplus funds, the company should have the capacity to repay its debt and reduce interest obligations.
(vii) Control:The capital structure of a company should not dilute the control of equity shareholders of the company. That is why,
convertible debentures should be issued with great caution.
8 (ii). i) GURU Ltd has paid up equity capital 60000 equity shares of Rs.10 each the current market price of shares is Rs.24. During the

current year, the company has declared a dividend of Rs.6 per shares. The company has also previously issued 14% preference shares of

Rs.100 each aggregating Rs.3,00,000 at 5% discount and 13% debentures of Rs.100 each for Rs.5,00,000. The corporate tax rate is 40% the

growth rate in dividends on equity shares is expected at 5%. Show the overall cost of capital of the company.
 9(i) i) How is cost of equity capital determined under CAPM.Explain? (7 marks)

Determining the Cost of Equity with CAPM:

 N
(b) Investors Preferences: Investors are risk averse:
ot
Investors have homogenous expectations
regarding the expected
es
returns, variances and correlation of returns among all securities.
Investors seek to maximise the expected utility of their portfolios
single period planning honz W l.
!

Illustr p； The Capital Ltd. wishes to calculate its cost of equity capital
ation
using the Capital Asset Pricing Model (CAPM) approach. Company s analyst
free rate of return equals 12 per cent beta equal equals 1.7
found, that its nsk
and the return on market portfolio equals 14.5 per cent
Solution.
Rf+(Rmf-Rf) 12 + [14.5-12] 1.7
12 + 4.25 16.25 per cent

Shares

(II). How would you explain the concept of capital rationing? (6 marks) CONCEPT OF CAPITAL RATIONING:

Capital rationing is the act of placing restrictions on the amount of new investments or projects undertaken by a company. This is
accomplished by imposing a higher cost of capital for investment consideration or by setting a ceiling on specific portions of a
budget. Companies may want to implement capital rationing in situations where past returns of an investment were lower than
expected.
Types of Capital Rationing:
The first type of capital rationing is referred to as "hard capital rationing." This occurs when a company has issues raising additional funds,
either through equity or debt. The rationing arises from an external need to reduce spending, and can lead to a shortage of capital to finance
future projects.
The second type of rationing is called "soft capital rationing," or internal rationing.
This type of rationing comes about due to the internal policies of a company. A fiscally conservative company, for example, may have a high
required return on capital in order to accept a project, self-imposing its own capital rationing.

Funds are insufficient to finance all projects Rank the projects

Allot funds based on initial outlay requirements
 10⑴ i) What are the problems in determining cost of capital? (7 marks) Problems inDetermination of Cost of

Capital:

1. Conceptual Controversies Regarding the Relationship between the Cost of Capital and the Capital Structure

2. Historic Cost and Future Cost

3. Problems in Computation of Cost of Equity

4. Problems in Computation of Cost of Retained Earnings

5. Problems in Assigning Weights.

Problem 1. Conceptual Controversies Regarding the Relationship between the Cost of Capital and the Capital Structure:
Different theories have been propounded by different authors explaining the relationship between capital structure, cost of capital and the
value of the firm.

This has resulted into various conceptual difficulties.

Problem 2. Historic Cost and Future Cost:

Another problem in the determination of cost of capital arises on account of the difference of opinion as regards the concept of cost itself.
It is argued that historic costs are book costs which are related to the past and are irrelevant in the decision-making process.In their
opinion, future estimated costs are more relevant for decision-making. In the same manner, arguments are given in favour of specific cost
and composite cost as well as explicit cost and implicit cost and the marginal cost.

Problem 3. Problems in Computation of Cost of Equity:

The computation of cost of equity capital depends upon the expected rate of return by its investors. But the quantification of the
expectations of equity shareholders is a very difficult task because there are many factors which influence their valuation about a firm.

Problem 4. Problems in Computation of Cost of Retained Earnings:

It is sometimes argued that retained earnings do not involve any cost. But in reality, it is the opportunity cost of dividends foregone by its
shareholders. Since different shareholders may have different opportunities for investing their dividends, it becomes very difficult to
compute the cost of retained earnings.
Problem 5. Problems in Assigning Weights:
For determining the weighted average cost of capital, weights have to be assigned to the specific cost of individual sources of finance.
The choice of using the book value of the source or the market value of the source poses another problem in the determination of cost of
capital.
(ii)- Can you assess the role of inflation in capital budgeting? (6 marks)

The Role of Inflation on Capital Budgeting:

When a business entertains the thought of undertaking a large project such as constructing a new building or acquiring a large amount of
expensive equipment, it will assemble financial information to test whether the project will ultimately make more money than it costs. A
well-planned and executed capital budget that accounts for inflation is the tool that helps companies make this type of decision.

Real Cost of Capital

Inflation affects capital budgeting in a significant way. It makes up a part of the market rate of return, and capital budgets reveal the true
project cost when using the real rate of return, rather than the market rate. Calculating the real rate of return begins with the market rate
of return, then subtracting inflation. This is sometimes stated as its inverse, the real cost of capital

Inflation's Impact
Inflation affects capital budgeting analyses since the market cost of capital is not completely representative of the real cost of borrowing
funds. However, performing the analysis in a manner that compensates for inflation removes its impact from the results of the capital
budget.

Inflation impacts can be removed from a capital budgeting analysis by calculating the real rate of return and using it in the capital
budgeting cash flow calculations. When formulating a capital budgeting scenario with the real rate of return, the answer has been
adjusted for inflation. Conversely, if the rate of return is not adjusted, the cash flows can be adjusted for inflation to match the inflation
that is "built in" to the market rate of return. In either scenario, it is important to make sure the cash flows and rate of return are on the
same basis, either with or without inflation.

Inflationary Issues
Inflation can be an especially difficult problem for businesses in developing countries, since in some countries it can exceed 100 percent
per year. As the rate of inflation increases, investors require a higher real rate of return to compensate, which makes many projects very
expensive.

Inflation affects the outcome of capital budgeting in other ways besides the rate of return. Generally, inflation drives up costs for goods
and services, including building
materials, equipment and labor. These increased costs might render certain projects unfeasible based on the results of the capital
budget analysis.

11._What is Modigilani-Miller approach to the problem of cost of capital structure? Under what assumptions do their conclusion hold
good?
MM Approach: (MODI GLANNI MILLER APPROACH )

Assumptions：

1. Perfect capital market conditions exist.

(a) Securities are infinitely divisible (Any number of shares can be purchased say, 5shares, 3.33 shares,10000 shares)

(b) There is no transaction cost(No brokerage ).

(c) There is no flotation cost (No advertising cost, No merchant banking charges )
 (d) All investors are rational (Logical).

(e) Perfect information about market is available to all the investors (Both individual and institutional investors).

(f) All investors will have the same perception about the EBIT of firm.

2. There are no taxes.

3. Home-made leverage exists.

4. Individual investor and the company can borrow at the same rate.

5. All earnings will be distributed as dividend (No retained earnings).

Statement: Changes in capital structure will not affect the value of firm.

Proposition-1:
If 2 companies are in same industry having the same EBIT and same business risks, assume one company as a levered firm (L)
[ which has got debt in its capital structure] and assume the other company to be an unlevered firm (UL)[which has got no debt]. MM
hypothesis claims that firm Levered firm and firm Unleverd firm will have the same value.

Proposition-2:

Even if there is a small difference between the firms, it will only be a temporary effect, Sooner or later the two companies will have the
same value(Equilibrium will be
attained).Equilibrium will be attained because the investors will start shifting from high value firm to low value firm due to economic
benefits.

