Professional Documents
Culture Documents
ON
The dissertation has been undertaken as a partial fulfillment of the requirement for
the award of the degree of MASTER OF BUSINESS ADMINISTRATION
(MBA) from SHARDA UNIVERSITY.
The dissertation was executed during the fourth semester under the supervision of
Prof SUNIL JOSHI (faculty guide).
Further, I declare that this dissertation is my original work and the analysis &
finding are for academic purpose only. This dissertation has not been presented in
any seminars or submitted elsewhere for the award of any degree
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ACKNOWLEDGEMENT
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PREFACE
related to the protection of the economic value of human life and this project is just
offered to draw the attention of individuals, who are interested in life insurance
personal lines where the insured amount is less than Rs.20lakh, in accordance with
the Ombudsman Scheme. Addresses can be obtained from the offices of LIC and
other insurers.
or, all information and data. This responsibility really in hence my effective
communication and convincing power and such quality will help me in near future
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TABLE OF CONTENTS
Contents
1. EXECUTIVE SUMMERY..................................................................................................................6
2. INTRODUCTION...................................................................................................................................8
2.1 BACKGROUND OF THE TOPIC....................................................................................................8
2.2 NEED OF THE STUDY..................................................................................................................10
2.3 OBJECTIVES OF THE PROJECT.................................................................................................10
2.4 SCOPE OF THE STUDY................................................................................................................10
2.5 LIMITATIONS TO THE PROJECT...............................................................................................10
3. COMPANY ANALYSIS...................................................................................................................11
3.1 INDIAN INSURANCE INDUSTRY AT PRESENT:.....................................................................12
3.2 VISION, MISSION AND VALUES...............................................................................................13
3.3 COMPETITORS OF IDBI FEDERAL LIFE INSURANCE CO. LTD...............................................14
3.4 ORGANIZATION STRUCTURE...................................................................................................15
3.5 PRODUCTS OF IDBI FEDERAL..................................................................................................16
3.6 SWOT ANALYSIS OF IDBI FEDERAL LIFE..............................................................................19
3.7 COMPETITOR ANALYSIS:..........................................................................................................21
4. ECONOMIC INDUSTRY ANALYSIS................................................................................................25
4.1. INTRODUCTION TO INSURANCE INDUSTRY:......................................................................25
4.2TYPES OF INSURANCE:...............................................................................................................25
4.3 INSURANCE SECTOR IN INDIA:................................................................................................26
4.4 INDIAN INSURANCE INDUSTRY AT PRESENT:.....................................................................27
4.5 REGULATORY ISSUES:...............................................................................................................27
4.6 CRITICAL SUCCESS FACTORS:.................................................................................................28
4.7 DOMESTIC ECONOMIC CONDITIONS:.....................................................................................30
4.8 GLOBAL ECONOMIC ENVIRONMENT:....................................................................................31
4.9 DEMAND DRIVERS:.....................................................................................................................32
5LITERATURE REVIEW........................................................................................................................33
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5.1 LITERATURE................................................................................................................................33
5.2 THEORIES OF CAPITAL STRUCTURE......................................................................................37
5.2.1 INTRODUCTION:...................................................................................................................37
5.3 DIFFERENT THEORIES OF CAPITAL STRUCTURE................................................................46
5.3.1 NET INCOME APPROACH....................................................................................................46
5.3.2 NET OPERATING INCOME (NOI) APPROACH:.................................................................49
5.3.3 TRADITIONAL APPROACH:................................................................................................50
5.3.4 MODIGLIANI – MILLER (MM) HYPOTHESIS....................................................................51
5.4 ARBITRAGE PROCESS................................................................................................................53
5.5 CRITICISM OF MM HYPOTHESIS..............................................................................................55
5.6 M-M HYPOTHESIS CORPORATE TAXES.................................................................................55
5.7 AGENCY COSTS...........................................................................................................................56
5.8 PECKING ORDER THEORY........................................................................................................57
6. DATA ANALYSIS…………………………………………………………………………………...52
8. BIBLOGRAPHY…………………………………………………………..………………………..68
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EXECUTIVE SUMMARY
The Indian insurance industry has undergone transformational changes since
2000 when the industry was liberalized. With a one-player market to 24 in 13
years, the industry has witnessed phases of rapid growth along with extent of
growth moderation and intensifying competition.
Regulatory changes were introduced during the past two years and life
insurance companies adopted many new customer-centric practices in this period.
Product-related changes, first in ULIPs (Unit Linked Insurance Plans) in
September 2011 and now in traditional products, will have the biggest impact on
the industry
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2. INTRODUCTION
2.1 BACKGROUND OF THE TOPIC
The term capital structure refers to the percentage of capital (money) at work
in a business by type. There are two forms of capital: equity capital and debt
capital. Debt includes loans and other types of credit that must be repaid in the
future, usually with interest. Equity involves selling a partial interest in the
company to investors, usually in the form of stock. In contrast to debt financing,
equity financing does not involve a direct obligation to repay the funds. Instead,
equity investors become part-owners and partners in the business, and thus earn a
return on their investment as well as exercising some degree of control over how
the business is run. Each has its own benefits and drawbacks.
There is a saying that “If capital structure is irrelevant in a perfect market, then
imperfections which exist in the real world must be the cause of its relevance.”
There are few theories backing this statement (trade-off theory and pecking order
theory).
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3. COMPANY ANALYSIS
ion to a sizeable network of advisors and partners. As on 28th February 2018, the
company has issued over 8.65 lakh policies with a sum assured of over
Rs.26,591Cr.
Federal Bank Ltd is engaged in the banking business. The Bank operates in four
segments: treasury operations, wholesale banking, retail banking and other banking
operations.
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Ageas is an international insurance group with a heritage spanning more than 180
years. Ranked among the top 20 insurance companies in Europe, Ageas has chosen
to concentrate its business activities in Europe and Asia, which together make up
the largest share of the global insurance market.
Life Insurance Corporation (LIC) had the monopoly over the market till the late
90’s when the insurance sector in India was opened for private players. Before that
there were only two state insurer, one was LIC (Life Insurance Corporation of
India) and GIC (General Insurance corporation of India).
