FINANCIAL MANAGEMENT

MODULE 3

Unit 3

Receivables Management

What is receivables Management?

Receivable management is the process of making decisions relating to investment in trade

debtors.

Definition

According to BOLTON, The objective of receviables management is “ to promote sales and

profit until the points is reached where the return on investment in further funding of
receivables is less than the cost of funds raised to finance that additional credit”

Explain the Scope and Importance of receivables management

1. Determining credit policy

Credit policy refers to those decision variables that influence the investment in
receivables. In developing an optimum credit policy the financial managers should
compare the benefits of credit extension with the cost of credit. The optimum credit
policy is determined by the trade off between liquidity and profitability.
2. Determining credit terms
The credit terms include the decisions like period, quantum of cash discount and
fixing the credit standard. The determination of credit depends to large extent on
seasonal dating, estimation of bad debts and default risks and determination of credit
period. The extent is depend upon the matching between the profits arising due to
increased sales and the costs to be incurred on the increased sales.
3. Evaluating the credit applicants
A firm cannot follow the policy of treating all customers equal for the purpose of
extending credit. It should lay down clear cut guidelines and procedures for granting
credit to individuals customers. This function will include the following steps

o Collection of credit information about the customers

o Investing about the credit capacity
o Credit analysis
o Fixing credit limit
o Deciding collection procedure

The credit information may be collected from trade references, financial statements, bank
references, and credit bureau report.
4. Control and Analysis of receivables
In order to analyses the size of investment in the current assets from time to time
following ratios may be very helpful.
I. Debtors turnover ratio
II. Average collection period
III. Ageing schedule of debtors

The finance manager should analyses the ratios and determines the trend in this
regard. It will help him to keep the investment in this asset within reasonable
limits as well as in assessing the effectiveness of the management of this current
assets.

Determinants of size of investments in receivables

Investments in account receivable form a major part of their assets in most of

business enterprises. Account receivables is one of the major components of
working capital. The financial executives should pay due attention to the
management of receivables so that each rupee invested in accounts receivables
may contribute to the net worth of the organisation.

Two types of factors

o General factors
o Specific factors
A) General Factors

General factors are those which are common to all firms and to the investments in all
types of assets- fixed and current. These include the following factors.

1. Type and nature of business

2. Volume of anticipated sales
3. Price level variation
4. Availability of funds
5. Attitude of executives

B) Specific Factors

o Volume of credit sale

Other things begin equal, accounts receivables vary directly with the
volume of sales. If sales increase, receivables expand. As sales decline,
investment in receivables also declines.
o Terms of sales
If a firm takes a decision not to sell goods on credit in order to avoid
blocking up funds in receivables and risk of bad debts, this items shall
not appear in the balance sheet. Such a decision, however, cannot be
enforced by a business enterprise. Trade customs ,competitions and
 business practices force the company to sell goods on credit, otherwise
their existence will be threatened. Therefore, the company should
establish a sound credit policy to suit its needs.
o Stability of sales
If the business is of seasonal character, its credit sale in the season
will be large, simultaneously a large volume of receivables will be
there. If a firm supplies goods on instalment basis its investment in
receivables will be high.
o Credit and collection policy
The credit and collection policy of firm also determine the level of
investment in receivables. It, as a matter of fact, determines the amount
of risk the firm is willing to understand in its sales activities. If a firm
has a liberal credit policy, it will experience a higher level of
receivables as compared to a firm with more stringent credit policy
o Bill discounting or endorsement
If bills are got discounted with banks or endorsed to third parties the
level of investment in this asset will be automatically low.

Optimum Credit policy

Credit Policy means those decision variables that influence the amount of trade credit ie,
investments in receivables. A firms credit policy provides the guidelines for determining
whether to extend credit or not. The credit policy may be lenient or tight. In developing an
optimum credit policy the financial executives will compare the benefits of extension with
cost of credit.

Factors affecting Credit Policy

Optimum credit policy depends on:

i) Cost of credit extension

A liberal credit policy increases the costs while tight credit policy reduces the
amount. The major categories of cost associated with the extension of credit are
the following.
Collection cost
It is the administrative costs incurred in collecting the receivables from the
customers to whom credit sales have been made.
Capital Cost
There is a time lag between the sale of goods to and payment by the customers.
The firms has to pay employees and suppliers of raw materials thereby implying
that the firm should arrange for additional funds to meet its own obligations while
waiting for payment from its customers. The cost on the use of additional capital
to support credit sales, is a part of the cost of credit extension.
Delinquency Cost
 It arises out of the failure of the customers to meet their obligations when
payments on credit sales, is a part of the cost of credit extension.

Default Cost
Because of the inability of the customers, the firm may not be able to recover the
over dues. Such debts are treated as bad debts and they cannot be realized. Such
costs are known as default cost.

B) Benefits of credit extension

Oriented to sales expansion
A firm may grant trade credit either to increase sales to existing customers or to
attract new customers. This motive for investment in receivables is growth oriented.

