CORPORATE FINANCE

Chapter1-Corporate Governance
Describe Corporate Governance

Corporate governance may be defined as the system of internal controls, processes, and procedures
by which a company is managed, directed or controlled. Weak corporate governance practices have
resulted in the failures of many companies.

The corporate governance practices of countries tend to be different, and it is also not strange for
different corporate governance systems to coexist within a single country.

Corporate governance systems generally reflect the influences of either shareholder theory, stakeholder
theory or a convergence of the two. Current trends, however, point to an increase in convergence.

Shareholder theory posits that the most important responsibility of a company’s managers is to
maximize shareholder returns. Stakeholder theory, on the other hand, emphasizes the need for a
company to consider the needs of all its stakeholders and not just its shareholders. This includes the
company’s customers, suppliers, creditors, employees and essentially anyone who has an interest in the
company.

Describe a Company’s Stakeholder Groups

Corporate governance systems can be influenced by several stakeholder groups which may or may not
have conflicting interests.

A company’s primary stakeholder groups include its shareholders, creditors, managers, other employees,
customers, suppliers, government/regulator, and its board of directors.

By providing a company with equity capital, the shareholders of a company are considered its owners.
Their interests lie primarily in the profitability of the company and anything which leads to an increase
in the company’s equity. In the event of bankruptcy, shareholders receive proceeds only after all
creditors’ claims have been paid. Controlling shareholders hold sufficient shares in a company to control
the election of its board of directors and to influence company resolutions. Minority shareholders, on the
other hand, have far fewer shares and limited ability to exercise control in voting activities.

The creditors of a company are the stakeholders who provide the company with debt financing. Included
in this category are bondholders and banks who expect to receive periodic interest payments and
principal repayments arising from money that they lent to the company.

Creditors generally prefer stability in a company’s operations and performance as this tends to increase
the likelihood that a company will generate sufficient cash flow to pay back its debt obligations. In
contrast, shareholders tend to accept higher risks in return for a higher return potential from strong
company performance.

Managers and other employees tend to benefit when a company performs well and are adversely
affected when the company’s financial position weakens. They seek to maximize the value of their total
remuneration while securing their jobs. Their interests are therefore not surprisingly different from those
of shareholders, creditors, and other stakeholders. Something of potential benefit to other stakeholders
may be disadvantageous to them.

The board of directors is elected by the shareholders of the company and is charged with the
responsibility of protecting shareholders’ interests, providing strategic direction and monitoring
company and management performance.

A company’s customers expect to receive value when they purchase its goods or services. They tend to
be more concerned with company stability and less with financial performance.

Suppliers, just like creditors, are concerned with a company’s ability to generate cash flows sufficient to
meet its financial obligations.

Governments and regulators seek to ensure that companies comply with the law and act in a manner
which safeguards the interests and well-being of the public.

Relationships in Corporate Governance

The term ‘Principal-agent relationship’ or just simply ‘Agency relationship’ is used to describe an
arrangement where one entity, the principal, legally appoints another entity, the agent, to act on its behalf by
providing a service or performing a particular task.

The agent is expected to act in the best interests of the principal. It is however not unusual for principal-agent
relationships to lead to conflicts. The most common example of this occurs when managers, acting as agents,
do not act in the best interests of the shareholders of the company (the principals).

Shareholder and Manager/Director Relationships

Directors and managers (agents) are expected to act in the best interests of the shareholders (principal) by
maximizing the company’s equity value. These two groups, however, tend to diverge on issues related to the
risks that a company should undertake. Managers and directors tend to act in a more risk-averse manner in
order to better protect their employment status, whereas shareholders would want for directors and managers
to accept more risk in order to maximize equity value.

Additionally, managers usually have greater access to information and are more knowledgeable about the
company’s affairs than the shareholders.  This information asymmetry makes it easier for managers to make
strategic decisions that are not necessarily in the best interests of shareholders.

Controlling and Minority Shareholder Relationships

Minority shareholders usually have limited or no control over management and limited or no voice in
director appointments or in major transactions that could directly impact shareholder value. As a result,
conflicts between minority and controlling shareholders usually occur wherein the opinions or desires of the
minority shareholders are overshadowed by the influence of the controlling shareholders.

Manager and Board Relationships

Whereas managers are involved in the day-to-day operations of a company, the board of directors, especially
the non-executive board members, are not. This leads to information asymmetry and makes it difficult for the
board to effectively carry out its functions.
 Creditor versus Shareholder Interests

Creditors desire a company to undertake activities which promote stable financial performance and maintain
default risk at an acceptable level to essentially guarantee a safe return of their principal and payment of
interest. Shareholders, on the other hand, prefer for the company to undertake riskier activities which have
strong earnings potential and are more likely to enhance equity value. There is, therefore, a divergence in risk
tolerance between these two groups.

Other Stakeholder Conflicts

Examples of other conflicts between stakeholders include: conflicts between customers and shareholders,
conflicts between customers and suppliers, and conflicts between shareholders and governments or
regulators.

Proper stakeholder management is critical to the success of any organization. It involves taking appropriate
steps to identify, prioritize and understand each stakeholder group in order to properly manage the
relationships with them. Effective communication and engagement are, therefore, necessary if an
organization wants to get the most out of its stakeholder management.

The approaches to stakeholder management may vary across organizations. Typically, however,
organizations try to balance stakeholder interests as best as possible. This has the effect of limiting any
potential conflicts.

Stakeholder Management Components

To assist with balancing stakeholder interests, corporate governance and stakeholder management
frameworks reflect legal, contractual, organizational, and governmental infrastructures. These four
components define the rights, responsibilities, and powers of each stakeholder group.

 Legal Infrastructure

The legal infrastructure defines the framework for legally establishing rights as well as the remedial action to
be taken for violations of these rights.

 Contractual Infrastructure

The contractual infrastructure refers to the contractual arrangements which are entered into by an
organization and its stakeholders and which help to define and secure the rights of both parties. An
organization has the most control with this component of stakeholder management.

 Organizational infrastructure

The organizational infrastructure refers to the internal systems and governance practices which an
organization uses to manage its stakeholder relationships.

 Governmental Infrastructure
The governmental infrastructure refers to the regulations which are imposed on an organization.

Mechanisms to Manage Stakeholder Relationships

In seeking to balance stakeholder interests, a company may employ various mechanisms for stakeholder
management. Common mechanisms include: holding general meetings, electing a board of directors, having
an audit function, company reporting and transparency, policies on related-party transactions, remuneration
policies (including say on pay), and other mechanisms to manage the company’s relationship with its
creditors, employees, customers, suppliers, and regulators.

General meetings
General meetings provide shareholders with the opportunity to participate in company discussions and to
vote on major corporate matters.

Companies usually hold an annual general meeting (AGM) within a certain period of time after the end of
their financial year. The main purpose of an AGM is to present shareholders with the annual audited
financial statements of the company, provide an overview of the company’s performance over the year, and
address any shareholder concerns.

It is also possible for extraordinary general meetings to be called by the company or by shareholders within
the year whenever significant resolutions requiring shareholder approval are proposed.

Ordinary resolutions require a simple majority of votes to be passed. These usually relate to the approval of
financial statements and the election of directors and auditors. Special resolutions require a supermajority
vote such as 75% of the votes to be passed. These are usually reserved for decisions that are more material in
nature such as effecting amendments to bylaws or voting on a proposed merger or takeover transaction.

Proxy voting allows shareholders who cannot attend a general meeting to authorize another individual to
vote on their behalf. It is the most common form of investor participation in meetings. Minority shareholders
tend to use proxy voting in an attempt to increase their influence on companies.

Cumulative voting allows a shareholder to accumulate and vote all of his or shares for a single candidate in
an election involving more than one director. By employing this process, minority shareholders have an
increased likelihood of being represented by at least one board director.

Board of directors
A board of directors is elected by company shareholders to provide oversight of the company. The board
appoints the top management of the company, is held accountable by shareholders and is also responsible for
the overall governance of the company. The board dictates the strategic direction of the company, guides and
monitors management’s actions towards executing the strategy and evaluates management performance. The
board also supervises the audit, control, and risk management functions of the company as well as its
compliance with all applicable laws and regulations.

The Audit Function

The audit function describes the systems, controls, policies and procedures which a company has in place to
examine its operations and financial records. It serves to limit insiders’ discretion with respect to the use of
the company’s resources and its financial reporting and is also designed to mitigate fraud or misstatements of
accounting information.

There are two types of audit functions: internal audit functions and external audit functions.

Internal audits are conducted by an independent internal audit department. The role of internal audit is to
provide independent assurance that a company’s risk management, governance, and internal control
processes are operating effectively.

External auditors, which are external to a company, perform audits of the company’s financial records with
the objective of providing a reasonable and independent assurance that they accurately reflect the company’s
financial position. The board of directors usually receives and reviews the financial statements and auditors’
reports as well as confirms their accuracy prior to them being presented for shareholder approval at the
AGM.

Reporting and Transparency

Shareholders are able to gain a range of financial and non-financial information mainly through annual
reports and other company disclosures. Access to this information reduces information asymmetry between
the shareholders and managers and allows the shareholders to better assess the performance of the company
and to make informed decisions on company valuations.

Remuneration Policies
Companies are increasingly establishing remuneration policies which discourage short-term focus and
excessive risk taking by managers. Long-term incentive plans delay the payment of all remuneration until
company strategic objectives, namely performance targets, have been met. Some incentive plans include the
granting of shares rather than options to managers and restrict their vesting or sale for several years or until
retirement.