The demand for the low value firm will increase. Market price of low value firm will increase and so the total value of firm also increases.
The demand price and the total value decreases for the high value firm. The process of shifting from one firm to another firm is called
“Arbitrage process”.

Proof: There are 2companies L and UL are in same industry having the same EBIT 1,00,000 and same business risks, assume one company as
a levered firm (L)[ which has got 5,00,000 debt@10% in its capital structure] and assume the other company to be an unlevered firm (UL)
[which has got no debt]. Prove MM hypothesis
Particulars Levered Unlevered

Debt 5,00,000@10% Nil

Cost of equity 16% 12.5%
EBIT 1, 00,000 1, 00,000

Particulars Levered Unlevered

Levered Firm:
EBIT 1, 00,000 1.00,000
(-)Interest (10% * 50,000 0
5,00,000)
50,000 1, 00,000
EATES 50,000 /.16 1, 00,000/ .125
S = EATES / Ke = 3, 12,500 = 8, 00,000
5,00,000 Nil
B = Interest / Ki
V=B+S
8, 12,500 (HighValue) 8, 00,000( Lo w Value )
Levered Firm:

Assume X invests 10% of shareholding in Levered firm Investment = 10% on 3, 12,500 =

31,250 Return = 10% on 50,000 = 5,000

X invests Rs 31,250 in levered firm to get a return of Rs 5,000

X analyses what would happen if he shifts to Levered Firm:

He wants to be a 10% shareholder.

Investment = 10% 0n 8, 00,000 = 80,000

Home made Borrowing calculation: 10%(Debt in the company )=10%(5,00,000) =50,000

80,000M minus 50,000=30,000(Own funds)

Return = 10% on 1, 00,000 = 10,000

(-)Interest (10% 0n 50,000) = 5,000

= 5,000

X invests Rs 30,000 in unlevered firm to get a return of Rs 5,000 Cash remaining =Rs. 1250

Hence it is beneficial to shift from high value firm to low value firm . All investors will shift from high value firm to low value firm. Sothe f
high value firm's demand decreases .So market price of the high value firm decreases. Value of the high value firm decreases . The demand
for the low value firm will increase. Market price of low value firm will increase and so the total value of firm also increases.

12- Machine X has a cost of Rs.75,000 and net cash flow of Rs.20000 per year, for six years. A substitute machine Y would cost Rs.50,000
and generate net cash flow of Rs.14000 per year for six years. The required rate of return of both machines is 11%. Calculate the IRR and
NPV for the machines. Which machine should be accepted and why?
11% 12% 13% 14% 15% 16% 17% 18%

PVF 6th 4.111 3.998 3.889 3.784 3.685 3.589 3.498

year
(4.231)
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13⑴ i) Analyse the important techniques used for decision making under risk and uncertainty in capital
budgeting. ( 7marks)

Techniques of capital budgeting

Non discounting technique Discounting technique

(Time value
of money will not be considered) (Time value of money will be
considered)

Pay back [PB] Net

present value method [NPV]

Accounting rate of returning method [ARR] Profitability index method [PI]

Internal rate of return method [IRR]

Discounted payback method [DP]

NON DISCOUNTING TECHNIQUES:

1. Pay back method: [PB]

Pay back period is the term referred to the time taken for getting back the original investment amount.

Payback=year before recover+(amount to be recoverd/cash flow of that year of recovery)

2. Accounting rate of return method: [ARR]

Accounting rate of return means for the average earnings after tax gained for the average
investment made.

ARR= Average EAT X100

Average investment

Discounting techniques:
1. Discount payback method:
The number of years required in recovering the cash outlay on the present value basis is the discounted
payable period. Except using discounted cash flows in calculating payback, this method has all the demerits
of payback.

2. Net present value method: [NPV]

It is a discounting technique because it uses the time value of money.

It is the difference between the Gross present value of CFAT and the initial outlay. NPV=Gross present

value of CFAT - Initial outlay n

NPV = ^ CFAT i=1

(1+k) i

3. Profitability index method: [PI]

It is the ratio the ratio between Gross present value of CFAT and the initial outlay. It shows
the index for the choice of the project.

PI = Gross PV of CFAT

Initial outlay

4. Internal rate of return: JIREl

It is the discount rate for which the NPV of the firm is equal to zero. In other words IRR is the discount
rate at which the Gross present value of the CFAT is equal to the initial outlay of the project.

IRR = lower% + difference between HV - NV

the two percentage HV - LV

13(ii) ii) A project costs Rs.20, 00, 000 and yields annually a profit of Rs.3, 00,000 after
depreciation at 12.5% but before tax at 50%. Discover payback period. (6
marks)
14 The following information has been taken from the balance sheet of Ram Co. as on 31-12-2016.

Equity share Capital : Rs. 6,00,000 10%

Debentures : Rs. 6,00,000 15% term loan

Rs.18,00,000 Total Rs. 30,00,000

i) Determine the weighted average cost of capital of the company. It has been paying dividends at a
constant rate of 20% p.a.
What difference will it make if the current price of Rs.100 share is Rs.200?
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PART C

3. _Debt is the cheapest source of funds”. Explain

Debt is actually the cheaper source of finance for a couple of reasons.

■ Tax benefit: The firm gets an income tax benefit on the interest component that is paid to the lender.
Dividends to equity holders are not tax deductable.

■ Limited obligation to lenders: In the event of a firm going bankrupt, which is what happened with
Lehman Brothers, equity holders lose everything. But, debt holders have the first claim on company
assets (collateral), increasing their security. So since debt has limited risk, it is usually cheaper. Equity
holders are taking on more risk, hence they need to be compensated for it with higher returns.

■ Limited upside: Since the equity holder has a stake in the business; he can actually participate in the
potential upside in earnings. PE, Venture Capital funds usually buy stakes in high potential companies
at cheap valuations, and since they have a minority stake in the company, they are entitled to a share
of the profits. Plus they can exit after a few years at a fantastic premium. On the other hand debt
holders have an upside limited to the fixed rate of interest they receive every year.

■ Tax deductibility feature of debt is the main point, on which we can say debt is the cheapest source of
financing.

There are some other points that may include with deductibility feature. These
are

■ Time value of money and preference of funds.

■ Dividends not payable to lenders

■ Interest rate.
Let us consider an example to show how debt financing helps to reduce the tax burden that is the tax
deductibility features of interest.

Example: Suppose XYZ company take loan of $1000000from ABC bank at the rate of 15%. Tax payable
to the government is 30% of the income. Income is = $500000
Only Equity is used
If there is no debt financing then XYZ company has to pay tax of total = $500000 X 30% = $150000

After tax income = $ 500000 - $150000 = $350000

If Debt and equity is used
On the other hand if company use debt financing then,

Interest on load amount = $1000000 X 15% = $150000

Taxable income is = $500000 - $150000 = $350000

Tax payable = $350000 X .3 = $105000

After tax income is = $500000 - $105000 = $395000 4 A firm finances all its investment by 40% debt & 6

0% equity. The estimated required rate of return on equity is 20% after tax and that of the debt is 8% after

tax. Firm is considering an investment proposal costing Rs.40000with an expected return that will last

forever. What amount must the proposal yield per year so that the market price does not change?