To protect its current sales against emerging competition

The motive of the firm is sales retention. The profit of the firm will be increase as a
result of increased sales.

Credit Terms
A firms credit terms specify the repayment terms required of all credit customers.
Credit terms have three components – cash discount, the cash discount period, and the
credit period
i) Cash discount
The discount terms indicate the rate of discount offered to the customers.
When a firm initiates or increases the rate of cash discount, the changes and
effects on profits can be expected.
ii) Credit period
The time duration for which credit is extended to the customers is referred to
as credit period.

Following will be the expected effects of an increase in credit period

 Sales volume of the firm will increase
 Average collection period would increase
 Bad debts expense would increase.
iii) Cash discount period

This also affects firms collecting period and profits. An increase in it will have
a positive effect on profits because many customers who did not take
advantage of discount in past may now avail it. It reduce average collection
period.

Credit evaluation procedure

 Obtaining credit information

 When a firm is approached by a customer desiring credit terms, the firms credit
department typically begins the credit evaluation procedure by obtaining credit
information about them confidentially.
Sources of credit information
i) Financial statements of the customer
ii) Bank references
iii) Trade references
iv) Credit information associations
 Credit investigations
After having obtained the credit information, the firm will get an idea regarding the
matters which should be further investigated. The information provided by trade
references or bank references can be verified by the study of customers financial
statements of last three four years. For existing customers, the firm can maintain
each customer‟s credit file.
 Credit analyses
The third step is credit analysis. A credit applicant‟s finance statements and
accounts payable ledger can be used to calculate its average age of account payable.
This figure can be then compared to the credit terms currently begin extended by the
firms.
 Fixing credit limits
Once decision has been taken to extend credit to the applicant, the next thing is to
decide the amount and duration of the credit. It involved the fixation of maximum
amount of trade credit to be allowed to a particular customer.
 Establishing collection procedure
The collection procedure to the firm should be clear cut and well administered. The
purpose of collection policy should be to speed up the collection of dues. The firm
may take various steps to collect dues from customers .

Important Formulas

Average collection period = Account Receivables x No.of working Days

Net Credit Sales

Average debt collection period = No. Of Working days

Debtors Turnover ratio

Or
Average debtors x No of working days
Net Credit Sales
Module 4

Financial decision

Unit – 1

What do you mean by cost of capital?

Cost of capital means it is the minimum rate of return a firm must earn on its investments.

Or

It is the minimum rate of return expected by the investors. It is the weighted average cost of
various source of finance used by the firm.

Definition of cost of Capital?

HAMPTON, JOHN J defines cost of capital as “ rate of return the firm requires from
investments in order to increase the value of the firm in the market place”.

Explain the characteristics of Cost of capital

 It is the rate of return a firm expected to earn from its project.

 It is the minimum rate of return which a firm has to earn atleast to maintain the
market value of the share.
 It comprises of three components
a) Expected normal rate of return at zero risk level
b) The premium for business risk
c) The premium for financial risk

Explain the significance of Cost of capital or( Importance) ?

1. Essential for Investment decision

It is the prime factor which is taken into consideration while taking investment
decisions. While making capital budgeting decisions cost of capital is compared
with the expected cash inflow and outflows.
2. Designing capital structure
Capital structure is the proportion of different kinds of long term securities. While
designing an optimal capital structure the management has to keep in mind the
objective of maximising the value of the firm by minimising cost of capital.
3. Evaluation of finance performance
It is used to evaluate the performance of a project. The profitability of the project
is compared with projected overall cost of capital and actual cost of capital of fund
raised to finance the project. If the actual profitability of the project is more han
 the projected and actual cost of capital, the performance of the project is Said to
be satisfactory.
4. Determination of accepting or rejecting expansion proposal
It is on the basis of comparison of cost of capital with marginal return on
investment, the decision is taken whether to accept or reject expansion proposals.
5. Optimum utilisation of resource
When a firm selects an investment proposal based on cost of capital it leads to
optimum utilisation of resources. It enables an organization to allocate funds from
non profitable areas to profitable channels.
6. Taking other financial decision
The concept of cost of capital is also used in other financial decision such as
dividend policy, capitalisation of profit, working capital management etc..

Explain the classification of cost of capital

o Historical Cost and future Cost:

Historical Cost represents the cost which has already been incurred for
financing a project. It is calculated on the basis of the past data. Future cost
refers to the expected cost of funds to be raised for financing a project.

o Specific Costs and Composite Cost:

Specific costs refer to the cost of a specific source of capital such
as equity shares, Preference shares, debentures, retained earnings etc.
Composite cost of capital refers to the combined cost of
various sources of finance. In other words, it is a weighted average cost
of capital. It is also termed as „overall costs of capital‟.

o Explicit Cost and Implicit Cost:

Explicit cost refers to the discount rate which equates the present value
of cash outflows or value of investment. The implicit cost represents
the rate of return which can be earned by investing the funds in the
alternative investments. In other words, the opportunity cost of the
funds is the implicit cost.
o Average cost and Marginal Cost
Average cost refers to the combined cost of various sources of capital such as
debentures, preference share and equity shares.
Marginal Cost
It refers to the average cost of capital which has to be incurred to obtain
additional funds required by a firm.