Regulators are placing increasing focus on company remuneration policies. In some parts of the world,
regulators require companies to base their remuneration policies on long-term performance measures. In
some instances too, companies are required to adopt claw back provisions which allow them to recover
previously paid remuneration if certain events such as misconduct or fraud are uncovered.

‘Say on Pay’ enables shareholders to vote on matters pertaining to executive remuneration. This allows them
to limit the discretion that directors and managers have in granting themselves excessive or inadequate
remuneration. It is often criticized by opponents who believe that the board is better suited to handling
remuneration matters given the limited involvement of shareholders in a company’s strategic operations.

Contractual agreements with creditors

The rights of creditors are established by laws and provisions in the contracts that are executed with a
company.

Indentures are legal contracts which describe the structure of a bond, the obligations of the issuer, and the
rights of the bondholders. Covenants within indentures enable creditors to specify the actions an issuer is
obligated to perform or prohibited from performing. Creditors often require a company to provide periodic
financial information in order to ensure that covenants are not violated and default risk is not increased.

Collateral in the form of assets or financial guarantees are often used to guarantee the repayment of debt to
creditors.
Employee Laws and Contracts

The rights of employees are primarily secured through labor laws. Labor laws define the standards for
employees’ rights and responsibilities and cover matters such as working hours, pension plans, hiring and
firing practices and vacation and leave entitlements. Unions seek to influence certain matters which affect the
well-being of employees on their jobs.

Employment contracts specify an employee’s rights and responsibilities but typically do not cover every
situation between employees and employers.

Effective human resource policies seek to attract and recruit high-quality employees while providing
remuneration, training/development and career growth prospects in order to improve employee retention.
Employee Stock Ownership Plans (ESOPs) are also used to retain and motivate employees.

Companies sometimes use Codes of Ethics and business conduct to establish the company’s values and the
standards of ethical and legal behavior which employees are expected to follow.

Other Mechanisms
Other mechanisms for stakeholder management include contractual agreements between companies and their
customers and suppliers, as well as laws and regulations.

Functions and Responsibilities of a Company’s Board of

Directors and its Committees

The board of directors provides oversight of the company and serves as the link between its shareholders and
managers. It has the ultimate responsibility of ensuring that the company adopts proper corporate governance
principles and complies with all applicable laws and regulations.

Board Composition
Boards with one-tier structures comprise a mix of executive and non-executive directors. The executive
directors are employed by the company and are usually members of senior management, while the non-
executive directors are external to the company and bring objectivity to the decision-making process. 
Independent directors are non-executive directors which do not have a material relationship w/ith the
company with respect to employment, ownership or remuneration.

In boards with two-tier structures, the supervisory and management boards are independent of each other.
The chairperson of the supervisory board is typically external to the company while the Chief Executive
Officer (CEO) usually chairs the management board.

In some countries such as the United States, many companies have “CEO duality” in which the CEO also
serves as the chairperson of the board. The CEO and chairperson roles are however becoming increasingly
separated.

Functions and Responsibilities of the Board

Duty of care and duty of loyalty are two well-established elements of directors’ responsibilities. The
Organization for Economic Co-operation and Development (OECD) Principles of Corporate Governance
indicate that duty of care “requires board members to act on a fully informed basis, in good faith, with due
diligence and care”, while duty of loyalty “is the duty of the board member to act in the interest of the
company and shareholders.”

The board:

– Guides and approves the company’s strategic direction

– Delegates strategy implementation to senior management

– Reviews corporate performance and determines relevant course of action

– Hires and fires senior managers

– Ensure leadership continuity through succession planning for the CEO and other key executives

– Sets the overall structure of the company’s audit and control systems

– Oversees reports by internal audit, the audit committee, and external auditors

Board of Directors’ Committees

The board of directors typically establishes committees and delegates some of its responsibilities to these
committees. Some of the most common committees include:

1. Audit Committee – The audit committee is responsible for recommending the appointment of an
independent external auditor and proposing the auditor’s remuneration. The audit committee also
monitors the company’s financial reporting process, including the application of accounting policies.
It also presents an annual audit plan to the board and monitors its implementation by the internal
audit function which it supervises.
2. Governance Committee – The governance committee ensures that the company adopts good
corporate governance practices.
3. Remuneration Committee – The remuneration or compensation committee develops remuneration
policies for the directors and key executives of the company and presents them for approval by the
board or shareholders.
4. Nomination Committee – This committee establishes the nomination procedures and policies,
including eligibility criteria for board directorship.
5. Risk Committee – This committee supervises the risk management function of the company.
6. Investment Committee – The investment committee reviews material investment opportunities
proposed by management, such as expansion plans or acquisitions, and considers their viability.

Factors that can Affect Stakeholder Relationships and Corporate

Governance
Both market and non-market related factors can affect stakeholder relationships and corporate governance.
Market factors are those factors which are related to the capital markets, while non-market factors are those
that are not related to the capital markets.
Market Factors
Market factors include shareholder engagement, shareholder activism, competition, and takeovers.

1. Shareholder Engagement involves a company’s interactions with its shareholders, namely through
AGMs and analyst calls.
2. Shareholder activism refers to the efforts of shareholders to create a change within a company or to
modify company behavior with the primary objective being to increase shareholder value.
3. Shareholders usually compare the earnings reports and market share of a company with those of its
competitors and use the comparison to judge the performance of the managers and/or board.
4. Corporate takeovers can be pursued in several ways. In a proxy fight, shareholders are persuaded to
vote for a group seeking a controlling position on the company’s board. In a tender offer,
shareholders sell their interests directly to the group seeking control, while in a hostile takeover an
attempt is made by one company to acquire another company without the consent of the company’s
management.

Non-market Forces
Non-market forces include the company’s legal environment, the role of the media, and the corporate
governance industry.

1. Legal environment – A company’s legal environment can significantly impact the rights and
remedies of stakeholders. In civil law systems, laws are created primarily through statues and codes
enacted by legislature. In contrast, in common law systems, laws are created both from statutes that
are enacted by legislature and by judges through judicial opinions. Regardless of the prevailing legal
system, creditors are generally more successful in seeking remedies in court to enforce their rights
than shareholders are.
2. The Media can quickly spread information and shape public opinion. Social media, in particular, has
become a tool that shareholders are increasingly using to protect their interests or influence corporate
matters.
3. With the increased importance of corporate governance, the demand for external corporate
governance services has grown considerably. As a result, an industry which provides corporate
governance services such as governance ratings and proxy advice has developed.

Potential Risks of Poor Corporate Governance

Weaknesses in corporate governance practices and stakeholder management processes expose a company
and its stakeholders to several risks. The reverse scenario is that effective corporate governance and
stakeholder management practices can create several benefits for a company and its stakeholders.

Potential Risks
1. One stakeholder group may benefit unfairly at the expense of other stakeholder groups due to
weaknesses in a company’s control systems.
2. Managers could make poor investment decisions which benefit them but are detrimental to the
company’s shareholders.
3. A company’s exposure to legal, regulatory and reputational risks could become heightened. For
example, a company may be subject to an investigation by a regulatory authority due to a violation of
laws and regulations. The company could also receive lawsuits from one of its stakeholders due to
 some form of impropriety. These could potentially damage the reputation of the company and lead to
significant legal costs.
4. A company’s ability to honor its debt obligations may become hindered. This exposes it to
bankruptcy risk if its creditors decide to take legal action against it.

Potential Benefits
1. Operational efficiency could be improved
2. A company’s control systems may be enhanced due to the proper functioning of its audit committee
and the effectiveness of its audit systems.
3. Operating and financial performance could be improved which may lead to a reduction in the costs
that are associated with weak control systems.
4. Business and investment risk may be lowered, thus reducing a company’s cost of capital and its
default risk.

Factors Relevant to the Analysis of Corporate Governance

There are several factors which analysts consider when assessing a company’s corporate governance
structure and stakeholder management. These factors can provide important insights into the quality of
management and the sources of potential risk.

Factors
The factors which analysts look at include:

1. Economic Ownership and Voting Control: Corporations usually have a voting structure which
involves one vote for each share. Shareholders are however exposed to significant risk when
economic ownership becomes separated from control. Dual-class structures, in which shares are
commonly divided into two classes with one having superior voting rights to the other (for example,
class A and class B shares), is a popular way in which voting power can be separated from economic
ownership. Analysts are particularly interested in determining the extent to which this separation
occurs.
2. Board of Director Representation: Analysts look at available information to determine whether the
experience and skill sets of board members are aligned with the current and future needs of the
company. It is quite possible that a board’s composition is appropriate for a particular point in time in
the company’s history but may need changing in order to adjust to new business needs. Additionally,
a board composition that is dominated by long-tenured board members may restrict the board’s
ability to adapt to change.
3. Remuneration and Company Performance . Analysts assess the components of remuneration plans to
determine if they support or conflict with key performance drivers. This assessment is somewhat
subjective but there are certain warning signs that may lead to further scrutiny 1.
4. The Effect of Investors in the company: Investor behavior can limit or enhance the process of
effecting corporate changes. For example, a sizable affiliated shareholder can shield a company from
the voting done by outside shareholders. Shareholder activism can also create a substantial turnover
in a company’s shareholder composition.
5. The Strength of Shareholder’s Rights. Analysts are interested in determining whether the rights of the
shareholders in a company are strong, weak, or average when compared with other companies.
6. The Management of Long-Term Risks. Analysts may consider how a company manages its long-
term risks as a significant factor in their overall assessment of the company.