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 UNIT 3

PART A:

1- Define stock split

STOCK SPLIT:
A stock split is a corporate action in which a company divides its existing shares into multiple shares to boost
the liquidity of the shares.Eg 10000 shares @2000 Rs may be split as 20000 share . Mkt price will drop to 1000
and now it is affordable to small investors.
2- Compare ‘bonus-issue” and ‘share-split’ on four aspects.
BASIS BONUS ISSUE SHARE SPLIT
Pre value of share It is unchanged It is reduced
Capitalization of reserves Capitalization takes place No capitalization
Shareholder proportion There will be no change in It remains unchanged
proportion
Book value, earning , market The value decline The value will decline
place per share

3- Identify the different forms of Dividend policies.:

I- Stable /constant dividend per share

II- Constant payout ratio

III- Constant DPS plus extra div

4- What is Financial Leverage?

Financial leverage:

Financial leverage is the ability of a firm to use debt in the capital structure to magnify the effect of
EBIT on EPS . FL = EBIT /EBIT 一 INT

Financial leverage = Percentage change in EPS / Percentage change in EBIT

5- Discuss any four factors which are relevant for determining the pay-out ratio. Factors determining payout
ratio:

I- Funds requirement

II- Availability of external source of financing

III- Shareholder preference

IV- Control and taxes.

6- Can you interpret the existence of Operating leverage in a firm’s Capital Structure?
Operating leverage refers as the firms ability to use Fixed cost to magnify the effects of changes in sales on its
EBIT. It is also defined as the change as the percentage of EBIT (operating income) for the change in
percentage of sales .

OL =Contribution /EBIT
Operating leverage = Percentage change in EBIT / Percentage change in Sales

7- Define any two bases upon which capital structure is determined.

CAPITAL STRUCTURE DETERMINATION:

I PROFITABILITY/RETURN:
It should generate maximum return to owners without adding additional cost.

II Solvency/risk:

Debt should be used till the point where it does not add significant risk.

III FLEXIBITY:
It means it should allow the existing capital structure to change according to the changing
condition without increasing cost.

8- What is meant by debt-equity ratio and interest coverage ratio?

The debt-to-equity ratio (D/E) is a financial ratio indicating the relative proportion of shareholders' equity and
debt used to finance a company's assets. Closely related to leveraging, the ratio is also known as risk, gearing or
leverage.

The interest coverage ratio (ICR) is a measure of a company's ability to meet its interest payments. Interest
coverage ratio is equal to earnings before interest and taxes (EBIT) for a time period, often one year, divided by
interest expenses for the same time period.

9. List some of the causes for ‘indifference point’？

Indifference Point means point at which different financial plans have same EPS Cause DIFFERENT

FINANCIAL Plans BUT SAME EPS

The indifference point is the level of volume at which total costs, and
hence profits, are the same under both cost structures. If the
company operated at that level of volume, the alternative used would
not matter because income would be the same either way.

10- What is MM hypothesis?

The Modigliani-Miller theory (of Franco Modigliani, Merton Miller) is a theorem on capital structure, arguably
forming the basis for modern thinking on capital structure. The basic theorem states that in the absence of taxes,
bankruptcy costs, agency costs, and asymmetric information, and in an efficient market,

Changes in capital structuredoes not affect value of firm

Changes in dividend policy does not affect value of firm

11- Discuss the different forms of capital structure Forms of capital structure:
1 Complete equity share capital

2 Different proportions of equity and preference share capital

3 DIFFERENT PROPORTION OF EQUITY AND DEBENTURE CAPITAL

4 Different proportions of equity and preference and debenture capital

12- Interpret arbitrage pricing in capital structure theory.

In finance, arbitrage pricing theory (APT) is a general theory of asset pricing that holds that the expected return
of a financial asset can be modeled as a linear function of various factors or theoretical market indices, where
sensitivity to changes in each factor is represented by a factor-specific beta coefficient.

13- Define dividend pay-out ratio? Brief with a simple illustration.

The dividend payout ratio measures the percentage of net income that is distributed to shareholders in the form
of dividends during the year. In other words, this ratio shows the portion of profits the company decides to keep
to fund operations and the portion of profits that is given to its shareholders.
 Example

Joe’s Kitchen is a restaurant change that has several shareholders. Joe reported $10,000 of net income on
his income statement for the year. Joe's issued $3,000 of dividends to its shareholders during the year.
Here is Joe's dividend payout ratio calculation.

Dividend Payout Ratio

30% = $3,000
$10,000

14 Compare the different forms of dividend

• Cash dividend. The cash dividend is by far the most common of the dividend types used. Stock dividend. A
stock dividend is the issuance by a company of its common stock to its common shareholders without any
consideration.

• Liquidating dividend. When the board of directors wishes to return the capital
originally contributed by shareholders as a dividend, it is called a liquidating dividend, and may be a
precursor to shutting down the business.

• Bonus shares : when there is no liquidity , extra shares can be given instead of dividend 15. How would you
show your understanding about trading on equity?

1. Trading on equity:
It is the ability to use debentures and preference shares & thereby maximizing
the wealth of equity share holders.

A firm has got 2 options

* Option A

* Option B

Option A:

10, 00,000 equity shares @ 15%

EBIT = 1, 50,000 Div =

1,50,000

Earnings of the company are just enough to meet expectations of share holders.
Option B:

5, 00,000 equity shares @ 15%

3, 00,000 preference shares @ 12% 2, 00,000 debentures @ 10%

EBIT = 1,50,000

(-)Interest = 20,000

1, 30,000

(-)Pref Div = 36,000

94,000

(-)Equity Div = 75,000

19,000

Earnings of company are greater than expectation of share holders. Therefore trading on
equity is the firm’s ability to use debenture and preference shares and thereby
maximizing the wealth of share holders.

16- How would you categorize the term leverage?

Leverage is the influence of one financial variable over the other financial variable.

Leverage is the influence of one financial variable over the other financial variable. Definition:
The employment or assets or sources of funds for which the firm has pay a fixed cost or fixed return.

Fixed cost: eg: Depreciation charged for machines

Rent paid for building

Fixed return: eg: Interest paid for Debentures

Preference dividend given to preference shares

LEVERAGE
17- Define reverse split.

In finance, a reverse stock split or reverse split is a process by which shares of corporate stock are
effectively merged to form a smaller number of proportionally more valuable shares. A reverse stock split
is also called a stock merge.
 18- .Classify NI & NOI approaches.

Distinction between NI Approach and NOI Approach:

NI Approach NOI Approach

1.Changes in capital structure will affect 1. Changes in capital structure will

value of firm. not affect value of firm.

2. Ke remains constant.
2. Ke starts increasing.
3. Overall cost of capital Ko decreases .
3. Overall cost of capital Ko remains
4. Value of firm increases. constant.

4. Value of firm remains constant.

19- Define Walter’s & Gordon model of Dividend.

Walter's and Gordons model: Changes in dividends will affect the value of the firm

Declining firm: r<ke then the firm should distribute the profits in the form of dividends to give the
shareholders higher returns.

Growth firm: r>ke then the investment opportunities reap better returns for the firm and thus, the firm
should pay less dividend and invest using retained earnings.

Normal firm: r=ke The company can pay or retain

20- Define composite leverage.

A degree of combined leverage (DCL) is a leverage ratio that summarizes the combined effect that the
degree of operating leverage (DOL) and the degree of financial leverage. It is the ability of affirm to use
fixed cost and financial charges to magnify the effect of Sales on EPS .