Indian insurance sector at present has undergone many structural changes in 2000.
The Government of India has liberalized the insurance sector in 2000 with IRDA
(Insurance Regulatory and development authority) lifting all entry restriction of
foreign players with a specific limit on direct foreign ownership. Under the current
guideline 26% of equity cap is there for foreign players in an insurance company
and proposal is being given to increase this limit to 49%.Post liberalization
insurance industry in India have come a long way and today it stands as one of the
most competitive, challenging and exploring industry in India. Increased use of
new distribution channels are in limelight today due to entry of private players. In
the long run the use of these distribution channels and modern IT tools has
increased scope of the insurance industry. Also the changing economics patterns,
changing political scenario, modern IT tools will eventually help in reshaping
future of Indian financial market and Life Insurance business in the country.
Milestones
Mission
To continually strive to enhance customer experience through innovative product
offerings, dedicated relationship management and superior service delivery while
striving to interact with our customers in the most convenient and cost effective
manner.
To be transparent in the way we deal with our customers and to act with integrity.
To invest in and build quality human capital in order to achieve our mission.
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Values
Transparency: Crystal Clear communication to our partners and stakeholders
Value to Customers: A product and service offering in which
customers perceive value
Rock Solid and Delivery on Promise: This translates into being financially
strong, operationally robust and having clarity in claims
Customer-friendly: Advice and support in working with customers and
partners
Profit to Stakeholders: Balance the interests of customers, partners,
employees, shareholders and the community at large
3.4ORGANIZATION STRUCTURE
CEOVIGNESH
SHAHANE
Marketing
& Under Finance Human Product
writin Resourc 15 | P a g e
Promotion
g e
East
North Zonal
Zonal Support
Support Manager
Manager
South West
Zonal Zonal
Support Support
Manager Manager
LIFE INSURANCE:
Often, the first step towards a long and arduous journey is the toughest. However,
once you have taken that first stride, the rest of the journey seems easier and more
enjoyable. With your investments, it is the same approach that will ensure you
build the right corpus to fulfil your dreams for yourself and your family – start
small, save big!
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HOW IT WORKS
CHILD INSURANCE:
Whether your child wants to be a doctor, an engineer, an MBA, a sportsman, a
performing artist, or dreams of being an entrepreneur, the IDBI Federal Child
Insurance Dream Builder Insurance Plan will keep your future-ready against both,
changing dreams and life’s twists. It allows you to create build and manage wealth
by providing several choices and great flexibility so that your plan meets your
specific needs. However, what makes Child Insurance a must-have for any parent
who is looking to make their child’s future shock-proof is its powerful insurance
benefits. Child Insurance allows you to protect your child plan with triple
insurance benefits so that your wealth-building efforts remain unaffected by
unforeseen events and your child’s future goals can be achieved without any
hindrance.
HOW IT WORKS
This second illustration below explains how the product works for a limited premium policy with
a policy term of 20 years
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INCOME INSURANCE:
IDBI Federal Income Insurance Endowment and Money Back Plan is loaded with
lots of benefits which ensure that you get Guaranteed Annual Payout along with
insurance protection which will help you to reach you goals with full confidence.
Income insurance Plan is very flexible and allows you to customise your Plan as
per your individual and family’s future requirements. Moreover, it also allows you
to choose Premium Payment Period, Payout Period, Payout Options and more.
HOW IT WORKS
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Age Payout Age Payout
40 135% 50 130%
41 135% 51 130%
42 134% 52 128%
43 134% 53 128%
44 133% 54 127%
45 133% 55 126%
46 132%
STRENGTH: -
The major strength of IDBI Federal Life is its sponsor companies which are
IDBI bank, Federal bank and Fortis. Because of its innovative ideas it is the
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first insurance company to collect 100cr within five months of its
commencement of business. One major strength of IDBI Federal is its
combined network of more than 1600 branches of IDBI bank and Federal
bank.
Superior customer service with huge network and innovative products
High level of customer (both internal & external) satisfaction because of its
management policy.
Large pool of technically skilled workforce with deep knowledge of
insurance market.
WEAKNESS: -
The major weakness of IDBI Federal is the constraint sectorial growth due
to low unemployment level.
Low confidence of people in private insurance company.
The corporate clients under group schemes and salary savings schemes are
captured by other major players.
OPPORTUNITIES: -
Only 10% of Indian population is covered by insurance policy out of 30%
insurable population.
Due to liberalization it can operate globally.
Fast track carrier development opportunities on an industrial wide basis.
After liberalization it is expected that insurance business is roughly 400
billion rupees per year now which shows big opportunities and market for
IDBI Federal Life Insurance.
The existing LIC and GIC, have created a large group of dissatisfied
customers due to the poor quality of service. Hence there will be shift of
large number of customers for other players.
THREATS: -
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LIC was founded in 1956 with the merger of 243 insurance company and
provident societies. It is the largest insurance and investment company in
India. It is a state owned with 100% stake owned by government of India.
Products offered by LIC are:
1. JeevanArogya plan:
Jeevanarogya plan is a unique non-linked health insurance plan which
provides health insurance against certain specified health risk. LIC’s
jeevanarogya plan is a direct competition to IDBI’s Healthsurance plan.
2. Bima Account plan:
Under this plan the premiums payed by the customer after deduction of
all charges, will be credited to the policyholders account maintained
separately for each policyholder. If all premiums are paid the amount
held in policyholder’s account will earn an annual interest rate of 6% p.a
3. Endowment plan:
It’s a unit linked endowment plan which offers investment cum insurance
cover during the term of the policy.
4. Children Plans
5. Plan for Handicapped Dependents
6. Endowment assurance plans
7. Plans for high worth Individual
8. Money Back Plans
9. Special Money Back Plan for Women
10.Whole Life Plans
11.Term assurance plans
12. Joint Life Plan
1.1 SWOT Analysis of LIC:
SWOT Analysis is a strategic planning method used to analyze strength,
weakness, opportunity and threat involved in a business or a project.
1. Strength:
LIC is India’s largest state-owned company and also India’s
largest investors
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LIC has over 2000 branches all across India and more than 1,
00,000 agents.
LIC is the largest investor in India with largest fund base.