Explain the factors determining the cost of capital?

First explain cost of capital

  General Economic Condition
It determine the demand for an supply of capital within the economy as well as the
level of expected inflation. If the demand money increase without an equivalent
increase in supply, creditors will raise their required rate of interest. Thus cost of
capital change.
 Market Condition
When an investor purchases a security with significant risk, an opportunity for
additional returns is necessary to make the investment attractive. As risk increase , the
investor requires a higher rate of return. This increase in risk is called risk premium.
When investors increase their required rate of return, cost of capital rises
simultaneously.
 Operating and Financing Decision
Risk or variability of returns may be the result of operating and financing decisions
made within the company. Risk resulting from these decisions is generally divided
into two types – business risk and financial risk. Business risk is the variability in
returns on assets and is affected by the company‟s investments decisions. Financial
risk is the increased variability in returns to common shareholders as a result of
financing with debt or preferred stock. As business risk and financial risk increase or
decrease the investor‟s required rate of return will remove in the same direction.
 Amount of finance
As the financing requirements of the firm become larger, the overall cost of capital
also increases. When management approaches the market for large amount of capital,
the investor‟s required rate of return may rise because of the increased risk. Also as
the size of the issue increase, there is greater difficulty in placing it in the market
without reducing the price of security, which also increases the firms cost of capital.
 Floatation Cost
It refer to the cost of marketing new securities. This includes legal fees, brokerage,
underwriting commission etc, when flotation cost are incurred the cost of capital will
be increased.

What do you mean by Cost of equity capital?

Cost of equity capital is the rare at which investors expect dividend. It is the
minimum rate of return that a firm must earn on the equity financed portion of an
investment project in order to leave the unchanged market price of the share.

It can be calculated from the following approach

 Dividend Price approach
 Dividend price plus approach
 Earning price Approach
 Realised yield Approach

What do you mean by cost of retained earnings?

Cost of retained earnings may be considered as the rate of return which the existing
shareholders can obtain by investing the after tax dividend in alternative investment
opportunities

Define cost of retained earnings?

Cost of retained earnings may be defined as “the opportunity cost of dividend foregone
by the shareholders”

Explain the advantages and limitation of computing weighted cost of capital?

 Calculation of after tax cost of capital

In financial decision making the after tax cost of capital is more relevant. The
weighted average cost of capital can be compared on after tax basis. In its calculation,
each source of capital fund gets its weightage according to its contribution in the total
capital structure.
 Provision of one single figure
The weighted average cost of capital provides one single figure which may be used as
a discount factor in computing the discounted cash inflows of the future stream of
earnings.
 Suitability in capital budgeting decisions
The capital structure will be changing due to issue and redemption of securities.
Weighted average cost of capital clearly reflects such overall changes. Therefore, it is
more suitable for capital budgeting decisions.
Limitation
 Cost of fund is not independent to value of funds
In calculating weighted average cost of capital it is assumed that the cost that the cost
of raising fund is independent to the value of fund raised. This presumption does not
hold good in practice.
 Fluctuation of cost of various sources of fund
In calculating weighted average cost of capital, it is assumed that the present cost of
various sources of fund would remain the same in future also. This is not true in
actual practice.
 Fluctuation in weighted average cost
The weighted average cost of capital will fluctuate from year to year due to the impact
of retained earnings. Therefore, the weighted average cost of capital once calculated
may not hold good for a long period of time, particularly beyond one accounting year.
 Useless in some situations
The weighted average cost of capital cannot be used in the following circumstances
o When the dividend policy of the company is being changed
o When there is a change in capital structure, ie, Debt –Equity ratio.
o When the company is trying to bring about radical changes in its debt policy.
 Difficult to compute
It is very difficult to assign weights to different components of capital structure. Thus
the computation of weighted average cost of capital is a difficult job.
.

Unit II
Capital structure and leverage

What do you mean by capitalisation?

Capitalisation refers to the total amount of securities issued by a company. Capitalisation

refer to the process of determining the quantum of funds that a firm needs to run its business.
It is an important constituent of the financial plan.

Define capitalisation?

According to Guthman & Dougal

“Capitalisations the sum of par value of stocks and bonds outstanding”.

Explain the concept of capitalisation?

The modern thinkers consider that even short term creditors should be included in
capitalisation.

Modern concept of capitalisation include

 Share capital
 Long term debt
 Reserves and surplus
 Short term debts
 Creditors

Explain the basis or theories of capitalisation

 Cost Theory

According to this theory, the amount of capitalisation is arrived at by adding up the cost of
fixed assets, working capital required for the continuous operations of the company, the cost
of establishing the company and the promotional expenses. This method is useful in case of
newly formed companies.

 Earning Theory

According to this theory, the capitalisation of a company depend upon its earnings and
the expected fair rate of return on its capital invested. Thus the value of capitalisation is
equal to the capitalised value of the estimated earnings.