Composite leverage =

Percentage change in EPS / Percentage change in Sales Combined

leverage = OL * FL

PART B:
 1■ ⑴ i)How would you explain the impact of financial leverage on earnings per share? (7 marks)

Financial Leverage (FL) refers to usage of Debt in the capital structure. It is the use of fixed cost of capital
(debt) in the total capitalization of the fir,. Fixed cost capital includes loans, debentures and preference
share capital. It is also collect capital gearing.

It, also called “Trading on Equity”，is expressed as the firm's ability to use fixed financial cost in such a
manner so as to have magnifying impact on the EPS due to any change in EBIT (Earning Before Interest
and Taxes). In other words, it is a process of using debt capital to increase the return on Equity.

A firm with high FL will have relatively high fixed financing costs compared to a firm with low FL.

According to Guttmann, “It is the ability of the firm to use fixed financial charges to magnify the effect of
changes in EBIT on the firms' EPS.

The following are the Essential of FL:

1. It relates to liabilities side of balance sheet.

2. It is related to capital structure.

3. It is related to financial risk.

4. It affects earning after tax and earning per share.

5. It may be favourable or unfavourable. Unfavourable leverage occurs when the firm does not earn as
much as the funds cost.

Financial leverage is useful in:

(i) Capital structure planning (ii) Profit Planning

It helps the finance managers while devising the capital structure of the company. A high FL means high
fixed financial costs and high financial risk. Increase in fixed financial costs may force the company into
liquidation. Shareholders of company will be benefited by the use of FL in terms of the increased Earning
Per Share (EPS) and Return
on Equity (ROE) only when firms return on investment (assets) is higher than the interest cost.

The financial Leverage (FL) can be calculated by the following formula:

FL = EBIT/EBIT - INTEREST where EBIT refers to earnings before interest and tax and EBT( EBT =EBIT -
INT ) refers to earnings before tax
It shows the percentage change in EPS in relation to percentage change in EBIT. In other words, if there is
increase in EBIT of the firm it will increase the EPS of the firm.

(ii)- ii) (Issued at par): Janaki Ltd., issued 12,000 10% debentures of Rs.100 each a par. The tax rate is 50%.
Find before tax and after tax cost of debt. (6 marks
 2. i)What is the main idea of Modigliani Miller approach on cost of capital? (7 marks) Assumptions：

MM hypothesis 1. Perfect capital market conditions exist.

(a) Securities are infinitely divisible (Any number of shares can be purchased say, 5shares, 3.33
shares,10000 shares)

(b) There is no transaction cost(No brokerage ).

(c) There is no flotation cost (No advertising cost, No merchant banking charges )

(d) All investors are rational (Logical).

(e) Perfect information about market is available to all the investors (Both individual and institutional

investors).

(f) All investors will have the same perception about the EBIT of firm.

2. There are no taxes.

3. Home-made leverage exists.

4. Individual investor and the company can borrow at the same rate.

5. All earnings will be distributed as dividend (No retained earnings).

Statement: Changes in capital structure will not affect the value of firm.

Proposition-1:
If 2 companies are in same industry having the same EBIT and same business risks, assume one
company as a levered firm (L)[ which has got debt in its capital structure] and assume the other company
to be an unlevered firm (UL)[which has got no debt].
MM hypothesis claims that firm Levered firm and firm Unleverd firm will have the same value.

Proposition-2:
Even if there is a small difference between the firms, it will only be a temporary effect, Sooner or later
the two companies will have the same value(Equilibrium will be attained).Equilibrium will be attained
because the investors will start shifting from high value firm to low value firm due to economic benefits.

The demand for the low value firm will increase. Market price of low value firm will increase and so the
total value of firm also increases. The demand price and the total value decreases for the high value firm.
The process of shifting from one firm to another firm is called “Arbitrage process”.

Proposition 3 : if there is tax, value of levered firm is greater than unlevered firm.
Vl= Vul + B*t

2(ii)- Show the operating leverage for Maruti Ltd., from the following information:
No. of Units produced : 50,000,Selling price per unit: Rs.50,Variable cost per unit: Rs.20

Fixed cost per unit at current level of sales is Rs.15. What will be the new operating leverage, if the variable
cost is Rs.30 per unit. (6 marks)
3- i) What are the various factors you consider in influencing Divided Policy? (7 marks)
Factors Affecting Dividend Policy Of A Firm

A firm's dividend policy is influenced by the large numbers of factors. Some factors affect the amount of dividend and some factors affect
types of dividend. The following are the some major factors which influence the dividend policy of the firm.

1. Legal requirements
There is no legal compulsion on the part of a company to distribute dividend. However, there certain conditions imposed by law regarding the
way dividend is distributed. Basically there are three rules relating to dividend payments. They are the net profit rule, the capital impairment
rule and insolvency rule.

2. Firm’s liquidity position

Dividend payout is also affected by firm's liquidity position. In spite of sufficient retained earnings, the firm may not be able to pay cash
dividend if the earnings are not held in cash.

3. Repayment need
A firm uses several forms of debt financing to meet its investment needs. These debt must be repaid at the maturity. If the firm has to retain
its profits for the purpose of repaying debt, the dividend payment capacity reduces.

4. Expected rate of return

If a firm has relatively higher expected rate of return on the new investment, the firm prefers to retain the earnings for reinvestment rather
than distributing cash dividend.

5. Stability of earning
If a firm has relatively stable earnings, it is more likely to pay relatively larger dividend than a firm with relatively fluctuating earnings.

6. Desire of control
When the needs for additional financing arise, the management of the firm may not prefer to issue additional common stock because of the
fear of dilution in control on management. Therefore, a firm prefers to retain more earnings to satisfy additional financing need which reduces
dividend payment capacity.

7. Access to the capital market

If a firm has easy access to capital markets in raising additional financing, it does not require more retained earnings. So a firm's dividend
payment capacity becomes high.

8. Shareholder’s individual tax situation

For a closely held company, stockholders prefer relatively lower cash dividend because of higher tax to be paid on dividend income. The
stockholders in higher personal tax bracket prefer capital gain rather than dividend gains.
3(ii)- Identify the different types of Dividend Policy? (6 marks)
Meaning of Dividend Policy:

The term dividend refers to that part of profits of a company which is distributed by the company among its shareholders. It is the reward of
the shareholders for investments made by them in the shares of the company. The investors are interested in earning the maximum return on
their investments and to maximise their wealth. A company, on the other hand, needs to provide funds to finance its long-term growth.

If a company pays out as dividend most of what it earns, then for business requirements and further expansion it will have to depend upon
outside resources such as issue of debt or new shares. Dividend policy of a firm, thus affects both the long-term financing and the wealth of
shareholders.

As a result, the firm's decision to pay dividends must be reached in such a manner so as to equitably apportion the distributed profits and
retained earnings.

Since dividend is a right of shareholders to participate in the profits and surplus of the company for their investment in the share capital of the
company, they should receive fair amount of the profits. The company should, therefore, distribute a reasonable amount as dividends (which
should include a normal rate of interest plus a return for the risks assumed) to its members and retain the rest for its growth and survival.

Types of Dividend Policy:

The various types of dividend policies are discussed as follows:

(a) Regular Dividend Policy:

Payment of dividend at the usual rate is termed as regular dividend. The investors such as retired persons, widows and other economically
weaker persons prefer to get regular dividends.

A regular dividend policy offers the following advantages:

(a) It establishes a profitable record of the company.

(b) It creates confidence amongst the shareholders.

(c) It aids in long-term financing and renders financing easier.

(d) It stabilises the market value of shares.

(e) The ordinary shareholders view dividends as a source of funds to meet their day-to day living expenses.