1
These warning signs include:
– Plans which offer little alignment with shareholders’ interests

– Plans which exhibit little variation in results over multiple years

– Plans which have excessive payouts relative to companies with comparable performance

– Plans which have specific strategic implications

– Plans that are based on incentives which are from an earlier period in the company’s life

Factors in Investment Analysis

Environmental, social and governance factors are collectively referred to by the acronym “ESG”. ESG
integration is the practice of considering environmental, social, and governance factors in the investment
process, and can be implemented across all asset classes, including equities, fixed income, and alternative
investments.

Sustainable investing (SI) and responsible investing (RI) are sometimes used interchangeably with ESG
integration. Socially Responsible Investing (SRI) is an investment strategy that is said to incorporate ESG
issues, but which has been historically represented by the practice of excluding companies and industries
from investment consideration on the grounds that they oppose an investor’s moral or ethical values.

Managers and investors tend to define and implement ESG mandates in many different ways. As a result,
there are often differences among investors regarding which ESG factors should be considered in the
investment process and to what extent they should be implemented within a portfolio.

Objective of the firm

Value Maximization

The objective in corporate finance can be stated broadly as maximizing the value of the entire business,
more narrowly as maximizing the value of the equity stake in the business, or even more narrowly as
maximizing the stock price for a publicly traded firm. The potential side costs increase as the objective
is narrowed.

Why Corporate Finance Focuses on Stock Price Maximization

1. Stock prices are the most observable of all measures that can be used to judge the
performance of a publicly traded firm. Unlike earnings or sales, which are updated once
every quarter or once every year, stock prices are updated constantly to reflect new
information coming out about the firm. Thus, managers receive instantaneous feedback
from investors on every action that they take. A good illustration is the response of
markets to a firm announcing that it plans to acquire another firm. Although managers
consistently paint a rosy picture of every acquisition that they plan, the stock price of the
acquiring firm drops at the time of the announcement of the deal in roughly half of all
acquisitions, suggesting that markets are much more skeptical about managerial claims
2. If investors are rational and markets are efficient, stock prices will reflect the long-term
effects of decisions made by the firm. Unlike accounting measures like earnings or sales
measures, such as market share, which look at the effects on current operations of
 decisions made by a firm, the value of a stock is a function of the long-term health and
prospects of the firm. In a rational market, the stock price is an attempt on the part of
investors to measure this value. Even if they err in their estimates, it can be argued that an
erroneous estimate of long-term value is better than a precise estimate of current
earnings.

MAXIMIZE STOCK PRICES: THE BEST-CASE SCENARIO

If corporate financial theory is based on the objective of maximizing stock prices, it is worth asking
when it is reasonable to ask managers to focus on this objective to the exclusion of all others. There is a
scenario in which managers can concentrate on maximizing stock prices to the exclusion of all other
considerations and not worry about side costs. For this scenario to unfold, the following assumptions
have to hold.

1. The managers of the firm put aside their own interests and focus on maximizing stockholder
wealth. This might occur either because they are terrified of the power stockholders have to replace
them (through the annual meeting or via the board of directors) or because they own enough stock in the
firm that maximizing stockholder wealth becomes their objective as well.

2. The lenders to the firm are fully protected from expropriation by stockholders. This can occur for
one of two reasons. The first is a reputation effect, i.e., that stockholders will not take any action that
hurts lenders now if they feel that doing so might hurt them when they try to borrow money in the
future. The second is that lenders might be able to protect themselves fully by writing covenants
proscribing the firm from taking any action that hurts them.

3. The managers of the firm do not attempt to mislead or lie to financial markets about the firm’s future
prospects, and there is sufficient information for markets to make judgments about the

4. There are no social costs or social benefits. All costs created by the firm in its pursuit of maximizing
stockholder wealth can be traced and charged to the firm.
 Chapter 2-Capital Budgeting
Capital budgeting describes the process which companies use to make decisions on capital projects i.e.
projects with a lifespan of one year or more. It is a cost-benefit exercise which seeks to produce end results
and benefits which are greater than the costs of the capital budgeting efforts.

There are several steps involved in the capital budgeting process. The specificity of the procedures adopted
by a manager is, however, dependent on factors such as the manager’s level in the company, the size and
complexity of the particular project being evaluated, and the size of the company.

Capital Budgeting Process

The typical steps involved in the capital budgeting process are:

Step 1: Generate ideas – Generating good ideas is the most important step.

Step 2: Analyze individual proposals – Information is gathered which helps to forecast cash flows for each
project and then evaluate the project’s profitability.

Step 3: Plan the capital budget – This step involves looking at project timing, scheduling, prioritizing, and
coordinating.

Step 4: Monitor and post-audit – How the project is performing is assessed and actual results (revenues,
expenses, cash flows etc.) are compared with planned or projected results.

Categories of Capital Projects

Capital budgeting projects may be classified in a number of ways. One common classification is as follows:

 Replacement projects – Sometimes capital budgeting decision involves replacing broken down,
worn out or older equipment with newer, more efficient equipment.
 Expansion projects – These increase the size of a company’s business activities, and ultimately the
size of the company.
 New products and services – capital budgeting projects which aim to increase a company’s product
and service offerings carry more uncertainty than expansion projects.
 Regulatory, safety, and environmental projects – These are usually undertaken due to a
requirement by a governmental agency, insurance company or some other external party. Oftentimes they do
not generate any revenue for the company, and it may actually be more prudent to shut down that part of the
business that is related to the project.
 Other – These projects tend to not be subject to the usual capital budgeting analysis, and include, for
example, pet projects of the company’s CEO.

Basic Principles of Capital Budgeting

Since capital budgeting describes the process by which all companies make decisions on their capital
projects, it is not unusual for some fairly sophisticated techniques to be employed. Regardless of this, capital
budgeting relies heavily on just a few basic principles.

Principles of Capital Budgeting

 Capital budgeting typically adopts the following principles:

 Decisions are based on cash flows and not on accounting concepts such as net income
 The timing of cash flows is critical
 Cash flows are based on opportunity costs. A comparison is made between the incremental cash
flows that occur with an investment and without the investment.
 Cash flows are analyzed on an after-tax basis. Taxes have to be fully reflected in capital budgeting
decisions.
 The financing costs are ignored. Financing costs are already reflected in the required rate of return
and therefore including them again in the cash flows and in the discount rate would lead to double counting.
 The capital budgeting cash flows are not the same as accounting net income.

Capital Budgeting Concepts

In addition to the basic capital budgeting principles outlined above, there are several concepts which capital
managers should be aware of in the capital budgeting process. These include:

 Sunk costs – These are costs which have already been incurred.
 Opportunity cost – This refers to what a resource is worth if it is put to its next-best use.
 Incremental cash flow – This is the cash flow which is realized because of a decision.
 Externality – This refers to the effect of an investment on other things besides the investment itself. If
possible, these should be part of the investment decision. Cannibalization is one example of an externality.
This occurs when an investment results in customers and sales moving away from another part of a
company.(Impact of investment in sales of any other product or part of the business)
 Conventional cash flows versus nonconventional cash flows – A conventional cash flow pattern is
one which has an initial cash outflow followed by a series of cash inflows. Conversely, a nonconventional
cash flow pattern is one in which the initial cash outflow is not followed by cash inflows only, but the cash
flows can flip from positive to negative again (or even change signs several times).

Mutually Exclusive Projects

Mutually exclusive projects are capital projects which compete directly with each other. For example, if a
manager has a choice to make between undertaking projects X and Y, and must choose either of the two and
not both, then projects X and Y are said to be mutually exclusive. This scenario differs from independent
projects which are those projects whose cash flows are independent of each other and can, therefore, be
undertaken together.

Project Sequencing
The purpose of project sequencing is to arrange projects in a logical order for completion. It enables a project
manager to determine the order of project completion which best manages the time and resources that are
available.

Through project sequencing, investing in one project may create the option to invest in future projects. For
example, a manager may invest in one project today and then invest in another project in a year’s time if the
financial results of the first project or new economic conditions are favorable.

Capital Rationing
Capital rationing is the act of placing restrictions on the amount of new investments or projects that a
company can undertake. It may occur either through the imposition of a higher cost of capital for
investment consideration or by the establishment of a ceiling on specific portions of a budget.

Capital rationing is more frequent whenever a company has a fixed amount of funds available to
invest. If however the company has more profitable projects than it has funds available for, then it will
be forced to allocate these scarce funds in a manner which achieves maximum shareholder value
subject to the funding constraints.

The opposite of capital rationing occurs whenever unlimited funds are available to a company. In this
situation, a company can raise the required funds for all profitable projects simply by paying the required rate
of return.

Measures of profitability
Several important decision criteria are used to evaluate capital investments. The two most comprehensive
and well-understood measures of whether or not a project is profitable are the net present value (NPV) and
internal rate of return (IRR) measures. Other measures include the payback period, discounted payback
period, average accounting rate of return (AAR), and the profitability index (PI)

Net Present Value (NPV)

The Net Present Value (NPV) of a project is the potential change in wealth resulting from the project after
accounting for the time value of money.  The NPV for a project with one investment outlay made at the start
of the project is defined as the present value of the future after-tax cash flows minus the investment outlay.

Where:

CFt = after-tax cash flow at time t

r = required rate of return for the investment

Outlay = investment cash flow at time zero

Many projects have cash flow patterns in which outflows occur not only at the start of the project (at time =
0) but also at future dates. In these instances, a better formula to use is:

The decision rule for the NPV is: Invest in the project if NPV > 0; do not invest in the project if NPV < 0;
and stay indifferent if NPV = 0.

In other words, positive NPV investments are wealth increasing, while negative NPV investments are wealth
decreasing.
NPV Example
Example 1

Suppose Company A is considering an investment of $100 million in a capital expansion project that will
return after-tax cash flows of $20 million per year for the first 3 years and another $33 million in year 4, the
final year of the project. If the required rate of return for the project is 8%, what would the NPV be and
should company undertake this project?