What do you mean by over capitalisation and under capitalisation?

Over capitalization is a state where earnings are not sufficient to justify the fair return on the
amount of share capital which has been issued by the company whereas under
capitalization is a state where the capital which is owned by the business is much less than
the borrowed capital.

What do you mean by capital structure?

Capital structure refers to the make up of a firm‟s capitalisation. It represents the mix of
different source of long term funds equity shares, preference shares, long term debts, retained
earnings etc..

Or

Capital structure means the proportion of debts and equity in the total capital of a company.
It involves decision with respect to a) type of securities to be issued. b) relative proportion of
each type of security.

State the difference between Capitalisation and Capital structure

Capitalisation Capital Structure

It is a Quantitative concept Qualitative concept

Total amount of capital raised through It is the make up or combination of

shares, debentures, loans, etc.. capitalisation

It refers to the determination of the total It is a part of capitalisation. It determine

needs of capital, Its structure and the proportion in which the total capital is
arrangements of funds contributed by different sources.

It is mainly influenced by internal force or It is mainly influenced by external forces

requirements of a company such as market conditions, investor’s
psychology etc..

Explain the importance and objective of capital structure?

1. Capital structure affects the financial risk assumed by the company

2. It affects the firm's cost of capital.
3. It affects the value of the firm.
4. Capital structure decision represents the management attitude towards risk and return.

OBJECTIVES OF CAPITAL STRUCTURE

The major objectives of a sound capital structure are as follows

1. A good capital structure should aim at maximisation of shareholder's wealth.

2.A capital structure should be designed in such a way that the cost of financing or average
cost capital from each sources of fund should be minimum.

3. A sound capital structure should also take into consideration the control aspect of the firm's
equity shareholders as they are not interested in losing their control in the firm.

4.A capital structure should be flexible.

5.A sound capital structure should keep in view the principle of conservatism. That means,
use of ownership securities should be made and use of debt capital should not be made
beyond a particular level.

Explain the factors determining the capital structure or Factors Governing Capital
Structure planning?

FINANCIAL LEVERAGE OR TRADING ON EQUITY

The use of long term fixed interest bearing debt and preference share capital along with
equity share capital is called financial leverage or trading on equity'. The use of long term
debt increases the earnings per share if the firm yields a return higher than the cost of debt.

GROWTH AND STABILITY OF SALES

The capital structure of a firm is greatly influenced by the growth and stability of sales.
Stability of sales ensures that the firm will not face any difficulty in meeting its commitment
on paying interest and repayment of debt. Similary greater the growth of sales greater debt
can be used in the capital structure.

COST OF CAPITAL

Cost of capital refers to the minimum return expected by investors. While formulating capital
structure, the overall cost of capital of the firm must be made minimum.

RISK FACTOR

Two types of risks are to be considered while designing the capital structure of the firm, viz
(a) Business risk and (b) Financial risk.
Business risk refers to the variability of earnings before interest andtaxes, Business risk may
be internal or external.

Financial risk refers to the risk of a business enterprise that may be able to cover its fixed
financial costs. When a firm pumps more and more debt in to its capital structure the
financial risk of the firm increases. It may not be able to pay the fixed interest charges to the
suppliers of debt.

CASH FLOW OF THE FIRM

Capital structure should be designed only after considering the cash flows of the firm. If the
firm has greater and stable cash inflows it can use more debt in its capital structure as it has
enough cash to pay the fixed interest charges.

NATURE AND SIZE OF THE FIRM

Nature and size of a firm also influence its capital structure. Business firms which have
stability in their earnings or which enjoy monopoly regarding their products can use more
debt in the capital structure as they will have adequate profit to meet the recurring cost of
interest. On the other hand a concern which is not able to provide stable earnings will have to
use mainly equity capital. Similarly it is suitable for smaller firms to depend upon owned
capital mainly as it is very difficult for such firms to raise funds to meet fixed interest.

CONTROL OF SHAREHOLDERS

The capital structure of the company is also affected by the extent to which the existing
management or owners' of the company desire to retain control over the affairs of the
company. In case more and more funds are raised through the issue of equity shares then the
control of existing shareholders is diluted. If the existing owners are not interested in losing
their existing control over affairs of the company they may raise additional funds by way of
fixed interest bearing debt and preference shares.

FLEXIBILITY

Capital structure of a firm should be flexible. Then it should be capable of being adjusted
according to the needs of the changing conditions. It is possible to raise additional funds
whenever necessary without any delay and difficulty.

REQUIREMENT OF INVESTORS

The requirement of investors is another factor which influences the capital structure of a firm.
Different types of securities are needed for different types of investors. Equity shares are best
suited to investors who are bold and who are willing to take risk on account of non repayment
of principal and return. Debentures are best suited for investors who are very cautious and
who are not willing to take risk.

STOCK MARKET CONDITIONS

The selection of securities in the capital structure is influenced by the market conditions.
Capital market conditions do not remain the same forever. If there is depression in the share
market and there are pessimistic business conditions the company should not issue equity
shares as investors would prefer safety. But in case there is boom, then it would be advisable
to issue equity shares.