LIC has over 1, 15,000 employees across India.
LIC is the 8th most trusted brand of India.
LIC has subsidiaries like LIC card services Ltd, LIC Housing
finance Ltd,LIC Nomura mutual fund.
2. Weakness:
It lacks imagination since it has an image of a government
company
Red tape, bureaucracy causes the problem since it is a government
company.
During the economic crises managing a he workforce is a lot of
burden.
2. ICICI Prudential:
ICICI prudential Life Insurance Company is the joint venture of ICICI bank
and Prudential Plc, one of the leading financial service groups in UK.
Products offered by ICICI prudential:
1. ICICI pru care:
It is an insurance plan that protects family’s future and ensures they lead
their life comfortably.
2. Save n Protect
3. Cash back
4. Home Assure
5. Life Guard
6. ICICI pruiprotect
7. Smartkid Regular premium
8. ICICI pru Elite Life
9. Group term insurance plan
10.Group Gratuity plan
11.Annuity solution
12. ICICI pru life link pension SP
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13.Forever Life
14.Immediate annuity
15.ICICI pru heath saver
16.ICICI pru Hospital care
17.ICICI pru crisis cover
18.ICICI pruMediassure
STRENGTHS: Weaknesses:
1.Strong tie up 1.Low customer awareness
2.Brand Equity 2.Less promotion
3.Strong network 3.Untouched Rural Population
4.Huge customer database
5.Strong financial base
OPPORTUNITIES: Threats:
1.Untouched Rural market 1.Competitors
2.Large Uninsured population 2.Customer beliefs in LIC
3.Network Building 3.Fast turnover of employees
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4. ECONOMIC INDUSTRY ANALYSIS
4.1. INTRODUCTION TO INSURANCE INDUSTRY:
Insurance is a form of risk management that shields insured from the risk of any
uncertain of unfortunate events. In simple terms insurance can be defined as
transfer of risk from one entity to another in exchange of the payment. The
transaction consists of insured assuming a guaranteed small loss in the form of
payment to the insurer in exchange of the promise to compensate insured in case of
any kind of financial loss to insured. In a layman’s term, insurance is a guard
against monetary loss arising on the happening of an unforeseen event. In
developing countries like India insurance sector still holds lot of potential which
need to be tapped.
4.2TYPES OF INSURANCE:
Insurance can be classified into three categories:
1. Life Insurance:
Life Insurance is a concord between the insurer and the policyholder, where
insurer promises to pay beneficiary designated sum of money upon death of
the insured person. Life Insurance covers number of contingencies like
Death, Disability, and Disease.
2. General Insurance:
General Insurance is a non-life insurance policy including automobile and
homeowner policy. General insurance specifically consist of non- life
insurance. It includes property insurance, liability insurance and other forms
of insurance. Fire and Marine insurance are called property insurance.
3. Social Insurance:
Social insurance is another type of insurance for weaker section of the
society. It provides protection to weaker section of the society who are
unable to pay premium. Industrial Insurance, sickness insurance, pension
plan, disability benefits, unemployment benefits are some the type of social
insurance.
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4.3 INSURANCE SECTOR IN INDIA:
Indian insurance sector has gone through different phases of competition, from
being an open competitive market to a nationalized market and then again getting
back to liberalized market. Indian insurance sector has witnessed complete
dynamism in past few centuries.
Insurance sector in India has a deep- rooted history. Its mention has been found in
writings of Manu (Manusmriti), Yagnavalkya (dharmashastra) and Kautilya
(Arthshastra). Ancient Indian history has preserved traces of insurance in the form
of marine trade loans and carrier contracts.
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estimate would be meaningless.
Indian insurance sector at present has undergone many structural changes in 2000.
The Government of India has liberalized the insurance sector in 2000 with IRDA
(Insurance Regulatory and development authority) lifting all entry restriction of
foreign players with a specific limit on direct foreign ownership. Under the current
guideline 26% of equity cap is there for foreign players in an insurance company
and proposal is being given to increase this limit to 49%. Post liberalization
insurance industry in India have come a long way and today it stands as one of the
most competitive, challenging and exploring industry in India. Increased use of
new distribution channels is in limelight today due to entry of private players. In
the long run the use of these distribution channels and modern IT tools has
increased scope of the insurance industry. Also the changing economics patterns,
changing political scenario, modern IT tools will eventually help in reshaping
future of Indian financial market and Life Insurance business in the country.
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higher market share. In order to gain higher market share companies, have to
differentiate themselves from others. Companies can differentiate themselves in
the market by using a number of critical success factors:
1. Product Quality:
One the most important factor that differentiates companies is by the quality
of product it offers. Quality of product instills a confidence in the customer
that the product offered by the company is better. Better the quality of
product, more successful is the company.
3. Market Segmentation:
Greater market segmentation should be done in which target audience
should be divided into homogenous groups and products and services should
be targeted towards such market. This would tie company to their client by
customized combination of coverage, easy payment plan, risk management
advice and quick claim handling.
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Rural market is India is still uncovered by this sector. Insurance penetration
can be achieved by tapping the untapped rural market of India.
7. Use of technology:
Technology plays a very important role in the success of the company.
Internet based Life insurance will help companies to reduce time and
transaction cost and also improves quality of services to its customer.
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While competing with a fixed income product higher assured returns are required
for high.
Interest rates in order to increase penetration. There may be some reductions in
actual growth rates, but Indian’s long term fundamentals remain intact as life
Insurance being an industry with long time horizon, it would be able to tide over
economic cycle.
Inflation on the other hand means lower disposal incomes in the hand of the
consumer leading to lower household savings which currently stands at 34.7%,
though significantly lower than china which is 50%.
According to the Swiss Re’s newly appointed Economist, Kurl Karl low interest
rates and euro debt crisis will prove to be a problem for insurance industry.
According to Kurt karl momentum of growth has been slowed down due to this
two factors, but the only bright spot according to him is the ongoing growth in the
emerging market. However, Kurl is lot more optimistic looking forward to 2013
forecasting a pick-up in investment yield and premium in a modest improvement
in economic conditions.
1. Political Development:
Political developments are the more serious threat in Europe and US. In
Europe this can lead to serious sovereign defaults and also exit from the
euro monetary union.