NPV = 18.519 + 17.147 + 15.877 + 24.256 – 100 = -$24.201 million

Since the NPV < 0, the project should not be undertaken.

Example 2

Gerhardt Corporation is considering an investment of $50 million in a capital project that will return
after-tax cash flows of $16 million per year for the next four years plus another $20 million in year five.
The required rate of return is 10 percent.

Solution

EXAMPLE-Z Ltd. has two projects under consideration A & B; each costing$ 6 million .The projects
are mutually exclusive. Life for project A is 4 years & project B is 3 years. Tax Rate 33.99%. Cost of
Capital is 15%.Calculate NPV

EBITD ( 00000)

At the end of the year Project A Project B P.V. @ 1 5%

1 60 100 0.870

2 110 130 0.756

3 120 50 0.685
 4 50 — 0.572

Solution :

Computation of Net Present V alue of the Projects.

Project A

Yr1 Yr. 2 Yr. 3 Yr. 4

1. Net Cash Inflow 60.00 110.00 120.00 50.00

2. Depreciation 15.00 15.00 15.00 15.00

3. PBT (1–2) 45.00 95.00 105.00 35.00

4. Tax @ 33.99% 15.30 32.29 35.70 11.90

5. PAT (3–4) 29.70 62.71 69.30 23.10

6. Net Cash Flow 44.70 77.71 84.30 38.10

(PAT+Deprn)

7. Discounting Factor 0.870 0.756 0.685 0.572

8. P.V. of Net Cash Flows 3 8.89 58.75 57.75 21.79

9. Total P.V. of Net Cash Flo w = 177.18

10. P.V. of Cash outflow (Initial Investment) = 60.00

Net Present Value = 117.18

Project B

Yr. 1 Yr. 2 Yr. 3

1. Net Cash Inflow 1 00.00 130.00 50.00

2. Depreciation 20.00 20.00 20.00

3. PBT (1–2) 80.0 110.00 30.00

4. Tax @ 33.99% 27.19 37.39 10.20

5. PAT (3–4) 52.81 72.61 19.80

6. Next Cash Flow 72.81 92.61 39.80

(PAT+Dep.)

7. Discounting Factor 0.870 0.756 0.685

8. P.V. of Next Cash Flows 63.345 70.013 27.263

9. Total P.V. of Cash Inflows = 160.621

10. P.V. of Cash Outflows = 60.00

(Initial Investment)

Net Present Value = 100.621

As Project “A” has a higher Net Present Value, it has to be taken up.

Internal Rate of Return

The internal rate of return (IRR) is the discount rate which makes the net present value (NPV) of all cash
flows from a particular project equal to zero. For a project with one initial outlay, the IRR is the discount rate
which makes the present value of the future after-tax cash flows equal to the investment outlay.

The IRR solves the equation –

It looks very much like the NPV equation except that the discount rate is the IRR instead of r, the required
rate of return. Discounted at the IRR, the NPV is equal to zero.

The decision rule for the IRR is to invest in the project if the IRR exceeds the required rate of return for the
project i.e. invest if IRR > r; do not invest if IRR < r.

In instances where the outlays for a project occur at times other than time 0, a more general form of the IRR
equation is:

IRR Example
Following on from the above NPV example, if company A is considering an investment of $100 million in a
capital expansion project that will return after-tax cash flows of $20 million per year for the first 3 years and
another $33 million in year 4, the final year of the project, what is the IRR for this project and should it be
undertaken given that the required rate of return for the project is 8%?

Solve for IRR in the following equation –

The solution can be found by trial and error. However, a much simpler approach is to use a financial
calculator or spreadsheet software.

The IRR is computed to be -2.626%. Since -2.626% < 8%, the project should not be undertaken.

Example.

Project Cost $ 1,10,000

Year 1 2 3 4

Inflow 60000 20000 10000 50000

Calculate the Internal Rate of Return.

Year Cash Inflows P.V. @ 10% DCFAT P.V. @ 12% DCFAT

1 60,000 0.909 54,540 0.893 53,580

2 20,000 0.826 16,520 0.797 15,940

 3 10,000 0.751 7,510 0.712 7,120

4 50,000 0.683 34,150 0.636 31,800

P.V. of Inflows 1,12,720 1,08,440

Less : Initial Investment 1,10,000 1,10,000

NPV 2,720 (1,560)

Example
We determined, at that time, that for an initial cash outflow of $100,000, the Faversham Fish Farm expected to generate net
cash flows of $34,432, $39,530, $39,359, and $32,219 over the next 4 years. Calculate IRR.
A 15 percent discount rate produces a resulting present value for the project that is greater than the initial cash outflow of
$100,000. Therefore, we need to try a higher discount rate to further handicap the future cash flows and force their present
value down to $100,000. How about a 20 percent discount rate?

Payback Period
The payback period refers to the number of years required to recover the original investment in a project. It is
very simple to compute and explain. It, however, ignores the time value of money and the risk of a project by
not discounting cash flows at the project’s required rate of return. It also ignores cash flows that occur after
the payback period is reached. It may be used as an indicator of a project’s liquidity but not of its
profitability.

Payback Period Example

The table below provides data on the cash flows of a project. How long would the project take to recover the
initial investment (payback period)?

Table 1 Payback Period Example

Year     0     1     2     3     4

Cash flow -5,000  1,500 3,500 4,000 4,000
Cumulative cash -5,000 -3,500     0 4,000 4,000
flow
 

After the first year, 1,500 of the initial investment of 5,000 is recovered, with 3,500 still unrecovered. In year
2, the project earns 3,500, which means that the initial investment is now fully recovered. The payback
period is therefore 2 years. Payback period ignores the cash flows which occur in years 3 and 4.

(a)When annual cash inflow are equal

Payback period = Original cost of the project (cash outlay)

Annual net cash inflow (net earnings)

Example-. A project cost$1, 00,000 and yields annual cash inflow of$20,000 for 8 years, calculate
payback period

(a) When annual cash inflow s are unequal

It is ascertained by cumulating cash inflows till the time when the cumulative cash inflows
become equal to initial investment.

Year Cash inflow Cumulative cash inflow

 1 2000 2000

2 4000 6000

3 3000 9000

4 2000 11000

The initial investment is recovered between the 3rd and the 4th year.

Pay back period =Y+ B = 3+ 1000 years = 3+ 1 years= 3year 6months

C 2000 2

Example

A project costing $2 million yields annually a profit of 300000 after depreciation @10% (straight line method) but before tax
50%.

Solution

cash inflow = Profit after tax + Depreciation = 3,00,000 – Tax 1,50,000 + Depre. 2,00,000 = 350000 p.a.

2000000/350000=5.7

Discounted Payback Period

The discounted payback period refers to the number of years for the cumulative discounted cash flows from
a project to equal to the original investment. By factoring in a discount rate, the discounted payback period is
a slight improvement over the payback period. It, however, ignores cash flows which occur after the
discounted payback period is reached.

Discounted Payback Period Example

Following on from the example in Table 1 above, what would be the discounted payback period assuming a
discount rate of 10%?

Year 0 1 2 3 4
Cash flow (CF) -5,000  1,500.00 3,500.00 4,000.00 4,000.00
Cumulative CF -5,000 -3,500.00     0 4,000.00 4,000.00
Discounted CF -5,000  1,363.64 2,892.56 3,005.26 2,732.05
Cumulative -5,000 -3,636.36   -743.80 2,261.46 4,993.51
discounted CF
The discounted payback period is between 2 and 3 years. More precisely, it is two years plus (the cumulative
discounted  CF after 2 years divided by the discounted cash flow in year 3) i.e.  2 + 743.80/3,005.26 = 2.25
years.

Profitability Index (PI)

The profitability index (PI) refers to the present value of a project’s future cash flows divided by the initial
investment.

In the form of an equation, it is –

Whenever the NPV > 0, the PI will be greater than 1.0; conversely, whenever the NPV is negative, the PI
will be less than 1.0.

The decision rule for the PI is; Invest in the project if PI>1.0; do not invest in the project if PI<1.0.

PI Example
If company A has a project with an initial outlay of $100 million and an NPV of -$24.201 million, the
profitability index is computed as:

Since the PI < 1.0, undertaking the project would not be a profitable investment.

Accounting Rate of Return method or Average Rate of Return (A RR)

This method measures the rate in profit expected to result from investment.

It is based on accounting profits and not cash flows.

Example.

A project costing $1,000000. EBITD (Earnings before Depreciation, Interest and Taxes) during the first
five years is expected to be$2,50,000;$3,00,000,$3,50 ,000;$4,00,000 and 5,00,000. Assume 33.99% tax
and 30% depreciation on WDV Method.

YEARS 1 2 3 4 5 TOTAL

EBITD 2,50,0 00 3,00,000 3,50,000 4,00,000 5,00,000 3,60,000

Less : Depreciation 3,00, 000 2,10,000 1,47,000 1,02,900 7 2,030 1,66,386
EBIT (50,0 00) 90,000 2,03,000 2,97,100 4,27,970 1,93,614
Less : Tax @ 33.99% - 13,596 69,000 1,00,984 1,4 5,467 65,809

Total (50,00 0) 76,404 1,34,000 1,96,116 2,8 2,503 1,27,805

ARR=127805/500000 X100=25.56%

Example

XYZ Company is considering investing in a project that requires an initial investment of $100,000 for
some machinery. There will be net inflows of $20,000 for the first two years, $10,000 in years three and
four, and $30,000 in year five. Finally, the machine has a salvage value of $25,000.