ASSETS STRUCTURE

While designing the capital structure, the liquidity and composition of assets should also be
kept in mind. If fixed assets constitute a major portion of total assets of the company it may
be possible for the company to raise more long term fund, otherwise it is better to raise short-
term fund.

PURPOSE OF FINANCING

In case funds are required for some productive purposes, for example purchase of new
machinery, the company can afford to raise the funds by the issue of debentures. This is
because the company will have the capacity to pay interest on debentures out of the profits so
earned. On the other hand, if the funds are required for non productive purposes, the company
should raise the funds by issue of equity shares.

PERIOD OF FINANCE

The period for which finance is required will also affect the determination of capital
structure. If the finance is required for a lon period of time then it will be appropriate to raise
them by the issue a debentures. In case funds are needed on permanent basis the equity share
capital is more appropriate.

FLOATATION COST

Cost of raising various kinds of securities or funds is to E considered while designing capital
structure. The cost of floating debt is generally less than the cost of floating an equity. To
reduc the cost of floating, the management may prefer to raise debt.

INFLUENCE OF TAX

As interest on fixed interest bearing securities is allowed to deducted from the taxable profits,
the companies prefer debt financing in order to reduce the corporate tax on profit.

LEGAL REQUIREMENTS

The guidelines issued by the Government for issue of debenture and shares are also to be
considered while designing the capital structure. The firm should also take care of norms set
by financial institutions, SEBI, stock exchanges etc.

Ehat do you mean by optimum capital structure?

The optimum capital structure may be defined as "that capital structure or combination of
debt and equity that leads to the maximum value of the firm".

or

The optimum capital structure is obtained when the market value per equity share is
maximum.

or

Optimum capital structure is the capital structure at which the weighted average cost of
capital is minimum and thereby the value of the firm is maximum.

Explain the essentials or requisites of optimum capital structure or features?

1. CLARITY OF OBJECTIVES

The capital structure of a company should be designed after considering the objectives of the
company. Whether the objective may be profit maximisation or wealth maximisation of
shareholders is to be clarified.

2.ECONOMY

The capital structure should be designed in such a way so that the overall cost of capital is at
its minimum.

3. LIQUIDITY AND SOLVENCY

The capital structure should be one which ensures better solvency position for the business.
The use of more debt capital may be harmful to the solvency position of the company. The
use of debt capital should be in accordance with its ability to generate income.

4.FLEXIBILITY

Investment opportunities coming out from business environment are uncertain and the capital
structure of the firm should be so flexible enough to accommodate the changes in the pattern
of investment. The capital structure should be such that it may be possible to raise funds
when required and to repay them when they are not required.

5.SIMPLICITY

A capital structure should define clearly the rights attached toeach class of security. It should
be simple to operate.

6. SAFETY

An ideal capital structure should ensure safety of investment to investors.

7.MAXIMUM RETURN
The capital structure should be one which generates maximum income to the shareholders. In
other words, it should minimise the overall cost of capital.

8. MAXIMUM CONTROL

Changes in prevailing capital structure should not lead to dilution of control over the equity
shareholders. Capital structure should be designed as to preserve control of the company's
management in the hands of the existing shareholders.

9. TIMING

Timing is an important element while taking investment and financing decisions. If the
interest rates are very high in the market, it would be difficult to procure money through the
issue of shares. Likewise, it will be difficult to mobilise debt funds from market during
depression times.

Explain the theories of capital structure?

Different kinds of theories have been propounded by different authors to explain the
relationship between capital structure, cost of capital and value of the firm. The main
contributors to theories are Durand, Ezra, Solomon, Modigliani, Miller etc.

These are four major theories or approaches explaining the relationship between capital
structure, cost of capital and value of the firm. They are:

1. Net Income Approach

2. Net Operating Income Approach

3. The Traditional Approach

4. Modigliani Miller Approach

NET INCOME APPROACH

I.This approach has been suggested by Durand (David Durand). According to this approach
capital structure decision is relevant to the valuation of the firm. In other words a change in
the capital structure causes a corresponding change in the overall cost of capital as well as the
total value of the firm.

According to this approach, a higher debt content in the capital structure will result in decline
in the overall cost of capital and thereby increase the value of the firm as well as market price
of equity shares. The theory propounds that a company can increase its value and decrease
the overall cost of capital by increasing the proportion of debt in the capital structure.

On the other hand, if the proportion of debt financing in the capital structure is reduced, the
weighted average cost of capital (overall cost of capital) will increase and the total value of
the firm will decrease.
This approach is based on the following assumptions:

1) The cost of debt is less than cost of equity.

2) There are no taxes.

3) The risk perception of investors is not changed by use of debt.