(f) If profits are not distributed regularly and are retained, the shareholders may have to pay a higher rate of tax in the year when
accumulated profits are distributed.
However, it must be remembered that regular dividends can be maintained only by companies of long standing and stable earnings, A
company should establish the regular dividend at a lower rate as compared to the average earnings of the company.

(b) Stable Dividend Policy:

The term ‘stability of dividends' means consistency or lack of variability in the stream of dividend payments. In more precise terms, it
means payment of certain minimum amount of dividend regularly.

A stable dividend policy may be established in any of the following three forms:

⑴ Constant dividend per share:

Some companies follow a policy of paying fixed dividend per share irrespective of the level of earnings year after year. Such firms, usually,
create a ‘Reserve for Dividend Equalisation' to enable them pay the fixed dividend even in the year when the earnings are not sufficient or
when there are losses.

A policy of constant dividend per share is most suitable to concerns whose earnings are expected to remain stable over a number of years.
(ii) Constant payout ratio:

Constant pay-out ratio means payment of a fixed percentage of net earnings as dividends every year. The amount of dividend in such a policy
fluctuates in direct proportion to the earnings of the company. The policy of constant pay-out is preferred by the firms because it is related to
their ability to pay dividends. Figure given below shows the behaviour of dividends when such a policy is followed.

(iii) Stable rupee dividend plus extra dividend:

Some companies follow a policy of paying constant low dividend per share plus an extra dividend in the years of high profits. Such a policy is
most suitable to the firm having fluctuating earnings from year to year.
 4- Examine the legal and procedural aspects of dividend according to Company 、 Act. Legal and Procedural Aspects of Payment of

Dividend:

1. Source of Declaring Dividend

2. Transfer to Reserves

3. Declaration of Dividend out of Past Profits or Reserves

4. Other Provisions and Aspects of Payment of Dividend

Legal and Procedural Aspect # 1. Source of Declaring Dividend:

(a) Out of current profits. Dividend can be declared by a company out of profits for the current year arrived at after providing
depreciation.

(b) Out of past profits. Dividend can also be declared out of the undistributed profits of the company for any previous financial year or
years arrived at after providing depreciation in accordance with the provisions of the Act.

(c) Out of moneys provided by the Government. A company may also declare dividend out of the moneys provided by the Central
Government for the payment of dividend in pursuance of a guarantee by the government.

It may, however, be noted that no dividend can be declared or paid by a company unless:
(i) Depreciation has been provided for in respect of the current financial year.

(ii) Arrears of depreciation in respect of the previous year's falling after the commencement of the companies (Amendment) Act, 1960
have been set off against profits of the company.

(iii) Losses, if any incurred by the company in previous years falling after 28th December, 1960 have been written off against profits of
the company for which dividend is proposed to be declared.

Legal and Procedural Aspect # 2. Transfer to Reserves:

The companies (Transfer of Profits to Reserves) Rules, 1975 require a company providing more than 10 per cent dividend to transfer a
certain percentage of the current year's profits to reserves as specified below:
(a) Where the dividend proposed exceeds 10 per cent but dos not exceed 12.5 per cent of the paid up capital, the amount to be transferred to
the reserves shall not be less than 2.5 per cent;
(b) Where the dividend proposed exceeds 12.5 per cent but does not exceed 15 per cent of the paid up capital, the amount to be transferred
to reserves shall not be less than 5 per cent;

(c) Where the dividend proposed exceeds 15 per cent but does not exceed 20 per cent of the paid up capital, the amount to be transferred to
reserves shall not be less than 7.5 per cent; and

(d) Where the proposed dividend exceeds 20 per cent of the paid up capital, the amount to be transferred to reserves shall not be less than
10 per cent of the current year's profits.

It may, however, be noted that that a company may voluntarily transfer a higher percentage of profits to reserves.

Legal and Procedural Aspect # 3. Declaration of Dividend out of Past Profits or Reserves:
If a company wants to declare dividend out of accumulated profits or reserves, it has to comply with the following conditions:
(a) The rate of dividend should not exceed the average of the rates at which dividend was declared by it in five years immediately preceding
that year or ten per cent of its paid up capital, whichever is less.

(b) The total amount to be drawn for the declaration of dividend from the accumulated profits should not exceed an amount equal to one-
tenth of the sum of its paid up capital and free reserves and the amount so drawn should first be utilised to set-off the losses incurred in the
financial year.

(c) The balance of reserves after such drawl should not fall below fifteen per cent of its paid up capital.

Legal and Procedural Aspect # 4. Other Provisions and Aspects of Payment of Dividend:
(a) The decision in regard to the payment of final dividend is taken at the annual general meeting of the shareholders only on the
recommendation of the directors. The shareholders themselves cannot declare dividend. However, interim dividend is declared by the
directors and there is no need for a meeting of the shareholders to sanction the payment of such a dividend.

(b) Dividend on equity shares can be paid only after declaration of dividend on preference shares.

(c) When dividend is declared by a company, it must be paid by the company within 30 days of declaration of dividend.

(d) According to section 205 of the Companies Act, no dividend shall be payable except in cash: Provided that nothing in this section
prohibits the capitalisation of profits or reserves of a company for the purpose of issuing fully paid up bonus shares.

(e) Any dividend payable in cash may be paid by cheque or warrant sent through the post directed to the registered address of the
shareholder entitled to the payment of the dividend.

(f) In the absence of any specific provision in the Articles of Association of the company, dividend is paid on the paid up capital of the
company. If there are calls in arrears, dividend is paid on the amount actually paid by the shareholders.

(g) No dividend can be paid on calls in advance.

5(i)- i)What are the practical considerations in formulating the dividend policy? (7 marks)

5(ii)- Elaborate in detail the various forms of dividends. (6 marks)

There are various forms of dividends that are paid out to the shareholders:

CASH DIVIDEND
A Cash dividend is the most common form of the dividend. The shareholders are paid in cash per share. The board of directors announces the
dividend payment on the date of declaration. The dividends are assigned to the shareholders on the date of record. The dividends are issued on
the date of payment. But for distributing cash dividend, the company needs to have positive retained earnings and enough cash for the
payment of dividends.

BONUS SHARE
Bonus share is also called as the stock dividend. Bonus sharesare issued by the company when they have low operating cash, but still want to
keep the investors happy. Each equity shareholder receives a certain number of additional shares depending on the number of shares originally
owned by the shareholder. For example, if a person possesses 10 shares of Company A, and the company declares bonus share issue of 1 for
every 2 shares, the person will get 5 additional shares in his account. From company's angle, the no. of shares and issued capital in the
company will increase by 50% (1/2 shares). The market price, EPS, DPS etc will be adjusted accordingly.
SHARE REPURCHASE
Share repurchase occurs when a company buys back its own shares from the market and reduces the number of shares outstanding. This is
considered as an alternative to the dividend payment as cash is returned to the investors through another way.

PROPERTY DIVIDEND
The company makes the payment in the form of assets in the property dividend. The asset could be any of this equipment, inventory, vehicle
or any other asset. The value of the asset has to be restated at the fair value while issuing a property dividend.

SCRIP DIVIDEND
Scrip dividend is a promissory note to pay the shareholders later. This type of dividend is used when the company does not have sufficient
funds for the issuance of dividends.

LIQUIDATING DIVIDEND
When the company returns the original capital contributed by the equity shareholders as a dividend, it is termed as liquidating dividend. It is
often seen as a sign of closing down the company.