 
Step Two: Calculate average investment

Average investment = ($100,000 + $25,000) / 2  = $62,500

Step 3: Divide profit into cost

ARR = 3,000/62,500 = 4.8%

 Chapter 3 Cost of Capital
Weighted Average Cost of Capital (WACC)
The concept of cost of capital is important to both the investment decisions made by a company’s
management and the valuation of the company by investors and analysts. A company which invests in a
project which produces a return which is greater than its cost of capital has created value, and if the return is
less than the cost of capital then value has been destroyed.

Cost of Capital
The cost of capital is not observable but must be estimated using assumptions. It is the rate of return which
the suppliers of capital i.e. bondholders and owners require as compensation for their contribution of capital.

The marginal cost is the cost to raise additional funds for a potential investment project. This is the cost of
capital that an investment analyst is most concerned with.

Weighted Average Cost of Capital

The cost of capital for a company refers to the required rate of return which investors demand for the
average-risk investment of a company. It is usually estimated by computing the marginal cost of each of the
various sources of capital for the company and then taking a weighted average of these costs. This is referred
to as the weighted average cost of capital (WACC). Given that it is the cost which a company incurs to raise
additional capital, the WACC may also be referred to as the marginal cost of capital (MCC).

The formula for the WACC is:

where –

wd = the proportion of debt that a company uses whenever it raises new funds

rd = the before-tax marginal cost of debt

t = the company’s marginal tax rate

wp = the proportion of preferred stock that the company uses when it raises new funds

rp= the marginal cost of preferred stock

we = the proportion of equity that the company uses when it raises new funds

re= the marginal cost of equity

How Taxes Affect the Cost of Capital

Taxes can have a significant impact on a company’s weighted average cost of capital (WACC). However,
taxes affect the cost of capital from different sources of capital in different ways.

The Effect of Taxes on Debt and Equity Financing

In many tax jurisdictions, interest on debt financing is a deduction made prior to arriving at a company’s
taxable income. You may recall that in the equation to compute a company’s WACC, the expected before-
tax cost on new debt financing, rd, is adjusted by a factor, (1-t). Multiplying rd, by the factor (1-t) results in an
estimate of the company’s after-tax cost of debt.

An example will help to explain this concept better. If for example, company XYZ pays $10,000 as interest
expense on debt to bondholders of $100,000, and the company is subject to a tax rate of 35%, then the cost
of debt would be ($10,000) (1- 0.35) =  $6,500. The cost of debt would not be the entire $10,000 that is paid
as interest expense given that the company’s taxable income would be reduced by the $10,000, which leads
to a reduction in the amount of tax that the company pays by ($10,000) * 35% = $3,500. The before-tax cost
of debt for the company would be ($10,000/$100,000) = 10%, while the after-tax cost of debt would be
($6,500/$100,000) = 6.5%.

Taxes do not affect the cost of common equity or the cost of preferred stock. This is the case because the
payments to the owners of these sources of capital, whether in the form of dividend payments or return on
capital, are not tax-deductible for a company. This explains why in the equation for computing a company’s
WACC, no tax adjustment is made for these sources of capital

Target Capital Structure and WACC

A company’s target capital structure refers to capital which the company is striving to obtain. In other words,
target capital structure describes the mix of debt, preferred stock and common equity which is expected to
optimize a company’s stock price. As a company raises new capital, it will focus on maintaining
this target or optimal capital structure.

Using Target Capital Structure to Estimate the Weighted

Average Cost of Capital (WACC)
In determining the weights to be used in the WACC computation for a company, ideally, a manager should
use the proportion of each source of capital which will be used.

For example, if a company has three sources of capital: debt, common equity, and preferred stock, then –

wd, the proportion of debt =

 we, the proportion of equity =

wp, the proportion of preferred stocks =

If however the target capital structure is known and the company attempts to raise capital in a manner which
is consistent with this target, then the target capital structure should be used.

Estimating Target Capital Structure Weights

A person such as an analyst who is external to a company will often not know the company’s target capital
structure, and will, therefore, have to estimate it using one of the following methods:

 Assume that a company’s current capital structure, at current market value weights for each capital
component, is equivalent to the company’s target capital structure;
 Examine trends in a company’s capital structure or statements made by its management relating to
capital structure policy to infer the target capital structure; and
 Use the averages of comparable companies’ capital structures as the target capital structure.

An example will help to explain this concept further.

Example
An analyst wishes to determine the proportion of debt and equity that Company ABC would use if estimating
these proportions using (i) company ABC’s current capital structure, and (ii) the average of company ABC’s
competitors’ capital structure. The following information is given:

Company ABC market value of debt    =       $25 million

Company ABC market value of equity =       $35 million

Company ABC’s competitors and their capital structures are:

Competitor Market Value of Debt Market Value of Equity

X $20 million $40 million
Y $32 million $55 million
Solution to (i):

wd, the proportion of company ABC debt =

we, the proportion of company ABC equity =

Solution to (ii):

wd, the arithmetic average of company ABC’s competitors’ debt =

we, the arithmetic average of company ABC’s competitors’ equity =

Although in the above example, the arithmetic average is calculated, it is also possible to compute the
weighted average which would give a greater weight to larger companies.
Example

Y Ltd issued$2,00,000, 9% debentures at a premium of 10%. The costs of floatation are 2%. The tax
rate is 50%. Compute the after tax cost of debt.

I 18000
Answer : kd (after-tax) = (1-t)= (1- 0.5) =4.17%

NP 215600

[Net Proceeds = 2,00,000 + 2 0,000 – (2/100×2,20,000)]

Example
XYZ Company Ltd., decides to float perpetual 12 per cent, debentures of $ 100 each. The tax rate is 50 per cent. Calculate cost
of debenture (pre- and post-tax cost).

Solution:

Pre-tax cost

12
= 12 per cent
K
di = 100

(ii) Post-tax cost

12 1 - 0.5
K = = 6 per cent
d

100

Example

Rama & Co. has 15 per cent irredeemable debentures of $100 each for $10, 00,000. The tax rate is 35 per cent. Determine
debenture assuming it is issued at (i) face value/par value (ii) 10 per cent premium and (iii) 10 per cent discount.

Issued at Pre-tax Post-tax

15 15(1 –
0.35)
(i) Face value = 15 per cent = 9.8 per cent
100
100

(ii) 10% premium 15 = 13.7 per cent (100 + 10) 15(1 – = 8.9 per cent
 0.35)

110
110

15 15(1 –
0.35)
(iii) 10% discount = 16.67 per cent (100 – 10) = 10.9 per cent
90
90

Example

A company issued $ . 1,00,000, 10% redeemable debentures at a discount of 5%. The cost of floatation
amount to $3,000. The debentures are redeemable after 5 years. Compute before – tax and after – tax
cost of debt. The tax rate is 50%.
 Method 2-

Cost of Redeemable Debentures

NI t Pn
NP =
 t + n

t=1  1 + K d   1 + Kd 

Where,

Kd = Cost of debentures.

n = Maturity period.

NI = Net interest (after tax adjustment).

Pn = Principal repayment in the year ‘n’.

Example

BE Company issues $ 100 par value of debentures carrying 15 per cent interest. The debentures are repayable after 7 years at
face value. The cost of issue is 3 per cent and tax rate is 45 per cent. Calculate the cost of debenture.

7 151 – 0.45 100

100–3= t + n

t=1 1 + K d  1 + Kd 

DF PV of Cash Outflows ( )

Year Cash outflow ( )

7% 10% 7% 10%

1-7 8.25 5.389 4.868 44.96 40.16

7 100 0.623 0.513 62.30 51.30

PV of cash out flows 106.76 91.46

(-) PV of Cash inflows 97.00 97.00

 9.76 5.54

Cost of debenture capital lies between 10 per cent and 12 per cent, because net present value $ 97 lies between the PV of 10 per
cent and 12 per cent. Exact cost can be computed only with interpolation formula:

Where,

LDF = Lower discounting factor.

HDF = Higher discounting factor.

LDFPV = Lower discounting factor present value.

HDFPV = Higher discounting factor PV.

PVCIF = Present value of cash inflows

NP = Net proceeds.

Installment repayment

Example

H.R & Co. issued 14 per cent debentures aggregate at$2,00,000. The face value of debenture is
$100. Issue cost is 5 per cent. The company has agreed to repay the debenture in 5 equal
instalment at par value. Instalment starts at the end of the year. The company’s tax rate is 35
per cent. Compute cost of debenture.

Solution:
 Sales proceeds = Face value – Flotation cost = 100–5= 95

Instalment amount = Face value ÷ No. of instalments = 100 ÷ 5 = 20.

Cash Outflow ( ) DF Factor PV of Cash Outflows ( )

Years

(NI + Instalment) 8% 13% 8% 13%

1 9.1 + 20 = 29.1 0.926 0.885 26.947 25.754

2 7.28 + 20 = 27.28 0.857 0.783 23.379 21.361

3 5.46 + 20 = 25.46 0.794 0.693 20.216 17.644

4 3.64 + 20 = 23.64 0.735 0.613 17.376 14.492

5 1.82 + 20 = 21.82 0.681 0.543 14.860 11.849

PV of cash out flows 102.778 91.230

PV of cash inflows 95.000 95.000

(+) 7.778 (-)3.770

1
Example :

A company issued 10,,000, 10% preference share of $10 each, Cost of issue is $2 per
share. Calculate cost of capital if these shares are issued (a) at par, (b) at 10% premium, and (c)
at5% discount.