As per the assumptions of Net Income Approach 'Kd' (cost of debt) and Ke (cost of equity)
remains constant with changes in Ke (cost of equity) remain constant with change in average.
As per assumptions Kd is less than Ke. (K d <K e ) Therefore Ko( overall cost of capital) will
decrease as the debt proportion in the capital structure increases. It also implies that theKo
will be equal to ke if the firm does not employ any debt and that the Ko will approach kd as
debt proportion increases or when firm uses complete debt financing

The total market value of the firm on the basis of Net Income Approach can be ascertained as
below:

V=S+D

Where. V = Total Market value of the firm

S =Market value of equity shares

D = Market value of debt

S= Earnings available to equity shareholders X 100 `

Equity capitalisation rate

CRITICISMS OF NET INCOME APPROACH

1.The theory considers employment of debt as a single factor responsible for increasing or
decreasing the value of the firm. But in reality the value of firm is affected by a number of
other factors.

Another assumption is that there is no tax. It is also unrealistic.

3. Another assumption is Kd(cost of debt) and K e (cost of equity) remain constant

irrespective of changes in the market and capital structure. But when debt content in the
capital structure increases, the risk of the equity shareholders increase and they K e expect a
high rate of return. Therefore in reality and do k d not remain constant.

NET OPERATING INCOME APPROACH

David Durand, the originator of Net Income Approach, put forward an opposite view in the
form of another theory called Net Operating Income Approach. According to this approach
the market value of the firm is not at all affected by the capital structure changes. According
to this theory, change in the capital structure of a company does not affect the market value of
the firm and overall cost of capital remains constant irrespective of the method of financing.
Thus there is nothing as an optimal capital structure and every capital structure is the
optimum capital structure.

ASSUMPTIONS OF NET OPERATING INCOME APPROACH

1. The market capitalises the value of the firm as a whole and therefore the split between
debt and equity is not relevant.

2. Business risk remains constant at every level of debt equity mix.

3. The cost of debt (ka) is constant.

4. Increased use of debt increases the financial risk of the equity shareholders and hence cost
of equity (K e ) increases.

5. Cost of debt is lower than cost of equity (k c )

6. There are no corporate taxes.

Under NOI approach the value of the firm remains insensitive to the leverage. This theory
states that the increased use of debt increases the financial risk of the equity shareholder and
hence the cost of equity increases. On the other hand, the cost of debt remains constant with
the increasing proportion of debt as the financial risk of the lenders is not affected. Thus the
advantage of using the cheaper source of funds, ie debt, is exactly offset by the increased cost
of equity. The value of the firm under NOI approach can be determined as below

V= EBIT / K O

V Where, V below. = value of the firm

EBIT = Earnings Before Interest and Tax

Ko = Overall cost of capital

The market value of equity according to this approach is determined by

S=V–D

Where,

s = Market value of equity shares

v = Value of the firm

D = Market value of debt.

The equity capitalisation rate can be calculated as

Cost of equity (Ke)= EBIT-I/ V-D

V Where, EBIT = Earnings Before Interest and Tax

I= Interest

V= Market value of firm

D= Market value of Debt

THE TRADITIONAL APPROACH

The traditional approach was propounded by Solomon Ezra in 1963. This theory is also
known as intermediate approach. This theory is a combination of net income approach and
net operating income approach. According to this approach the value of the firm can be
increased initially or cost of capital can be decreased by using more debt as the debt is a
cheaper source of fund than equity. Thus the optimum capital structure can be reached by
proper debt equity mix. Beyond a particular point, the cost of equity increases because
increased debt increases the financial risk of equity shareholders. The advantage of cheaper
debt at this point of capital structure is offset by increased cost of equity. After this there
comes a stage when the increased cost of equity cannot be offset by the advantage of low cost
debt. Thus overall cost of capital according to this approach, decreases upto a certain point,
remains more or less unchanged for moderate increase in debt and thereafter increases
beyond a certain point.

According to traditional approach the effect of changes in the degree of leverage on the value
of the firm (V) and overall cost of capital are explained in three stages.

In the FIRST STAGE the increased use of debt increases the value of the firm and decreases
the overall cost of capital and reaches an optimum level (o).

In the SECOND STAGE the increase in debt beyond a particular limit (o), there is no effect
on the value of the firm and overall cost of capital. In this stage the firm continues at
optimum level.

In the THIRD STAGE further increase in debt in the capital structure will increase the
overall cost of capital (ko) and reduce the value of the firm.

MODIGLIANI & MILLER APPROACH

Modigliani and Miller Approach is identical with Net operating income approach if taxes are
ignored. It is identical to Net Income approach when corporate taxes are assumed to exist.
Franco Modigliani and Merton Miller developed Capital Structure theory in 1958.

IN THE ABSENCE OF TAXES (Theory of Irrelevance)

This theory is similar to Net operating income. This theory proves that the cost of capital and
value of the firm are not affected by the changes in the capital structure. It says that debt-
equity mix is irrelevant in the determination of the value of the firm.

The reason argued by Modigliani and Milller is that though debt is cheaper to equity, with
increased use of debt the cost of equity increases. This increase in cost of equity offsets the
advantages of low cost debt. Thus eventhough the leverage affects the cost of equity, the
overall cost of capital remains constant.