2. Emerging markets has been negatively impacted by faltering growth in
the developed economy. Also tighter monetary policies on the part of
several emerging economies also slowed down growth.
3. Both global in-force and new business life insurance fell in 2011, but it
again recovered. According to the economist in order to return to the pre-
crisis profitability short- term factors like low investment returns, high
hedging cost and more onerous capital requirement. Life Insurance
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industry’s capitalization has improved markedly and it is in the better
shape to cope up with the future challenges.
4. Because of some Regulatory changes in China and India, coming two
years will see life insurance business in emerging market returning to its
long term trend of around 8%.
to the smaller companies to compete against giants like Life Insurance Corporation
of India Ltd (LIC) which has 70% market share are:
1. Rural market:
According to the Mckinsey report, titled India Insurance 2016: Fortune
Favors the Bold, finds that the sector is still in a dissident with different
players in different stage of development and market presence.
According to the Mckinsey’s report the rural penetration is likely to
increase from about 25% at present to around 35-40% in 2016. With 65%
of the Life insurance coming from rich urban class, smaller companies
can look for rural and low income group as potential demand driver.
2. Product Mix;
A better product mix would also drive growth of insurance companies,
with companies making a move to lower the share of single premium
products.
Life insurance product can also fill the gap that is created by growing demand for
investment products and long-term savings
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LITERATURE REVIEW
5.1 LITERATURE
Capital structure is defined as the specific mix of debt and equity a firm uses to
finance its operations. Four important theories are used to explain the capital
structure decisions. These are based on asymmetric information, tax benefits
associated with debt use, bankruptcy cost and agency cost. The first is rooted in the
pecking order framework, while the other three are described in terms of the static
trade-off choice. These theories are discussed in turn.
The concept of optimal capital structure is expressed by Myers (1984) and Myers
and Majluf (1984) based on the notion of asymmetric information. The existence
of information asymmetries between the firm and likely finance providers causes
the relative costs of finance to vary among different sources of finance. For
example, an internal source of finance where the funds provider is the firm will
have more information about the firm than new equity holders, thus these new
equity holders will expect a higher rate of return on their investments. This means
it will cost the firm more to issue fresh equity shares than to use internal funds.
Similarly, this argument could be provided between internal finance and new debt-
holders. The conclusion drawn from the asymmetric information theories is that
there is a certain pecking order or hierarchy of firm preferences with respect to the
financing of their investments (Myers and Majluf, 1984). This “pecking order”
theory suggests that firms will initially rely on internally generated funds, i.e.,
undistributed earnings, where there is no existence of information asymmetry; they
will then turn to debt if additional funds are needed, and finally they will issue
equity to cover any remaining capital requirements. The order of preferences
reflects the relative costs of various financing options. Clearly, firms would prefer
internal sources to costly external finance (Myers and Majluf, 1984). Thus,
according to the pecking order hypothesis, firms that are profitable and therefore
generate high earnings are expected to use less debt capital than those that do not
generate high earnings.
Capital structure of the firm can also be explained in terms of the tax benefits
associated with the use of debt. Green, Murinde and Suppakitjarak (2007) observe
that tax policy has an important effect on the capital structure decisions of firms.
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Corporate taxes allow firms to deduct interest on debt in computing taxable profits.
This suggests that tax advantages derived from debt would lead firms to be
completely financed through debt. This benefit is created, as the interest payments
associated with debt are tax deductible, while payments associated with equity,
such as dividends, are not tax deductible. Therefore, this tax effect encourages debt
use by the firm, as more debt increases the after tax proceeds to the owners
(Modigliani and Miller, 1963; Miller, 1977). It is important to note that while there
is corporate tax advantage resulting from the deductibility of interest payment on
debt, investors receive these interest payments as income. The interest income
received by the investors is also taxable on their personal account, and the personal
income tax effect is negative. Miller (1977) and Myers (2007) argue that as the
supply of debt from all corporations expands, investors with higher and higher tax
brackets have to be enticed to hold corporate debt and to receive more of their
income in the form of interest rather than capital gains. Interest rates rise as more
and more debt is issued, so corporations face rising costs of debt relative to their
costs of equity. The tax benefits arising from the issue of more corporate debt may
be offset by a high tax on interest income. It is the trade-off that ultimately
determines the net effect of taxes on debt usage (Miller, 1977; Myers, 2001).
Bankruptcy costs are the costs incurred when the perceived probability that the
firm will default on financing is greater than zero. The potential costs of
bankruptcy may be both direct and indirect. Examples of direct bankruptcy costs
are the legal and administrative costs in the bankruptcy process. Haugen and
Senbet (1978) argue that bankruptcy costs must be trivial or nonexistent if one
assumes that capital market prices are competitively determined by rational
investors. Examples of indirect bankruptcy costs are the loss in profits incurred by
the firm as a result of the unwillingness of stakeholders to do business with them.
Customer dependency on a firm’s goods and services and the high probability of
bankruptcy affect the solvency of firms (Titman, 1984). If a business is perceived
to be close to bankruptcy, customers may be less willing to buy its goods and
services because of the risk that the firm may not be able to meet its warranty
obligations. Also, employees might be less inclined to work for the business or
suppliers less likely to extend trade credit.
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These behaviours by the stakeholders effectively reduce the value of the firm.
Therefore, firms that have high distress cost would have incentives to decrease
outside financing so as to lower these costs. Warner (1977) maintains that such
bankruptcy costs increase with debt, thus reducing the value of the firm. According
to Modigliani and Miller (1963), it is optimal for a firm to be financed by debt in
order to benefit from the tax deductibility of debt. The value of the firm can be
increased by the use of debt since interest payments can be deducted from taxable
corporate income. But increasing debt results in an increased probability of
bankruptcy. Hence, the optimal capital structure represents a level of leverage that
balances bankruptcy costs and benefits of debt finance. The greater the probability
of bankruptcy a firm face as the result of increases in the cost of debt, the less debt
they use in the issuance of new capital (Pettit and Singer, 1985).
The use of debt in the capital structure of the firm also leads to agency costs.