Solutions : Cost of preference capital, (Kp) = D/NP

a) When issued at par :

10000

Kp = 100 =12.5%

100000 20000

[Cost of issue = 10,00 0 × 2 = Rs. 20,000]

b) When issued at 10% premium

 10000

Kp= 100 =11.11%

-
100000 -10000 20000

c) When issued at 5% discount :

10000
100
Kp= =13.33%

100000 -5000 -20000

Cost of irredeemable preference stock (with dividend tax)

D 1 + Dt 
Kp (with tax) =
CMP or NP

Where,

Dt = tax on preference dividend

Example

A company is planning to issue 14 per cent irredeemable preference share at the face value of $250 per share, with an
estimated flotation cost of 5%. What is the cost of preference share with 10% dividend tax.
Solution:

D  1 + Dt 
K = × 100
p

NP

351 + 0.10
= ×100 =16.21 per cent
 237.5

Example

Sai Ram & Co. is planning to issue 14 per cent perpetual preference shares, with face value of $100 each. Floatation
costs are estimated at 4 per cent on sales price. Compute (a) cost of preference shares if they are issued at (i) face/par
value, (ii) 10 per cent premium, and (iii) 5 per cent discount, (b) compute cost of preference share in these situation
assuming 5 per cent dividend tax.

Solution:

Without dividend tax With dividend tax

(i) Issued at face value (i) Issued at face value

Kp = 14 =14.6 per cent Kp = 14 (1 + 0.05) =15.4 per cent

(100 - 4) 96

(ii) Issued at 10% premium (ii) Issued at 10% premium

14 14(1 + 0.05)
Kp = =13.2 per cent Kp = =13.9 per cent

(110 - 4) 106

(iii) Issued at 5% discount (iii) Issued at 5% discount

Kp = 14 =15.4 per cent Kp = 14(1 + 0.05) =16.2 per cent

(100 -5-3.8) 91.2

Cost of Redeemable Preference Shares

Example

A company issues $1, 00,000, 10 per cent preference shares of $100 each redeemable
after 10 years at face value. Cost of issue is 10 per cent. Calculate the cost of preference
share.

Solution

The trial and error method is used here, for the computation of the cost of preference share.

PV factor Present Values

Year Cash outflow ( )

10% 12% 10% 12%

 1-10 10 6.145 5.650 61.45 56.5

10 100 0.386 0.322 38.60 32.2

Total PV of Cash outflow 100.05 88.70

(-) PV of Cash inflow 90.00 90.00

10.05 (-) 1.3

In trials, PV of cash outflow did not equal to the PV of cash inflow ( 100). Hence, cost of preference share is calculated
by using interpolation formula.

Where,

LDF = Lower discounting factor in %.

LDFPV = Lower discounting factor present value ( ).

HDFPV = Higher discounting factor present value ( ).

PV of CIF = Present value of cash inflows.

Cost of Equity Capital

A company is able to increase its common equity by either reinvesting its earnings or issuing new
stock. The cost of equity will, therefore, be the rate of return that is required by its shareholders.

There are three methods that are typically used to estimate the cost of equity. These are: the capital
asset pricing model, the dividend discount model, and the bond yield plus risk premium method.

Dividends Capitalisation Approach (D/MN Approach)

Dividends Capitalisation Approach (D/MN Approach)

According to this approach, the cost of equity capital is calculated on the basis of a required rate of return in terms of
the future dividends to be paid on the shares. Accordingly, K e is defined as the discount rate that equates the present
value of all expected future dividends per share, along with the net proceeds of the sale (or the current market price)
of a share. It means investor arrives at a market price for a share by capitalizing dividends at a normal rate of return.
The cost of equity capital can be measured by the given formula:

Ke = D/CMP or NP

Where,
Ke = Cost of equity
D = Dividends per share
CMP = Current market price per share
NP = Net proceed per share
This method assumes that investor give prime importance to dividends and risk in the firm remains unchanged and
it does not consider the growth in dividend.

Example

XYZ Ltd., is currently earning $ 1,00,000, its current share market price of $ 100 outstanding equity shares is 10,000.
The company decides to raise an additional capital of $ 2,50,000 through issue of equity shares to the public. It is
expected to pay 10 per cent per share as floatation cost. Equity capital is issued at a discount rate of 10 per cent, per
share. The company is interested to pay a dividend of $ 8 per share. Calculate the cost of equity.

Solution:

D
K = ×100
e

NP

Ke = 100 – 10 – 10 × 100

8
× 100
K
e = 80

= 10 per cent
Example:

ABC Ltd plans to issue 1,00,000 new equity share of 10 each at par. The floatation costs are
expected to be 5% of the share price. The company pays a dividend o f$ 1 per share and the
growth rate in dividend is expected to be 5%. Compute the cost of new equity share. If the
current market price is 15, compute the cost of existing equity share.
Solution:

Cost of new equity shares = (Ke) = D1/NP +g

Ke = 1.05 / (10-0.5) + 0.0 5 = 1 / 9.5 + 0.05

= 0.01053 + 0.05

= 0.160 or 16%

Cost of existing equity share: ke = D1 / MP + g

Ke = 1.05/ 15 + 0.05 = 0.12 or 12%

Example

Equity shares of a paper manufacturing company is currently selling for $100. It wants to finance its capital
expenditure of $100000 either by retaining earnings or selling new shares. If company seeks to sell shares, the issue
price will be $95. The expected dividend next year is$ 4.75 and it is expected to grow at 6 per cent perpetually.
Calculate cost of equity capital (internal and external).

Solution

Earnings Capitalization Approach (E/MP Approach)

According to this approach, the cost of equity (Ke) is the discount rate that equates the present value of expected
future earnings per share with the net proceeds (or current market price) of a share. The advocates of this approach
establish a relationship between earnings and market price of the share. They say that, it is more useful than the
dividend capitalisation approach, due to two reasons, one, the earnings capitalization approach acknowledges that
all earnings of the company, after payment of fixed dividend to preference shareholders, legally belong to equity
shareholders whether they are paid as dividends or retained for investment, secondly, and most importantly,
determining the market price of equity shares is based on earnings and not dividends.

Where,
Ke = Cost of equity
E = Earnings per share
CMP = Current market price per share
NP = Net proceeds per share.

Example

Well do Company Ltd. is currently earning 15 per cent operating profit on its share capital of $2 million (FV of $200
per share). It is interested to go for expansion for which the company requires an additional share capital of 1 million.
Company is raising this amount by the issue of equity shares at 10 per cent premium and the expected floatation cost
is 5 per cent. Calculate the cost of equity.

1. Calculation of EPS
Operating Profit = 20,00,000 × 0.15 = 3,00,000
No.of Equity Shares = 20,00,000/200 = 10,000 Shares
EPS = 3,00,000/10,000 = 30
2. Net Proceeds (NP) = Face value + Premium – Floatation cost
= 200 + 20 – 10 = 210

Cost of Capital under Variable Growth Rate:

The computation cost of equity after a specific period, is based on the estimation of growth rate in dividends of a
company. Expected growth rate will be calculated based upon the past trend in dividend. It may not be unreasonable
to project the trend into the future, based on the past trend. The financial manager must estimate the internal growth
rate in dividends on the basis of long range plans of the company. Expected growth rate in the internal context
requires to be adjusted. Compound growth rate in dividends can be computed with the following formula.

gr = D 1 (1 + r)n = Dn

Where,
gr = Growth rate in dividends
D1 = First year dividend payment
(1 + r)n = compound value factor for ‘nth’ year
Dn = Last year dividend payment.

From the following dividends record of a company, compute the expected growth rate
in dividends.

Year 1996 1997 1998 1999 2000 2001 2002 2003

Dividends per share ( ) 21 22 23 24 25 26 27 28

Solution:
gr = D1 (1 + r)n =Dn
21 (1 + r)7 = 28

(1 + r)7 = 28 ÷ 21

(1 + r)7 = 1.334

During seven years the dividends has increased by 7 giving a compound factor of 1.334. The growth rate is 4 per cent
since the sum of 1 would accumulate to 1.334 in seven years at 4 per cent interest.

Example
Mr. A an investor, purchases an equity share of a growing company for $210. He expects the company to pay
dividends of $10.5, $11.025 and $11.575 in years 1, 2 and 3 respectively and he expects to sell the shares at a price of
$243.10 at the end of three years.
1. Determine the growth rate in dividends.
2. Calculate the current dividend yield.
3. What is the required rate of return of Mr. A on his equity investment?

Solution
(i) Growth rate in dividend = D1(1 + r)n = Dn,
that is, 10.50(1 + r)2 = 11.575 (1 + r)2 = 11.575 ÷ 10.50 = 1.1024
Table A-1 (compounded sum of $1) suggests that 1 compounds to 1.102 in 2 years at the compound
rate of 5 per cent. Therefore, growth rate in dividend is 5 per cent.

(ii) Current dividend yield (Dy) = Expected dividend/Current price = 10.50/210 = 5 per cent

(iii) Required rate of return (Ke) = (D1/P0) + g, i.e., 10.50/210 + 0.05 = 10 per cent

(Variable growth rates)

Example
A textile company’s dividends have been expected to grow in the following manner.
1 – 2 years 15 per cent
3 – 5 years 10 per cent
6 year and beyond 5 per cent
The company currently pays a dividend of $2 per share, which is currently selling at $75 per share. What would be
the cost of equity capital assuming a fixed dividend pay out ratio?

Solution
Capital Asset Pricing Model
Application of the Capital Asset Pricing Model (CAPM) to compute the cost of equity is based on the
following relationship:

where:
E(Ri) = the cost of equity or the expected return on a stock

Rf = the risk-free rate of interest

Bi = the equity beta or return sensitivity of stock i to changes in the market return

E(Rm) = the expected market return

Of note, the expression E(Rm) – Rf  is known as the expected market risk premium or equity risk
premium.