The theory emphasises the fact that a firm's operating income the determinant of its total
value.

The theory further states that beyond a certain limit of debt, the cost of debt increases but the
cost of equity falls, thereby again balancing, two costs. In the opinion of Modigliani &
Miller, two identical firms in all respects except their capital structure, cannot have different
market values or cost of capital because of arbitrage process. the following assumptions:

The M&M approach is based upon

1. There are no corporate taxes.

2.There is perfect market.

3. Investors act rationally

4. The expected earnings of all the firms have identical risk characteristics.

5. The cut off point of investment in a firm is capitalisation rate.

6. There is no transaction cost.

7. All earnings are distributed to the shareholders.

8. The risks associated with personal leverage and corporate leverage are same.

WHEN THE CORPORATE TAXES ARE ASSUMED TO EXIST (Theory of

Relevance)

Modigliani and Miller say that when corporate taxes are assumed to exist, the value of the
firm will change with change in the capital structure of the firm. This theory is similar to Net
income approach. According to this approach capital structure decision is relevant to the
valuation of the firm.

Modigliani & Miller in their article in 1963 have recognised that the value of the firm will
increase or decrease and cost of capital will increase or decrease with the use of debt in the
capital structure.

Interest on debt is deductible for tax purpose. But dividend is not deductible and hence the
cost of debt is lesser than cost of equity. Thus due to the existence of tax the overall cost of
capital of the levered firm (the firm which uses debt in the capital structure) will be lower
than that of unlevered firm (the firm which does not use debt). Therefore the value of the
levered firm will be more than that of unlevered firm even if the both firms are identical in all
respects.

What do you mean by arbitrage?

The term arbitrage refers to an act of buying an asset or security in one market having lower
price and selling it in another market at a higher price. The consequence of such an action is
that the market price of the securities of the two firms, exactly similar in all respects except in
their capital structures, cannot remain different in different markets for long period.

Explain the limitations of MM hypothesis?

RATE OF INTEREST IS NOT SAME FOR INDIVIDUALS AND FIRMS

The assumption made under MM approach is that firms and individuals can borrow and lend
at the same rate of interest. But it is not possible in actual practice. Because the firms can
borrow at a cheaper rate than individuals on account of the firm's higher credit standing.

PERSONAL LEVERAGE AND CORPORATE LEVERAGE HAVE DIFFERENT

RISK.

Under MM approach it is assumed that same risk is associated with personal leverage and
corporate leverage. But the risk of an investor is not identical when the investor himself
borrows and when the firm borrows. When the firm borrows, the liability of investors limited
only to the extent of his proportionate shareholding. However when an individual borrows he
has an unlimited liability and even his personal property can be used for payment to his
creditors.

TRANSACTION COST INVOLVED

MM approach assumes no transaction costs. This means securities can be bought and sold
without incurring any costs. In actual situation buying and selling of securities involve
transaction costs like brokerage, commission etc.

INSTITUTIONAL RESTRICTIONS

The switching option from unlevered to levered firm and vice versa is not available for all
investors particularly institutional investors viz, LIC, UTI etc. Thus institutional investors
cannot take the advantage of arbitrage opportunity.

NO PERFECT MARKET

Under MM approach it is assumed that there is a Perfect Capital Market. But the real capital
market is not always perfect. Perfect market is a market which is characterised by (a) Every
information is available to all investors (b) All investors are free to enter and exit into the
market (free to buy or sell securities) (c) Investors act rationally (d) No investor can make
huge profit because of arbitrage process.

EXPECTED EARNINGS OF DIFFERENT FIRMS HAVE DIFFERENT RISK

CHARACTERISTICS
Different firms have different risk perception regarding their anticipated earnings as earnings
are influenced by a number of specific factors.

What do you mean by capital gearing?

Capital Gearing refers to the relationship between equity capital and long term debt. It means
the ratio between various types o in the capital structure of the company. A company is said
to be in high gear when it uses more proportion of debt in the capital structure for raising long
term finance and it is securities.

PRINCIPLES OF CAPITAL STRUCTURE DECISIONS

The main principles of capital structure decisions are:

1) Cost principle

2) Risk principle

3) Control Principle

4) Flexibility Principle

5) Timing Principle

All these principles have already been explained while discussing factors determining capital
structure.

What do you mean by leverage? Explain the different type of leverage?

In Financial Management, the term leverage is used to describe firm's ability to use fixed cost
assets or funds to increase the return to its owners.

Leverage may be defined as "meeting a fixed cost or paying fixed return for employing assets
or funds

James Horne defined leverage as "the employment of asset or sources of funds for which the
firm has to pay a fixed cost or fixed return".

TYPES OF LEVERAGE

Leverages are of three types (1) Financial leverage (2) Operating leverage and (3)
composite leverage

FINANCIAL LEVERAGE OR TRADING ON EQUITY.

The use of long term fixed interest bearing debt and preference share capital along with
equity share capital is called financial leverage or trading on equity. Financial leverage is
defined as the firm's ability to use fixed financial charges to magnify the effects of changes in
EBIT on the firm's EPS. It indicates the effect on earnings created by the use of fixed charge
securities in the capital structure.