Agency costs arise as a result of the relationships between shareholders and
managers, and those between debt-holders and shareholders (Jensen and Meckling,
1976). The relationships can be characterized as principal-agent relationships.
While the firm’s management is the agent, both the debt-holders and the
shareholders are the principals. The agent may choose not to maximize the
principals’ wealth. The conflict between shareholders and managers arises because
managers hold less than 100% of the residual claim (Harris and Raviv, 1990).
Consequently, they do not capture the entire gain from their profit-enhancing
activities but they do bear the entire cost of these activities. Separation of
ownership and control may result in managers exerting insufficient work,
indulging in perquisites, and choosing inputs and outputs that suit their own
preferences. Managers may invest in projects that reduce the value of the firm but
enhance their control over its resources. For example, although it may be optimal
for the investors to liquidate the firm, managers may choose to continue operations
to enhance their position. Harris and Raviv (1990) confirm that managers have an
incentive to continue a firm’s current operations even if shareholders prefer
liquidation.
On the other hand, the conflict between debt-holders (creditors) and shareholders is
due to moral hazard. Agency theory suggests that information asymmetry and
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moral hazard will be greater for smaller firms (Chittenden et al., 1996). Conflicts
between shareholders and creditors may arise because they have different claims
on the firm. Equity contracts do not require firms to pay fixed returns to investors
but offer a residual claim on a firm’s cash flow. However, debt contracts typically
offer holders a fixed claim over a borrowing firm’s cash flow. When a firm
finances a project through debt, the creditors charge an interest rate that they
believe is adequate compensation for the risk they bear. Because their claim is
fixed, creditors are concerned about the extent to which firms invest in excessively
risky projects. For example, after raising funds from debt-holders, the firm may
shift investment from a lower-risk to a higher-risk project.
According to Jensen and Meckling (1976), the conflict between debt-holders and
equity-holders arises because debt contract gives equity-holders an incentive to
invest sub optimally. More specifically, in the event of an investment yielding
large returns, equity-holders receive the majority of the benefits. However, in the
case of the investment failing, because of limited liability, debt-holders bear the
majority of the consequences. In other words, if the project is successful, the
creditors will be paid a fixed amount and the firm’s shareholders will benefit from
its improved profitability. If the project fails, the firm will default on its debt, and
shareholders will invoke their limited liability status. In addition to the asset
substitution problem between shareholders and creditors, shareholders may choose
not to invest in profitable projects (under invest) if they believe they would have to
share the returns with creditors.
The agency costs of debt can be resolved by the entire structure of the financial
claim. Barnea et al. (1980) argue that the agency problems associated with
information asymmetry, managerial (stockholder) risk incentives and forgone
growth opportunities can be resolved by means of the maturity structure and call
provision of the debt. For example, shortening the maturity structure of the debt
and the ability to call the bond before the expiration date can help reduce the
agency costs of underinvestment and risk-shifting. Barnea et al. (1980) also
demonstrate that both features of the corporate debt serve as identical purposes in
solving agency problems.
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5.2 THEORIES OF CAPITAL STRUCTURE
5.2.1 INTRODUCTION:
The Capital Structure or financial leverage decision should be examined from the
point of its impact on the value of the firm. If capital structure decision can affect a
firm’s value, then it would like to have a capital structure, which maximizes its
market value. However, there exist conflicting theories on the relationship between
capital structure and the value of a firm. The traditionalists believe that capital
structure affects the firm’s value while Modigliani and Miller (MM), under the
assumptions of perfect capital markets and no taxes, argue that capital markets and
no taxes, argue that capital structure decision is irrelevant. MM reverses their
position when they consider taxes. Tax savings resulting from interest paid on debt
create value for the firm. However, the tax advantage of debt is reduced by
personal taxes and financial distress. Hence, the tradeoff between costs and
benefits of debt can turn capital structure into a relevant decision. There are other
views also on the relevance of capital structure; we first discuss the traditional
theory of capital structure followed by MM theory and other views.
Since capital is expensive for small businesses, it is particularly important for small
business owners to determine a target capital structure for their firms. The capital
structure concerns the proportion of capital that is obtained through debt and
equity. There are tradeoffs involved: using debt capital increases the risk
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associated with the firm's earnings, which tends to decrease the firm's stock prices.
At the same time, however, debt can lead to a higher expected rate of return, which
tends to increase a firm's stock price. As Brigham explained, "The optimal capital
structure is the one that strikes a balance between risk and return and thereby
maximizes the price of the stock and simultaneously minimizes the cost of capital."
Capital structure decisions depend upon several factors. One is the firm's business
risk—the risk pertaining to the line of business in which the company is involved.
Firms in risky industries, such as high technology, have lower optimal debt levels
than other firms. Another factor in determining capital structure involves a firm's
tax position. Since the interest paid on debt is tax deductible, using debt tends to be
more advantageous for companies that are subject to a high tax rate and are not
able to shelter much of their income from taxation.
A third important factor is a firm's financial flexibility, or its ability to raise capital
under less than ideal conditions. Companies that are able to maintain a strong
balance sheet will generally be able to obtain funds under more reasonable terms
than other companies during an economic downturn. Brigham recommended that
all firms maintain a reserve borrowing capacity to protect themselves for the
future. In general, companies that tend to have stable sales levels, assets that make
good collateral for loans, and a high growth rate can use debt more heavily than
other companies. On the other hand, companies that have conservative
management, high profitability, or poor credit ratings may wish to rely on equity
capital instead.
SOURCES OF CAPITAL
DEBT CAPITAL Small businesses can obtain debt capital from a number of
different sources. These sources can be broken down into two general categories,
private and public sources. Private sources of debt financing, according to W.
Keith Schilit in The Entrepreneur's Guide to Preparing a Winning Business Plan
and Raising Venture Capital, include friends and relatives, banks, credit unions,
consumer finance companies, commercial finance companies, trade credit,
insurance companies, factor companies, and leasing companies. Public sources of
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debt financing include a number of loan programs provided by the state and federal
governments to support small businesses.
When evaluating a small business for a loan, Jennifer Lindsey wrote in her book
The Entrepreneur's Guide to Capital, lenders ideally like to see a two-year
operating history, a stable management group, a desirable niche in the industry, a
growth in market share, a strong cash flow, and an ability to obtain short-term
financing from other sources as a supplement to the loan. Most lenders will require
a small business owner to prepare a loan proposal or complete a loan application.