6 Interpret the role of finance manager keeping in mind the degree of financial Leverage in evaluating financing plans? When does leverage
become favourable?
Leverage:
It is the influence of one financial over the others.
There are three types of leverage:
I- OPERATING LEVERAGE
II- FINANCIAL LEVERAGE
III- COMBINED LEVERAGE

OPERATING LEVERAGE:
CHANGE IN SALES OVER CHANGE IN EBIT .FINANCIAL. LEVERAGE.：.
CHANGE IN EBIT OVER CHANGE IN EPS COMBINEDLEVERAGE:
CHANGE IN SALES OVER CHANGE IN EPS

OPERATING LEVERAGE:
% CHANGE IN EBIT/%CHANGE IN SALES (OR)
CONTRIBUTION/EBIT FINANCIAL LEVERAGE:
% CHANGE IN EPS/%CHANGE IN EBIT (OR)
IF PREFERENCE DIVIDEND IS THERE:
EBIT(1-t)/(EBIT-INT)(1-t)-P.D

IF NO PREFERENCE DIVIDEND IS THERE:

 EBIT/EBIT-INT

COMBINED LEVERAGE:
% CHANGE IN EPS/%CHANGE IN SALES (OR)

IF PREFERENCE DIVIDEND IS THERE:

CONT(1-t)/(EBIT-INT)(1-t)-P.D

IF NO PREFERENCE DIVIDEND IS THERE:

CONT/EBIT-INT

7- Define the essentials of Walters Dividend model? Explain its shortcomings.

Walter’s Model:

Definition: According to the Walter’s Model, given by prof. James E. Walter, the dividends are relevant and have a bearing on the firm's
share prices. Also, the investment policy cannot be separated from the dividend policy since both are interlinked.

Walter's Model shows the clear relationship between the return on investments or internal rate of return (r) and the cost of capital (K). The
choice of an appropriate dividend policy affects the overall value of the firm. The efficiency of dividend policy can be shown through a
relationship between returns and the cost.

■ If r>K, the firm should retain the earnings because it possesses better investment opportunities and can gain more than what the
shareholder can by re-investing. The firms with more returns than a cost are called the “Growth firms” and have a zero payout ratio.

■ If r<K, the firm should pay all its earnings to the shareholders in the form of dividends, because they have better investment opportunities
than a firm. Here the payout ratio is 100%.
If r=K, the firm's dividend policy has no effect on the firm's value. Here the firm is indifferent towards how much is to be
retained and how much is to be distributed among the shareholders. The payout ratio can vary from zero to 100%.

Assumptions of Walter's Model:

1. All the financing is done through the retained earnings; no external financing is used.
2. The rate of return (r) and the cost of capital (K) remain constant irrespective of any changes in the investments.

3. All the earnings are either retained or distributed completely among the shareholders.

4. The earnings per share (EPS) and Dividend per share (DPS) remains constant.
5. The firm has a perpetual life.
 Criticism of Walter's Model:

1. It is assumed that the investment opportunities of the firm are financed through the retained earnings and no external financing such as
debt, or equity is used. In such a case either the investment policy or the dividend policy or both will be below the standards.

2. The Walter's Model is only applicable to all equity firms. Also, it is assumed that the rate of return (r) is constant, but, however, it
decreases with more investments.

3. It is assumed that the cost of capital (K) remains constant, but, however, it is not realistic since it ignores the business risk of the firm,
that has a direct impact on the firm's value.

8- Can you explain the considerations involved in evolving a balanced capital structure of a corporation.
Features of an ideal capital structure:

1. Profitability
Cost of firm should be minimum & the firm should maximize the wealth. A proper trading on equity will
maximize wealth of share holders.

2. Solvency:
It means ability of the firm to ay back its liabilities. Too much of debt will threaten the solvency
position of organization, so a proper balance must be maintained between debt & equity.
3. Flexibility:
If the firm has excess of funds it should be able to settle the liabilities of firm.

4. Control:

A good capital structure is designed in such a way that the equity share holders should have a better
control over the business. Too much of debentures will shift the control over business in the hands of financial
institutions. There is restrictive covenant.( covenant is a bond that cannot be broken). A restrictive covenant
restricts the normal course of business.
5. Economy :
Sources of finance should relate to the present trend of the market. The firm should finance the sources
which are cheap in nature and which are available in market.

6. Attraction of investors:
The firm should make the sources in such a way that the investors are given a variety based on the risk
perception.

7. Balanced leverage:
Depending upon nature of business ,debt & equity portion must be maintained in a balanced way which is
permissible within the industry.

8. Simplicity: A complicated capital structure may not be understood by all, on the contrary it may raise
suspicious & create confusion. A capital structure must be as simple as possible.
 9(i) i) How to measure the degree of operating, financial leverage? Illustrate with an example. (7 marks)

Leverage:
It is the influence of one financial over the others.
There are three types of leverage:
I- OPERATING LEVERAGE
II- FINANCIAL LEVERAGE
III- COMBINED LEVERAGE

OPERATING LEVERAGE:
CHANGE IN SALES OVER CHANGE IN EBIT FINANCIAL LEVERAGE:
CHANGE IN EBIT OVER CHANGE IN EPS COMBINED LEVERAGE:
CHANGE IN SALES OVER CHANGE IN EPS
OPERATING LEVERAGE:
% CHANGE IN EBIT/%CHANGE IN SALES (OR)
CONTRIBUTION/EBIT FINANCIAL LEVERAGE:
% CHANGE IN EPS/%CHANGE IN EBIT (OR)

IF PREFERENCE DIVIDEND IS THERE:

EBIT(1-t)/(EBIT-INT) (1-t)-P.D

IF NO PREFERENCE DIVIDEND IS THERE:

EBIT/EBIT-INT

COMBINED LEVERAGE:
% CHANGE IN EPS/%CHANGE IN SALES (OR)

IF PREFERENCE DIVIDEND IS THERE:

CONT(1-t)/(EBIT-INT)(1-t)-P.D

IF NO PREFERENCE DIVIDEND IS THERE:

CONT/EBIT-INT
 9 ii) Can you make a distinction between a policy of stable dividend pay-out ratio and a policy of stable
dividends or steadily changing dividends? What are the reasons

Meaning of Dividend Policy:

The term dividend refers to that part of profits of a company which is distributed by the company among its
shareholders. It is the reward of the shareholders for investments made by them in the shares of the
company. The investors are interested in earning the maximum return on their investments and to maximise
their wealth. A company, on the other hand, needs to provide funds to finance its long-term growth.

If a company pays out as dividend most of what it earns, then for business requirements and further
expansion it will have to depend upon outside resources such as issue of debt or new shares. Dividend
policy of a firm, thus affects both the long-term financing and the wealth of shareholders.

As a result, the firm's decision to pay dividends must be reached in such a manner so as to equitably
apportion the distributed profits and retained earnings.

Since dividend is a right of shareholders to participate in the profits and surplus of the company for their
investment in the share capital of the company, they should receive fair amount of the profits. The company
should, therefore, distribute a reasonable amount as dividends (which should include a normal rate of
interest plus a return for the risks assumed) to its members and retain the rest for its growth and survival.

Types of Dividend Policy:

The various types of dividend policies are discussed as follows:

(a) Regular Dividend Policy:

Payment of dividend at the usual rate is termed as regular dividend. The investors such as retired persons,
widows and other economically weaker persons prefer to get regular dividends.

A regular dividend policy offers the following advantages:

(a) It establishes a profitable record of the company.

(b) It creates confidence amongst the shareholders.