The long term fixed interest bearing debt is employed by a firm to earn more from the use of
these resources than their cost so as to increase the return on owner's equity. The fixed cost
funds are employed in such a way that the earnings available for equity shareholders are
increased. A fixed rate of interest is paid on such long term debts. The interest is a liability
and must be paid irrespective of earnings. But the dividend is paid only when the company
has surplus profits. The equity shareholders are entitled to residual income after paying
interest and dividend to preference share holders. The aim of financial leverage is to increase
the revenue available for equity shareholders using the fixed cost funds.

Operating Leverage

The operating leverage may be defined as the tendency of operating income to change with
sales. It indicates the impact of change in sales in the operating income.

Operating leverage results from the presence of fixed cost which helps in magnifying the net
operating income. The fixed cost is treated as fulcrum of a leverage. The changes in sales are
related to changes in revenue. The fixed cost does not change with change in sales. It is
always constant or fixed. Any increase in sales, will increase the operating revenue. The
operating leverage occurs when a firm has fixed cost which must be recovered irrespective of
sales volume. The fixed cost remaining the same, the percentage change in operating income
will be more than the percentage change in sales. This occurrence is known as operating
leverage.

The degree of operating leverage depends upon the amount of fixed elements in the cost
structure. Operating leverage can be determined by means of break even analysis or cost
volume profit analysis.

Operating leverage in a firm is a function of three factors:

1. The amount of fixed costs

2. The contribution margin

3.The volume of sales.

COMPOSITE LEVERAGE (COMBINED LEVERAGE)

Composite leverage expresses the relationship between the revenue (sales) and taxable
income. It is a combination of operating leverage and financial leverage.

It helps in finding out the resulting percentage change in taxable income on account of
percentage change in sales. It is a combination of operating leverage and Financial leverage.
It is also known as overall leverage.

DIFFERENCES BETWEEN OPERATING LEVERAGE & FINANCIAL LEVERAGE

Operating Leverage

1. It magnifies the effect of changes in sales volume on operating profit

2. It consists of fixed operating expenses of the firm

3. It establishes the relationship

4. It is associated with the investment activities of the company.

5. It explains business risk of the firm.

6. It depends upon fixed costs.

7. It influences Earnings Before Interest and Tax

Financial Leverage

1. It magnifies the effect of changes in operating profit on EPS.

2. It consists of operating profit of the company.
3. It establishes the relationship between operating profit and return on equity
4. It is associated with the financing activities of the company.
5. It explains the financial risk of the firm
6. It depends upon the operating profit
7. It influences Earnings After Tax.

Explain the uses or importance of operating leverage?

1. PROFIT PLANNING

Operating Leverage plays an important role in capital structure leverage, small change in
sales will have a large effect on operating income. The operating profit of such a firm will
increase at a faster decisions and capital budgeting. If a firm has a high degree of operating
rate than increase in sales.

2. CAPITAL STRUCTURE PLANNING

Operating Leverage shows the effect of change in sales or the operating profit. Operating
income is to be considered while designing the capital structure because of the use of fixed
interest bearing securities in capital structure. Operating leverage influences the debt equity
mix in a firm.
Explain the significance of financial leverage or importance and Limitation?

1. PLANNING OF CAPITAL STRUCTURE:

Financial leverage helps the finance manager while devising the capital structure of the
company. A finance manager must plan the capital structure in a way that the firm is in a
position to meet its fixed financial charges. A financial manager has to decide about the ratio
between fixed cost funds and equity share capital.

2. PROFIT PLANNING

The Earning Per Share is affected by the degree of financial leverage. If the profitability of
the concern is increasing then fixed cost funds will help in increasing the availability of profit
for equity shareholders. Therefore financial leverage helps in profit planning.

LIMITATIONS OF FINANCIAL LEVERAGE

1. DOUBLE EDGED WEAPON :

Financial leverage can be successfully employed to increase the earnings of the shareholders
only if the company has enough profit which is more than fixed interest and dividend on
preference shares. Otherwise if the firm has not enough profit as much as the cost of interest
bearing securities, then it will work adversely.

2. BENEFICIAL TO COMPANIES HAVING STABILITY OF EARNINGS

Financial leverage is beneficial only to companies having stable and regular earnings. This is
because interest on debt is a fixed and recurring liability to the company. The company
having an irregular profit is not able to pay interest on its borrowing during the year when
profit is less.

3. INCREASES RISK AND RATE OF INTEREST

Another limitation of financial leverage is that even though the increased use of debt
increases the earnings of shareholders, every rupee of extra debt increases the risk and hence
the rate interest for additional borrowing will also increase. It becomes difficult for the
company to obtain further debts without offering extra securities and higher rate of interest
reduces their earnings.

4.RESTRICTIONS FROM FINANCIAL INSTITUTIONS

The financial institutions also impose some restrictions on companies which are using excess
debt because of the increasing risk and to maintain a balance in the capital structure of the
company.