The lender will then evaluate the request by considering a variety of factors. For
example, the lender will examine the small business's credit rating and look for
evidence of its ability to repay the loan, in the form of past earnings or income
projections. The lender will also inquire into the amount of equity in the business,
as well as whether management has sufficient experience and competence to run
the business effectively. Finally, the lender will try to ascertain whether the small
business can provide a reasonable amount of collateral to secure the loan.
EQUITY CAPITAL Equity capital for small businesses is also available from a
wide variety of sources. Some possible sources of equity financing include the
entrepreneur's friends and family, private investors (from the family physician to
groups of local business owners to wealthy entrepreneurs known as "angels"),
employees, customers and suppliers, former employers, venture capital firms,
investment banking firms, insurance companies, large corporations, and
government-backed Small Business Investment Corporations (SBICs).
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There are two primary methods that small businesses use to obtain equity
financing: the private placement of stock with investors or venture capital firms;
and public stock offerings. Private placement is simpler and more common for
young companies or startup firms. Although the private placement of stock still
involves compliance with several federal and state securities laws, it does not
require formal registration with Securities and Exchange Commission. The main
requirements for private placement of stock are that the company cannot advertise
the offering and must make the transaction directly with the purchaser.
1) Minimization of Risk: a> capital structure must be consistent with business risk
b> It should result in a certain level of financial risk.
2) Control: It should reflect the management’s philosophy of control over the firm.
3) Flexibility: It refers to the ability of the firm to meet the requirement of the
changing situation.
4) Profitability: It should be profitable from the equity shareholders point of view.
5) Solvency: The use of excessive debt may thereafter the solvency of the
company.
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Capital Budgeting
decision
Long-term sources
of funds
Capital Structure
Decision
Value of Firm
Debt comes in the form of bond issues or long-term notes payable, while equity is
classified as common stock, preferred stock or retained earnings. Short-term debt
such as working capital requirements is also considered to be part of the capital
structure.
Assumptions:
1) There are only two sources of funds i.e. the equity and debt, having a fixed
interest
2) The total assets of the firm are given and there would be no change in the
investment decision of the firm
3) EBIT (Earnings before Interest & Tax)/ NOP (Net Operating Profits) of the
firm are given and is expected to remain constant.
4) Retention ratio is NIL, i.e., total profits are distributed as dividends. [100%
dividend pay-out ratio]
5) The firm has a given business risk which is not affected by the financing
wise.
6) There is no corporate or personal taxes
7) The investors have the same subjective probability distribution of expected
operation profits of the firms
8) The capital structure can be altered without incurring transaction costs.
A company formulating its long term financial policy should, first of all analyze its
current financial structure, the following are the important elements of the
company’s financial structure that need proper scrutiny and analysis.
1) Capital Mix: -Firms have to decide about the mix of debt and equity capital,
debt capital can be mobilized from a variety of sources, how heavily does the
company depend on debt? What is the mix of debt instruments? Given the
company’s risks, is the reliance on the level and instruments of debt
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reasonable? Does the firm’s debt policy allow its flexibility to undertake
strategic investments in adverse financial condition? Ther firms and analysts
use debt ratios, debt service coverage ratios, and the funds flow statement
analyze the capital mix
2) Maturity and priority: -The maturity of securities used in the capital mix
may differ. Equity is the most permanent capital. Within debt, commercial
paper has the shortest maturity and public debt has the longest, Similarly, the
priorities of securities also differ. Capitalized debt like lease or hire purchase
finance is quite safe from the lender’s point of view and the value of assets
backing the debt provides the protection to the lender. Collateralized or
secured debts are relatively safe and have priority over unsecured debt in the
event of insolvency. Do maturities of the firm’s assets and liabilities match?
If not, what trade off is the firms making? A firm may obtain a risk neutral
position by matching the maturity of assets and liabilities that is it may use
current liabilities to finance current assets and short medium and long term
debt for financing the fixed assets in that order of maturities. In practise,
firms do not perfectly match the sources and uses of funds. They may show
preference for retained earnings. Within debt, they may use long term funds
to finance current assets and assets with shorter life. Some firms are more
aggressive, and they use short term funds to finance long term assets.
3) Terms & Condition: - Firms have choices with regard to the basis of
interest payments. They may obtain loans either at fixed or floating rates of
interest. In case of equity, the firm may like to return income either in the
form of large dividends or large capital gains. What is the firm’s preference
with regard to the basis of payments of interest and dividend? How do the
firm’s interest and dividend payments match with its earnings and operating
cash flows? The firm’s choice of the basis of payments indicates the
management’s assessment about the future interest rates and the firm’s
earnings. Does the firm have protection against interest rates fluctuations?
The financial manager can protect the firm against interest rates fluctuations
through the interest rates derivatives. There are other important terms and
conditions that the firm should consider. Most loan agreements include what
the firm can do and what it can’t do. They may also state the schemes of
payments, pre-payments, renegotiations, etc. What are the lending criteria
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used by the suppliers of capital? How do negative and positive conditions
affect the operations of the firm? Do they constraint and compromise the
firm’s competitive position? Is the company level to comply with the terms
and conditions in good time and bad time?
4) Currency: - Firms in a number of countries have the choice of raising funds
from the overseas markets. Overseas financial markets provide opportunities
to raise large amounts of funds. Accessing capital internationally also helps
company to globalize its operations fast. Because international financial
markets may not be perfect and may not be fully integrated, firms may be
able to issue capital overseas at lower costs than in the domestic markets. The
exchange rates fluctuations can create risk for the firm in servicing it foreign
debt and equity. The financial manager will have to ensure a system of risk
hedging. Does the firm borrow from the overseas markets? At what terms
and condition? How has firm benefited operationally and or financially in
raising funds overseas? Is there a consistency between the firm’s foreign
currency obligations and operating inflows?