(c) It aids in long-term financing and renders financing easier.

(d) It stabilises the market value of shares.

(e) The ordinary shareholders view dividends as a source of funds to meet their day-to day living expenses.
(f) If profits are not distributed regularly and are retained, the shareholders may have to pay a higher rate
of tax in the year when accumulated profits are distributed.

However, it must be remembered that regular dividends can be maintained only by companies of long
standing and stable earnings, A company should establish the regular dividend at a lower rate as compared
to the average earnings of the company.
(b) Stable Dividend Policy:

The term ‘stability of dividends' means consistency or lack of variability in the stream of dividend
payments. In more precise terms, it means payment of certain minimum amount of dividend regularly.

A stable dividend policy may be established in any of the following three forms:

⑴ Constant dividend per share:

Some companies follow a policy of paying fixed dividend per share irrespective of the level of earnings year
after year. Such firms, usually, create a ‘Reserve for Dividend Equalisation' to enable them pay the fixed
dividend even in the year when the earnings are not sufficient or when there are losses.

A policy of constant dividend per share is most suitable to concerns whose earnings are expected to remain
stable over a number of years.

(ii) Constant payout ratio:

Constant pay-out ratio means payment of a fixed percentage of net earnings as dividends every year. The
amount of dividend in such a policy fluctuates in direct proportion to the earnings of the company. The
policy of constant pay-out is preferred by the firms because it is related to their ability to pay dividends.
Figure given below shows the behaviour of dividends when such a policy is followed.

10(i)- List the determinants while considering capital structure of a company? (7 marks).
Factors affecting capital structure:

2. Trading on equity:
It is the ability to use debentures and preference shares & thereby maximizing
the wealth of equity share holders.

A firm has got 2 options

* Option A
Option B

Option A:

10, 00,000 equity shares @ 15%

EBIT = 1, 50,000

Div = 1, 50,000

Earnings of the company are just enough to meet expectations of share holders.

Option B:

5, 00,000 equity shares @ 15%

3, 00,000 preference shares @ 12%

2, 00,000 debentures @ 10%

EBIT = 1,50,000 ㈠ Interest =

20,000

1, 30,000

(-)Pref Div = 36,000

94,000

(-)Equity Div = 75,000

19,000

Earnings of company are greater than expectation of share holders. Therefore trading on
equity is the firm’s ability to use debenture and preference shares and thereby
maximizing the wealth of share holders.

Desire to control the business:

Sources Risk Rights

Low risk D ebenture holders are do

1. Debentures not have any rights

2. Equity shares High risk Share holders havevoting

rights..
3. Purpose of financing:
Productive financing eg; Expansion of a Nonproductive financing :eg;
plant Welfare facility for staff
If the firm wants more control over business it should issue less of equity shares &
For productive
more purposes
of debentures loans
Whereas can be wants to
if company F irm
havehas
lowtocontrol,
use its more
own funds
equity.so
andcapital
less
availed from banks or financial
of debt can be issued . structure will contain more of equity &
institutions. So capital structure will less of debentures.
contain more of debts & less of equity.
 4. Period of financing:

• Requirement of funds
Long Term Purpose Short Term Purpose

If it is a long term requirement of funds, If it is a short term requirement of fund,

firm funds can be raised through debentures &
Can fund it through equity shares & less of equity capital will be involved.
Less of debentures will be involved.

5. Nature of business:The debt to equity ratio depends on nature of business.

Nature Debt Equity

Manufacturing or service 2 1
sector

Infrastructure, Power 4
1

5. Size of business:

For large scale business, more of debt is required because it involves a very huge
amount of investment & much of securities are present. It is easy to borrow from banks
showing its asset base.

For small scale business, more of equity & less of debentures, because it requires
less amount of funds. It is difficult to borrow from banks showing its asset base.

6. Nature of investors:

In order to attract the investors, firm should provide variety of options to suit
the investors. The investors will have an option to choose based on risk perception.

Option 1: Debentures:

* Redeemable * convertible

* Irredeemable * non convertible

Option 2: Preference Shares:
 * Redeemable * Convertible

* Irredeemable * Non convertible

* Participative * Cumulative

* Non participative * Non Cumulative

7. Cost of financing:
Firm should combine different sources of financing in such a way that overall cost
of financing is minimum & value of firm is maximum.

8. Market conditions:

Recession: A temporary decline in the economic activity.

At this stage the firm will not be in a position to take risk. They are low risk
takers under the recession stage. So the company will issue less equity shares and more
debentures.

Boom: A period of prosperity.

Firm will be ready to take risk under boom stage so at this stage. The company will
issue more equity shares & less debentures.

9. Policy of financial institutions

a. If the financial institutions has Harsh policy, then the firms find it difficult
to borrow , Hence employ more equity & less debt.

b. . If the financial institutions has Soft policy: then the firms find it easy to
borrow , Hence employ more debt and less equity.

10. Regularity of income:

If a firm expects Regular EBIT, the firm can issue more debentures & less
equity.

If a firm has Irregular EBIT, then the firm can issue more equity & less
debentures.

12. Flexibility of capital structure/provision for future:

If firm does not require funds ie surplus of funds it should be able to settle its
liabilities . If there is shortage of fundsthen it must have provision to borrow..

10(ii)- ii) Find out operating, financial and combined leverages from the given data: Sales 50,000 units at

Rs.12 per unit.

Variable cost at Rs.8 per unit.

Fixed cost Rs.90,000 (including 10% interest on Rs.2,50,000). (6 marks)
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11- Chetan Ltd. Earns Rs.50 per share.

The capitalization rate is 15% and the return on investment is 18%. Under Walter’s Model, Determine

a) The optimum Pay-out

b) The market price of the share at this pay out
c) The market price of the share if pay-out is 40%. The market price
of the share if pay-out is 80% (6 marks)
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12i12⑴ A firm has sales of Rs.75, 00,000, variable cost of Rs.42, 00,000 and fixed cost of Rs.6, 00,000. It has a debt of Rs.45,00,000 @ 9
% and equity of Rs.55,00,000

i) What is the firm’s ROI?

ii) Does it have favourable financial leverage?
iii) What are the operating, financial and combined leverages of the firm?
iv) If the sale drops to Rs.50, 00,000, What will be the new EBIT?
At what level will the EBT of the firm be equal to zero.
THE FIRM ROI WILL BE :

EBIT/DEBT+EQUITY*100

=2700000/10000000*100
 27%.
13- Discuss the procedure for determining the weighted average cost of capital. What are the factors affecting weighted average cost of
capital?

METHOD TO CALCULATE WACC USING FORMULA

The method for calculation of weighted average cost of capital is very simple.

1. Determine cost of capital of equity, preference, debt and any other capital.

2. Assign the Market Value Weights by finding out percentage of amount of investment made by each form of capital in the total capital of
the firm. (Refer: Market Value vs. Book Value WACC).