The risk-free rate of interest may be estimated by the yield on a default-free government debt
instrument.

Example
A company’s equity beta is estimated to be 1.2. If the market is expected to return 8% and the risk-
free rate of return is 4%, what is the company’s cost of equity?

Solution

The company’s cost of equity = 4% + 1.2(8% – 4%) = 4%+4.8% = 8.8%.

Bond Yield plus Risk Premium Approach

According to the bond yield plus risk premium approach, the cost of equity may be estimated by the
following relationship:

re = rd + Risk Premium

where:

re = the cost of equity

rd = the cost of debt

Risk premium = compensation which shareholders require for the additional risk of equity compared
with debt

For example, if a company’s before-tax cost of debt is 4.5% and the extra compensation required by
shareholders for investing in the company’s stock is 3.2%, then the cost of equity is 4.5% + 3.2% =
7.7%.
Realized Yield Approach

Realized Yield Approach takes into consideration that, the actual average rate of returns realized in the past few
years, may be applied to compute the cost of equity share capital i.e., the average rate of returns realized by
considering dividends received in the past few years along with the gain realized at the time of sale of share.

Example
An investor purchased equity share of HPH Company at $240 on 01.01.1998 and after holding it for 5 years sold the
share in early 2003 at $300. During this period of 5 years, he received a dividend of $14 in 1998 and 1999 and $14.5
from 2000 to 2002. Calculate the cost of equity capital based on realized yield approach with 10 per cent discounting
factor.

Solution

Years Cash inflows ( ) DF 10% PV of Cash inflows ( )

1998 14.0 0.909 12.7

1999 14.0 0.826 11.6

2000 14.5 0.751 10.9

2001 14.5 0.683 9.9

2002 14.5 0.621 9.0

2003 300.0 0.621 186.3

240.4

(-) Purchase price in 1998 240.0

0.4

At 10 per cent discount rate, the total PV of cash inflows equals to the PV of cash outflows. Hence,
cost of equity capital is 10 per cent.
Example
A firm has the following capital structure as the latest statement shows:

Source of Funds $ After Tax Cost (%)

Debt 30,00,000 4

Preference shares 10,00,000 8.5

Equity share 20,00,000 11.5

Retained earnings 40,00,000 10

 Total 100,00,000

Based on the book values compute the cost of capital.

Solution

Example
XYZ company supplied the following information and requested you to compute the cost of capital based on book
values and market values.

Source of Finance Book Value ( ) Market Value ( ) After Tax Cost (%)

Equity capital 10,00,000 15,00,000 12

Long-term debt 8,00,000 7,50,000 7

Short-term debt 2,00,000 2,00,000 4

Total 20,00,000 24,50,000

Solution
Computation of Cost of Capital based on Book Value

Source of Finance Book Value ( ) Weights Specific cost Weighted cost

(1) (2) (3) (4) (5) = (3) × (4)

Equity capital 10,00,000 0.50 0.12 0.060

Long-term debt 8,00,000 0.40 0.07 0.028

Short-term debt 2,00,000 0.10 0.04 0.004

Total 20,00,000 1.00 0.092

Cost of Capital based on Market Value Weight

Source of Finance Book Value ( ) Weights Specific cost Weighted cost

(1) (2) (3) (4) (5) = (3) × (4)

Equity capital 15,00,000 0.613 0.12 0.074

Long-term debt 7,50,000 0.307 0.07 0.022

Short-term debt 2,00,000 0.080 0.04 0.003

24,50,000 1.000 0.099

Example:

XYZ Ltd. (in 40% Tax bracket) has the following book value capital structure

Equity Capital (in shares of $10 each, fully $ 15 Crores

paid-up at par)
11% Prefernece Capital (in shares of $ 100 1 Crore
each, fully paid-up at
par)
Retained Earnings 20 Crores

13.5% Debentures (of $100 each) 10 Crores

15% Term Loans 12 .5 Crores

The next expected dividend on Equity Shares is $ 3.60 per share. Dividends are expected to
grow at 7% and the Market price per share is $40.

-Preference Stock, redeemable after ten years, is currently selling at $75 per share.

-Debentures, redeemable after 6 years, are selling at $ 80 per debenture

-Dividends are included in the market value of equity

Present Cost of Term Loans = Kd = Interest (100%—Tax Rate) = 15% × (1 00% –40%) = 9.00%. Cost
of Additional Debt for first $2.50 Crores=Interest (100%–Tax Rate ) = 15%×60%= 9. 00% Cos fo
Additional Debt for next $2.50 Crores=Interest (100%–Tax Rate)=16%×60%=9.60%.

3. Computation of Present WACC base on Book Value Proportions

Particulars Amount Proportion Individual Cost WACC

Equity Capital 15 Crore 15/58.5 16.00% 4.10%

Preference Capital 1 Crore 1/58.5 15.43% 0.26%

Retained Earnings 20 Crores 20/58.5 16.00% 5.47%

Debentures 10 Crores 10/58.5 12.70% 2.17%

Loans 12.5 Crores 12.5/58.5 9.00% 1.92%

Total 58.5 Crores 100% K0=13.92%

4. Computation of Present W ACC base on Market Value Proportions

 PARTICULARS AMOUNT PRPORTION INDIVIDUAL COST WACC
EQUITY CAPITAL 600000000 60/81.25 16% 11.82%

PREFERENCE 7500000 .75/81.25 15.43% .14%

RETAINEDEARNINGS NA NA

DEBENTURES 80000000 8/81.25 12.70% 1.25%

LOANS 12500000 12.5/81.25 9% 1.38%

TOTAL 81.25 CRORES 100 % K0=14.59%

*Retained Earnings Included in Market Value of Equity Share Capital, hence not applicable

Chapter 4-Measures of Leverage

Business, Sales, Operating risk, and Financial Risks
Risk can be defined in several ways. However, one fairly simple definition is: risk refers to the
uncertainty of a return and the potential for financial loss. Risk can arise from both financing and
operating activities and can be classified in several ways. Some examples of risk are business risk,
sales risk and operating risk.

Leverage
The term ‘leverage’ describes the use of fixed costs in a company’s cost structure. It increases the
volatility of a company’s earnings and cash flows as well as the risk of lending to or owning the
company. Companies which use more fixed costs relative to variable costs in their cost structure will
have a greater variation in net income as their revenues fluctuate.

The greater a company’s leverage, the more risk it has and the higher the discount rate which should
be used in valuing the company.
Highly leveraged companies also have a much greater chance of suffering serious losses during a
downturn, which makes them more prone to financial distress and bankruptcy.

Financial Risk
Financial risk is the risk associated with how a company finances its operations i.e. whether through
equity or debt financing. Therefore, it takes into account the amount of leverage which a company
has.

The higher the amount of leverage a company has, the higher the financial risk which exists to
stockholders of the company.

Business Risk
Business risk is the risk which is inherent in a company’s operations (or risk associated with its
operating earnings). It may also be considered the risk of a company’s assets when no debt is used.

Business risk reflects a company’s sales risk as well as its operating risk.

Companies operating in the same line of business will generally have a similar business risk.

Sales Risk
The uncertainty associated with the price and quantity of goods and services is referred to as sales
risk. It is affected by demand for a company’s product as well as the price per unit of the product.

Operating Risk
Operating risk is the risk which is attributed to a company’s operating cost structure, specifically in
relation to the use of fixed costs. The greater a company’s level of fixed operating costs relative to its
variable operating costs, the greater is its operating risk.

DOL, DFL and DTL

The Degree of Operating Leverage, Degree of Financial Leverage and Degree of Total Leverage are
three important ratios that help us to quantify a company’s exposure to operational risk, financial risk
and a combination of the two, respectively.

Degree of Operating Leverage (DOL)

Example: A firm sells its product at 100%, as variable operating cost of 50% and fixed operating
cost of 50,000 per year. Show the various levels of EBIT that would result from sale.
1. 1000 units
2. 2000 units
3. 3000 units

Solution
Operating leverage of base data

OL=Contribution/EBIT=100000/50000=2

Case 1=Increase of 50 % sales resulted 100 % increase in EBIT(2X50%)

Case 2=Decrease of 50 % sales resulted 100% decrease in EBIT(2X-50%)

Example

C Company Ltd. a small food company expects EBIT of 10,000 in the current year. It has 20,000 bond with 10%
(annual) coupon rate of interest and 600 shares of 4 (annual dividend on share) preferred stock outstanding. It has
also 1000 equity shares outstanding. The firm is in the 40% tax bracket. Two situations are shown:
Case 1: A 40% increase in EBIT from 10,000 – 14,000
Case 2: A 40% decrease in EBIT from 10,000 – 6,000

Solution

Financial leverage for base year=EBIT (1-T)/Earnings available to equity shares

=10000x (1-0.4)/2400=2.5

Case 1-Increase 40% in EBIT resulted to 100% increase in EPS (2.5X40%)

Case 2-Decrease 40% in EBIT resulted to 100% decrease in EPS (2.5X-40%)

Example
If DOL for a company is 1.6, and unit sales increase by 3%, what is the percentage change in
operating income that would be expected?

, if a company’s DFL is 2.0, then a 5% increase in operating income is expected to give rise to a 10%
increase in net income.

Solution

The percentage change in operating income = 1.6 * 3% = 4.8%.

Example

Calculate the degree of operating leverage (DOL), degree of financial leverage (DFL) and the
degree of combined leverage (DCL) for the following firms and interpret t he results.