5) Financial innovation: -Firms may raise capital either through the issue of
simple securities or through the issues of innovative securities. Financial
innovations are intended to make the security issue attractive to investors and
reduce cost of capital. For example, a company may issue convertible
debentures at a lower interest rate rather than non convertible debentures at a
relatively higher interest rate. A further innovation could be that the company
may offer higher simple interest rate on debentures and offer to convert
interest amount into equity. The company will be able to conserve cash
outflows. A firm can issue varieties of option linked securities it can also
issue tailor made securities to a large suppliers of capital. The financial
manager will have to continuously design innovative securities to be able to
reduce the cost. An innovation introduced once does not attract investors any
more. What is the firm’s history in arms of issuing innovative securities?
What were the motivations in issuing innovative securities and did the
company achieve intended benefits?
6) Financial market segments: -There are several segments of financial
markets from where the firm can tap capital form example, a firm can tap the
private or the public debt market for raising long terms debt. The firm can
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raise short term debt either from banks or by issuing commercial papers or
certificate deposits in the money market. The firm also has the alternative of
raising short term funds by public deposits. What segments of financial
markets have the firm tapped for raising funds and why? How did the firm
tap and approach these segments?
T= Tax Rate
EBIT/ NOP= Earnings Before interest and tax or Net Operating Profit
=EBIT/V
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5.3 DIFFERENT THEORIES OF CAPITAL STRUCTURE
1> Net Income (NI) Approach
2> Net Operating Income (NOI) Approach.
3> Traditional Approach
4> Modigliani-Miller Model
a> without taxes.
b> with taxes.
= 700/0.0933= Rs 7,500
Similarly, the value of a firm’s debt is the discounted value of debt-holders interest
income. The value of L’s debt is: 300/0.06 = Rs 5000
D=Interest/Cost of debt=INT/kd
=300/0.06= Rs 5000
The value of firm L is the sum of the value of equity and the value of debt:
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Value of firm=value of equity + Value of debt
V= E+D
= 7,500+5,000= Rs 12,500
Firm’s L’s value is Rs12,500 and its expected net operating income is Rs 1,000.
Therefore, the firm’s overall expected rate of return or the cost of capital is:
Ko=NOI/V
= 1000/12,500=0.08 or 8%
The firm’s overall cost of capital is the weighted average cost of Capital (WACC).
There is an alternative way of calculating WACC. WACC is the weighted average
of costs of all of the firm’s securities Firm L’s securities include debt and equity.
Therefore, firm’s L’s WACC or Ko is the weighted average of the cost of equity
and the cost of debt firm L’s value is Rs 12,500, Value of its equity is Rs 7,500 and
value of its debt is Rs 5000. Hence the firm’s debt ratio (D/V) is 5000/12500 =0.40
or 40 percent and equity ratio (E/V) is 7,500/12,500 = 0.60 or 60 percent. Firm’s
L’s weighted average cost of capital is:
Ko = ke x E/V + Kd x D/V
Assumption
1> Total capital requirement of the firm is given and remain constant
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2> Kd<Ke
3> Kd and Ke are constant
4> Kd decreases with the increase in leverage.
Ke
Cost
Of
Capi Ko
tal Kd
(%)
O Degree of Leverage
Illustration
Interest 50,000
Assumption: -
1) Ko and Kd is constant.
2) Ke will change with degree of leverage
3) There is no tax.
Ke
Cost Ko
Of
Capital Kd
(%)
O Degree of Leverage
Illustration
A firm has an EBIT of Rs 5,00,000 and belongs to a risk class of 10%. What is the
cost of equity if it employs 8% debt to the extent of 30%, 40% or 50% of the total
capital fund of Rs 20,00,000?
Solution
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Particulars 30% 40% 50%
(EBIT/Ko)
(V-D)
Assumption
1> The value of the firm increases with the increase in financial leverage. Uptoa
certain limit only.
2> Kd is assumed to be less than Ke
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K
Cost eKo
Of Kd
Capital
(%) O
Optimal Leverage
Capital (Degree)
Structure
Ke
Ko
Kd
O P Leverage
Range of Optimal (Degree)
Capital Structure
(Part 1) (Part 2)
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5.3.4 MODIGLIANI – MILLER (MM) HYPOTHESIS
The Modigliani- Miller hypothesis is identical with the net operation Income
approach, Modigliani and Miller argued that, in the absence of taxes the cost of
capital and the value of the firm are not affected by the changes in capital structure.
In other words, capital structure decision is irrelevant and value of the firm is
independent of debt-equity mix.
Basic propositions
1) The overall cost of capital (Ko) and the value of the firm are independent of the
capital structure. The total market value of the firm is given capitalising the
expected net operating income by the rate appropriate for that risk class.
2) The financial risk increases with more debt content in the capital structure. As a
result, cost of equity (Ke) increases in a manner to offset exactly the low- cost
advantage of debt. Hence overall cost of capital remains the same.
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Preposition 1
According to M-M for the firms in the same risk class, the total market value is
independent of capital structure and is determined by capitalising net operating by
the rate appropriate to that risk class. Preposition 1 can be expressed as follows
According the preposition 1 the average cost of capital is not affected by degree of
leverage and determined as follows
Ke = X/V
According to M-M the average cost of capital is constant as shown in the following
firms
Y
Cost Of
Leverage
Ko
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5.4 ARBITRAGE PROCESS
According to M-M two firms identical in all respects except their capital structure,
cannot have different market values or different cost of capital. In case, these firms
have different market values, the arbitrage will take place and equilibrium in
market values restored in no time. Arbitrage process refers to switching of
investment of investment from one firm another. When market values are different,
the investors will try to take advantage of it by selling their securities with high
market price and buying the securities with low market price. The use of debt by
the investors is known as personal leverage or homemade leverage.
Because of this arbitrage process, the market price of securities in higher valued
market will come down and the market price of securities in the lower valued
market will go up, and this switching process is continued until the equilibrium is
established in the market values, so M-M argue that there is no possibility of
different market value for identical firms
Arbitrage process also works in the reverse direction, Leverage has neither
advantage nor disadvantage. If an unlevered firm (With debt Capital) has higher
market value than a levered firm (With debt capital) arbitrage process works in
reverse direction. Investors will try to switch their investments from unlevered firm
to levered firm to levered firm so that equilibrium is established in no time
Thus M-M proved in terms of their proposition 1 that the value of the firm is not
affected by debt equity mix.