3. Multiply the weights to the respective cost of capital to find out weighted cost.

4. Add the weighted cost of all the forms of capital to determine weighted average of
capital.

FORMULA USING ONLY DEBT AND EQUITY

Weighted Average Cost of Capital

K = Cost of Equity Capital

D = Cost of Debt Capital Tax% = Percentage of Tax

MVe = Market Value of Equity

MVd = Market Value of Debt

MVf = Market Value of Firm

Note: (1-Tax) is for applying the tax shield of debt and find the real cost of debt capital for the firm by eliminating the tax benefit
received due to debt.
FACTORS AFFECTING WACC:

These are the factors affecting cost of capital that the company has control over: 1. Capital Structure Policy As we have been discussing
above, a firm has control over its capital structure, targeting an optimal capital structure. As more debt is issued, the cost of debt
increases, and as more equity is issued, the cost of equity increases.2. Dividend PolicyGiven that the firm has control over its payout
ratio, the breakpoint of the MCC schedule can be changed. For example, as the payout ratio of the company increases the breakpoint
between lower-cost internally generated equity and newly issued equity is lowered.3. Investment PolicyIt is assumed that, when making
investment decisions, the company is making investments with similar degrees of risk.
If a company changes its investment policy relative to its risk, both the cost of debt and cost of equity change.Uncontrollable Factors
Affecting the Cost of CapitalThese are the factors affecting cost of capital that the company has no control over:1. Level of Interest Rates
The level of interest rates will affect the cost of debt and, potentially, the cost of equity. For example, when interest rates increase the
cost of debt increases, which increases the cost of capital.2. Tax RatesTax rates affect the after-tax cost of debt. As tax rates increase, the
cost of debt decreases, decreasing the cost of capital.
 14- Calculate financial and operating leverage under situations when fixed costs are i) Rs.50000 ii)
Rs.10000 and financial plans 1 and 2 respectively, from the following information pertaining to the
operation and capital structure of ABC Co.
Total assets Rs.30000
Total assets turnover based on sales 2
Variable costs as percentage of sales 60
Capital Financial plan 1 Financial plan 2
structure
Equity 30000 10000
10% Debenture 10000 30000
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 3._Does the financial leverage always increase the earnings per share-illustrate your answers
Financial leverage:
 The Leverage associated with financing activities is called financial leverage.

Definition:

The ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT on EPS.

Formula:

Financial Leverage EBIT

^=> "
(Single structure) j (EBIT-Int) (1-tax rate )- Pref Dividend

%change in EPS
Financial Leverage
%change in EBIT
(Double structure)

Uses of financial leverage:

1. It helps to find the relationship between EBIT sales and EPS.

2. It helps to measure the Financial risk.

3. It helps to analyze the sensitivity of EPS to changes in EBIT.

FINANCIAL LEVERAGE DOES NOT ALWAYS INCREASE EPS.
IF EBIT INCREASES 10%, IF FINANCIAL LEVERAGE IS 2, EPS INCREASES 20%
IF EBIT DECREASES10 % , AND FL =2, EPS DECREASES 20 %

4-_Explain the assumptions and implications of NI and NOI approach illustrate your
answers with hypothetical examples Meaning:

Capital structure is defined as “the proportion of debt to equity sources

utilized by the organization”.

Capitalization is defined as “the total value of money collected through

various long term sources of financing”.

E.g.
Equity : 10L

Preference : 10L

Debentures : 5L
10L _______^ Capitalization

Capital Structure Theories:

1. Net Income Approach (N.I Approach)

2. Net Operating Income Approach(NOI)

All these theories try to explain the impact of changes in capital

structure over the value of the firm.

Assumptions common to all the approaches:

1. There are only 2 sources of financing (debt, equity).No preference capital .

2. Taxes do not exit (This assumption will be removed later).

3. Total financing remains constant. (Debt and equity pattern will vary or changes
but the total amount of financing remains constant).

4. Asset base of the company remains constant (No purchase / No sale of asset).

5. All earnings available to equity shareholders is distributed as dividend. (No

retained earnings).

6. Expectation of EBIT will be the same among all investors.

7. Firm will be a perpetual firm.

Commonly used notations in the theory:

Ki cost of the debt (interest).

Ke — cost of equity (dividend).

Ko ^ . overall cost if capital.

B value of debt.

S ♦ value of equity.

V > total value of the firm (V=B+S)

EBIT ―^ earnings before interest and tax.

EAT —► earnings after tax.

Formulas:

1. B X Ki = INTEREST.

2. S X Ke = EATES.

3. V X Ko = EBIT

4. EBIT - Interest = EATES.(No tax and pref. Div.)

⑴NET INCOME APPROACH THEORY:

Statement:

N.I approach theory states that changes in capital structure will affect value of firm.

Assumptions:

1. Cost of debt is always less than cost of equity. i.e. (Ki < Ke)

2. Ki remains constant irrespective of value of debt. (Rate of interest constant).

3. Ke remains constant.

Proof:

Assume EBIT = 50,000; value of debt is 2, 00,000; Ki = 10%; Ke = 15%, What happens to the
value of the firm if the debt is raised to 3, 00,000.

When debt is 2, 00,000

EBIT 50,000

(-) Interest 20,000

EATES 30,000

S = EATES / Ke = 30,000 / .15 = 2,00,000

B = 2,00,000 / .10 = 2,00,000

V = B + S 2L + 2L = 4L
Ko = EBIT/V = (50,000 / 4,00,000) * 100 = 12.5%

When Debt is 3L

EBIT 50,000

(-)Interest 30,000

=EATES 20,000

S = EATES / Ke = 20,000 / .15 = 133333.33 B =

30,000 / .10 = 3,00,000 V = B + S = 4,33,333

Ko = EBIT/V = 50,000/ 4,33,333 * 100 = 11.5%

Graph showing relationship between capital Structure ,Cost of capital and Value of the
Firm

Ke

Ko

--------------------Ki

Debt /V^iue
X axis - Debt / Value Y axis - Value
X axis - Debt / value Y axis - Cost of

Capital
INFERENCE:

As there is a increase in debt in the capital structure, overall cost of capital Ko

decreases and value (V) of the firm decreases .Thus it is proved that changes in capital
structure will affect the value of the firm.

Note:

As more debt is employed, it means cheaper source of financing and hence overall cost of
capital Ko decreases. Since Ko decreases hence the value of the firm increases.

(ii) NET OPERATING INCOME APPROACH:

Assumptions:

1. Cost of debt is always less than cost of equity. i Ki < Ke. 2

.Ki remains constant irrespective of value of debt.

3. Ke starts increasing value of debt increases.

Statement:

Changes in capital structure will not affect value of firm.

Proof: Assume a company has a debt of 2L, Ki= 10%, Ke= 15%, EBIT= 50,000. Assume that
value of debt increases to 3L & simultaneously cost of equity Increases to to 20%.

When debt = 2L:

EBIT 50,000

(-)Interest (10%) 20,000

EATES 30,000

S = EATES / Ke = 30,000 / .15 = 2L

B = Interest / Ki = 20,000 / .10 = 2L

1
V = S + B > 2L + 2L = 4L

Ko = E B I T / V = 50,000 / 4L * 100 = 12.5%

When debt to 3L:

EBIT = 50,000

(-)Interest (10%) 30,000

EATES 20,000

S = EATES \ Ke = 20,000 / .20 = 1,00,000

B = Interest / Ki = 30,000 / .10 = 3,00,000

V = B + S i > 4L

Ko = E B I T / V = 50,000 / 4L * 100 = 12.5%

Graph showing relationship between capital Structure ,Cost of capital and Value of the
Firm
Ke
 Debt/Value

X axis - Debt / Value

Y axis - Value

Debt/Value

X axis - Debt / value Y axis - Cost of Capital

INFERENCE:

1. As debt in capital structure increases, it means cheaper source of financing and hence
it is considered to a positive impact.

2. As debt increases share holders feel very risky and so they try to increase the cost of
equity which is a negative impact.

3. Positive and negative impact nullifies each other and hence Ko remains constant. Value
of firm is constant.