Firm K Firm L Firm M

1. Output (Units) 60,000 15,000 1,00,000

2. Fixed costs 7,000 14,000 1,500

3. Variable cost per unit ( 0.20 1.50 0 .02

4. Interest on borrowed funds ( ) 4,000 8,000 —

5. Selling price per unit ( ) 0.60 5.00 0.10

Solution :

Firm K Firm L Firm M

Output (Units) 60,000 15,000 1,00,000

Selling Price per unit ( ) 0.60 5.00 0.1 0

Variable Cost per unit 0.20 1.50 0.02

Contribution per unit ( ) 0.40 3.50 0.0 8

Total Contribution 24,000 52,500 8,00 0

(Unit × Contribution per unit)

Less : Fixed Costs 7,000 14,000 1,5000

EBIT 17,000 38,500 6,5 00

Less : Interest 4,000 8,000 —

Profit before Tax (P.B.T.) 13,000 30,500 6,500

Degree of Operating Leverag e

Contribution 24000 52500 8000

DOL=
EBIT 17000 38000 6500

=1.41 = 1.38 = 1.23

Degree of Financial Leverage

EBIT 17000 38500 6500

DFL=
EBIT  I 13000 30500 6500

=1.31 = 1.26 = 1.00

Breakeven Quantity of Sales

“Breakeven point” or “breakeven quantity of sales” refers to the number of units of a company’s
product that is produced and sold at which point the company’s net income becomes zero.
Computing Breakeven Quantity of Sales
At the point at which a company’s net income is zero, its revenues equal its costs. Company’s costs
are however made up of variable operating costs, fixed operating costs, and fixed financing costs.

With this in mind, if revenue = costs, then –

PQ = VQ + F + C

where:

P = price per unit

Q = number of units produced and sold

V = variable cost per unit

F = fixed operating costs

C = fixed financing costs

Therefore if QBE is the breakeven quantity of sales, then –

and

In other words, a company’s breakeven quantity of sales is equal to the sum of the company’s fixed
operating and financing costs divided by its unit contribution margin or the difference between
the price per unit and variable cost per unit.

Example
Assume a company’s product costs are represented by the figures below.

Product Costs
Price per Unit Sold $8.00
Variable Cost per Unit $4.00
Fixed Cost per Unit $2,500.00
Fixed Financing Cost $1,200.00
(i) Calculate the company’s breakeven quantity of sales

Solution

The breakeven quantity of sales, units

Determining Net Income at various sales levels

(ii) Determine the company’s net income at various sales levels.

At various sales levels, the net income is as follows in the table:

Units sold Sales ($) Net Income ($)

625 5,000 -780
725 5,800 -520
825 6,600 -260
925 7,400 0
1,025 8,200 260
1,125 9,000 520
1,225 9,800 780
As can be seen from the table, at the breakeven quantity of sales, net income =0, below the breakeven
quantity of sales, net income < 0, and above the breakeven quantity of sales, net income >0.

Operating Breakeven Quantity of Sales

The breakeven quantity of sales or just simply breakeven point indicates the number of units of a
company’s product that is produced and sold at which point the company’s net income becomes zero.
Similarly, we can specify the breakeven point in relation to operating profit. This is referred to as the
“Operating breakeven point” or “Operating breakeven quantity of sales”.

Calculating Operating Breakeven Quantity of Sales

At the operating breakeven quantity of sales, revenues = operating costs i.e.

PQOBE = VQOBE + F

where:

P = price per unit

QOBE  = number of units produced and sold

V = variable cost per unit

F = fixed operating costs

Therefore, rearranging the formula, the operating breakeven quantity of sales,

In other words, a company’s operating breakeven quantity of sales is equal to the company’s fixed
operating costs divided by the difference between the price per unit and variable cost per unit.

Example
Assume a company’s product costs are represented by the figures below.

Product Costs
Price per Unit Sold $8.00
Variable Cost per Unit $4.00
Fixed Cost per Unit $2,500.00
Fixed Financing Cost $1,200.00
Calculate the company’s operating breakeven quantity of sales

Solution

The operating breakeven quantity of sales:

Chapter 5-Capital structure
The value of the firm on the basis of Net income approach can be ascertained as follows:
V= S+D.
Where
V = Value of the firm
S = Market value of equity.
D = Market value of debt.
Example 1: Expected EBIT of the firm is 2,00,000. The cost of equity (i.e., capitalization rate) is 10%. Find out the value
of Firm and overall cost of capital if degree of leverage is:
200000
500000
700000
Debenture interest rate is 6%.

Conclusion: Firm is able to increase its value and to decrease it’s (WACC) increasing the debt
proportion in the capital structure.
The NI approach, though easy to understand, ignores perhaps the most important aspects of
leverage that the market price depends upon the risk, which varies in direct relation to the
changing proportion of debt in capital structure.
Example 1: Expected EBIT of the firm is 2,00,000. The cost of equity (i.e., capitalization rate) is 12%. Find out the value
of Firm and overall cost of capital if degree of leverage is:

Firm A=Nill,Firm B=500000

700000
Debenture interest rate is 10%.
Example: A firm has an EBIT of 200,000 and belongs to a risk class of 10%. What is the
value of cost of equity capital, if it employs 6% debt to the extent of 30%, 40% or 50% of the total
capital fund of 10,00,000?

The NI and the NOI approach hold extreme views on the relationship between the leverage, cost
of capital and the value of the firm. In practical situations, both these approaches seem to be
unrealistic. The traditional approach takes a compromising view between the two and
incorporates the basic philosophy of both. It takes a midway between the NI approach (that the
value of the firm can be increased by increasing the leverage) and the NOI approach (that the
value of the firm is constant irrespective of the degree of financial leverage).
Example

A firm has an EBIT of 5,00,000 and belongs to a risk class of 10%. What is the cost of
Equity if it employs 6% debt to the extent of 30%, 40% or 50% of the total capital fund of
2000000

Solution

30% 40% 50%

EBIT ( .) 5,00,000 5,00,000 5,00,0 00

Overall cost of capital 10% 10% 10%

Value of the Firm (V) ( ) 50,00,000 50,00,000 50,00,0 00

(EBIT/Ko)

Value of 6% Debt 600000 800000 1000000

Value of Equity (E)= 44,00,000 42,00,000 40,00,000

(V–D)

Net Profit (EBIT–Int.) ( ) 4,64,000 4,52,000 4,40,000

Ke (NP/E) 10.545% 10.76% 11%

Traditional Approach :

It takes a mid-way between th e NI approach and the NOI

approach Assumptions

(i) The value of the firm increases with the increase in financial leverage, upto a certain
limit only.

(ii) Kd is assumed to b e less than Ke.

Arbitrage Process
The “arbitrage process” is the operational justification of MM hypothesis. The term ‘arbitrage’ refers to an act of buying a
security in one market having lower price and selling it in another market at higher price. As a result of such action, the market
prices of the securities can not remain different markets. Thus, arbitrage process restores equilibrium in the value of securities.
This is because investors of the overvalued firm would sell their shares, borrow additional funds on personal account and invest
in the undervalued firm in order to obtain the same return on smaller investment outlay. The use of debt by the investor for
arbitrage is termed as ‘home made leverage’ or ‘personal leverage’. Arbitrage process can be explained with the help of the
following example.

Example: Two firms X Ltd. & Y Ltd. are alike and identical in all respects except that X
Ltd. is a levered firm and has 10% debt of 30,00,000 in its capital structure. On the other
hand Y Ltd. is an unlevered firm and has raised funds only by way of equity capital.
Both these firms have same EBIT of 10,00,000 and equity capitalization rate (Ke) of 20%.
Under these parameters, the total value and the WACC of both the firms may be
ascertained as follows:

Comments
Though, EBIT is same, value of both the firm and WACC are different. MM argue that this position can not persist for
a long; and soon there will be equilibrium in the values of the two firms through arbitrage process, which is
explained, in the following paragraphs.

Mr. A is holding 10% equity shares in X Ltd. The value of his loading is 3,50,000 i.e., 10% of 35,00,000. Further, he is
entitled for 70,000 income (i.e., 10% of total profits of 7,00,000). In order to earn more income, he disposes off his
holding in X Ltd. for 3,50,000 and buys 10% holding in Y Ltd. For this purpose, he adopts following steps.

Step 1: In order to buy 10% holding in Y Ltd, he requires total funds of 5,00,000, whereas his proceeds are only
3,50,000. Therefore, he borrows 3,00,000 loan @ 10% i.e. (10% of Debt of X Ltd). Thus, he substitutes personal loan for
corporate loan.

Step 2:
Mr. A now has total funds of 6,50,000
Sale proceeds 3,50,000
10% personal loan 3,00,000
Total 6,50,000
Less: Invest in shares of Y Ltd shares - 5,00,000
Surplus funds (which he invests 1,50,000
in some other securities say at 10%)

Step 3:
Mr. A will earn more through arbitrage process.
Profits available to A from Y Ltd. (10% of 10,00,000) 1,00,000
Less: interest on borrowing (10% 300,00,000) – 30,000
+ Interest income on some other investment (150000 × 10%) + 15,000
Total income after Arbitrage Process 85,000

Conclusion
MM model argues that this opportunity to earn extra income through arbitrage process will attract so many
investors. The gradual increase in sales of shares of the levered firm X Ltd. Will push down its prices and the
tendency to purchase the shares to unlevered firm Y Ltd. Will drive its prices up. These selling and purchasing
processes will continue until the market value of the two firms is equal. At this stage, the value of the leverage and
unleveled firm and also their cost of capital are same. Thus overall cost of capital is independent of the financial
Leverage