Preposition 2
M-M argue that Ko will not increase with the increase in the leverage because the
low-cost advantage of debt capital will be exactly offset by the increase in the cost
of equity as caused by increased risk to equity shareholders. The crucial part of the
M-M thesis is that an excessive us of leverage will increase the risk to the debt
holders which results in an increase in cost of debt (Ko). However, this will not
lead to a rise in Ko, M-M maintain that in such a case Ke, will increase at a
decreasing rate or even it may decline. This is because of the reason that at an
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increased leverage. The increased risk will be shared by the debt holders. Hence
Ko remain constant. This is illustrated in the figure given below.
Ke
Ko
Kd
O Leverage X
1) Rates of interest are not the same for individuals and firms. The firms generally
have a higher credit standing because of which they can borrow funds at a
lower rate of interest as compared to individuals
2) Home- Made leverage is not a perfect substitute for corporate leverage. If the
firm borrows, the risk to the shareholders is limited to hi shareholding in that
company. But if he borrows personally, the liability will be extended to his
personal property also. Hence, the assumption that personal home-made
leverage is a perfect substitute for corporate leverage is not valid.
3) The assumption that transactions costs do not exist is not valid because these
costs are necessarily involved in buying and selling securities
4) The working of arbitrage is affected by institutional restrictions, because the
institutional investors are not allowed to practice home-made leverage.
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5) The major limitation of M-M hypothesis is the existence of corporate taxes.
Since the interest charges are tax deductible, a levered firm will have a lowest
cost of debt due to tax advantage when taxes exist
T = tax rate
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The pecking order theory is able to explain the negative inverse relationship
between profitability and debt ratio within an industry. However, it does not full
explain the capital structure differences between industries.
6.1RATIO ANLYSIS
WORKING CAPITAL = CURRENT ASSET – CURRENT LIABILITIES
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Interpretation:
Difference between current asset and current liabilities is increasing that’s mean
company is now more liable to tackle their short term obligations or needs.
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Interpretation:
In 2014 the current ratio is nearly 1:1 which is means bad working capital but in
coming years the condition of working capital is become well and the ratio is grow
to nearly 2:1 which means co. able to pay their current liabilities.
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Interpretation:
In this figure quick ratio is not up to the mark company may face liquidity problem
because the quick ratio is below 1:1. It indicate that the company relies too much
on inventory or other assets to pay its short-term liabilities.
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Interpretation:
Cash flow indicates ability to cover their total debt with its yearly cash flow from
operation. But here company’s percentage is from 2014, 0.141 to 2018, 0.075.
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Interpretation:
Debt is rapidly increase year by year in comparison of equity that’s show company
is more reliable on debt.2014 it was 3.02 and till 2018 it was 4.84.
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Interpretation:
The ratio is increasing show that company is able to generate income from new
investment. It goes up from -0.23 in 2014 to 0.1001 in 2018. From 2017 it’s in
favorable.
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If in 2018 the company is going to employee a debt of 20,000,000 at 6% interest
and in 2017 25,000,000 at 6%
6% OF RS
16,709,694 6% OF RS 6% of rs
ZERO DEBT DEBT 2,00,00,000 2,50,00,000
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INTERPRETATION
From the graph we can observe that as debt in the capital structure increases the
WACC decreases and value of the firm increases, but if the company is going for
more in upcoming year the value of the firm decreases and the financial risk might
increase, this can be balanced by the expected rate of returns by the equity share
holder hence company can go for extra debt but keeping the shareholders returns in
tact
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6.3NET OPERATING INCOME APPROACH
SHARE HOLDERS
EARNINGS 7711463.4
COST OF EQUITY 0.145492
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CALCULATION THE VALUE OF THE COMPANY
EBIT 8714045
WACC 12.50%
MARKET VALUE
OF THE
COMPANY 69712360
DEBT 20,000,000
EQUITY 49,712,360
SHARE HOLDERS
EARNINGS 7514045
COST OF EQUITY 0.151150438
SHARE HOLDERS
EARNINGS 7214045
COST OF EQUITY 0.161343
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2017 2018 2019
EBIT 8714045 8714045 8714045
WACC 12.50% 12.50% 12.50%
Market value of 69712360 69712360 69712360
the company
Debt 16709694 20000000 25000000
Equity 53,002,666 49,712,360 44712360
Shareholders 68709778 7514045 7214045
earning
Cost of equity 1.2963457 0.15112044 0.161343
INTERPRETATION
From the graph we can observe that the market value of the firm is not affected by
leverage even if the company is going for more debt in the upcoming year
Thus the financing decision is irrelevant hence it does not help in creating wealth
to the shareholders
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Hence in going to extra debt does not affect the shareholders interest
6.4EBIT OR NOI
REVENUE EXPENDITURE
Expense other than
(a) Interest, dividends & those directly related to
rent - gross 176,685 the insurance business 17,240
(b) Profit on
sale/redemption of
investments 17,691 Bad debts
Amount written offto
transferred -
(c) (Loss on sale/ the Policyholders'
redemption of Account (Technical
investments) -5,422 Account) 966,841
(d) (Amortisation of
premium) / discount on Provision for tax -Wealth
investments (net) 71,118 Tax 97
Provisions (other than
Other Income taxation)
(a) For diminution in the
(a) Miscellaneous Income 452 value of investments -
(b) Provision for doubtful
debts -
TOTAL 1,076,610 (c) Others -
Total 984,178
NOI = REVENUE-EXPENDITURE
92,432
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7 CONCLUSION AND FINDINGS
Debt in the capital structure increases the WACC decreases and value of the firm
increases.
but if the company is going for more in upcoming year the value of the firm
decreases and the financial risk might increase.
this can be balanced by the expected rate of returns by the equity share holder
hence company can go for extra debt but keeping the shareholders returns in tact
market value of the firm is not affected by leverage even if the company is going
for more debt in the upcoming year
Thus the financing decision is irrelevant hence it does not help in creating wealth
to the shareholders
Hence in going to extra debt does not affect the shareholders interest
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8 BIBLOGRAPHY
Reference of Books
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