Capital Structure:

Introduction

 A firm’s investment decision dictate its funding needs.  Patanjali’s acquisition of

Ruchi Soya

 The four steps involved in investment and financing decisions in corporate finance
are:  What Investments?  which project to acquire, whether it is good?  How
much funding is required?  What types of financing?  Sources of financing  Where
to obtain the financing?  Forms of financing

 Best SOURCE of Funds: Should it be from  Internal cash flows  Debt  External
equity  Convertibles  So forth….

 Forms of Financing: Should  Internal CF funding come from excess cash or by

cutting dividends?  Debt financing be from BANKS or from issuing BONDS in the
Capital Markets?  EQUITY be raised from VENTURE CAPITAL firms or from CAPITAL
MARKETS, and in the form of PREFERRED or COMMON STOCK?

 These TWO decisions – the SOURCE and FORMS of funding – determine the
CAPITAL STRUCTURE.

 A firm’s capital structure is defined by how a firm’s assets are financed.  It

represents the mix of claims against the firm’s assets and cash flows.

 Three KEY QUESTIONS are:  Is there an optimal capital structure (i.e., an optimal
mix between sources of financing – in particular between debt and equity)?  YES. 
Is this optimal structure different across firms and time?  YES, optimal capital
structure differs across different firms because it is dependent on a firm’s o perations
and risk.  Can a CFO or Manager add value to Liabilities Side of the Balance Sheet
with good financing policy?  Probably, but (s)he can definitely destroy value with a
bad financing policy!

Modigliani-Miller Value Irrelevance Proposition

Assumptions relate to expectations and market  Expectations are homogeneous 

Perfect capital markets  No transaction costs, no taxes, no bankruptcy,  Everyone
has same information….. Information symmetry  Two investments with identical
cashflow streams and risk must trade for the same price.  Borrow and lend at same
risk-free IR  No agency costs  Managers always act to maximizing the shareholders’
wealth  Financing decision and investment decisions are independent  Operating
income is unaffected by change in capital structure

MM Proposition I

 Weighted Average Cost of Capital for a company in absence of tax case is unaffected by its capital
structure 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐴𝑠𝑠𝑒𝑡𝑠 𝑜𝑟 𝑊𝐴𝐶𝐶, 𝑟𝐴 = 𝑟𝐷 𝐷 𝑉 + 𝑟𝐸 𝐸 𝑉  Leverage increases the E(EPS) but
not share price!  Why?  The change in Expected earnings stream is exactly offset by a change in
the rate at which the earnings are discounted.  Investors can substitute their own leverage for a
company’s leverage by borrowing or lending appropriate amount in addition to holding shares of the
company.
Leverage increases the E(EPS) but not share price Why?

 The change in Expected earnings stream is exactly offset by a change in the rate at which the
earnings are discounted.  Investors can substitute their own leverage for a company’s leverage by
borrowing or lending appropriate amount in addition to holding shares of the company.

MM Proposition II without Taxes:

Higher Financial Leverage Raises the Cost of Equity

 MM’s II proposition focuses on cost of capital of the company.

 Consider WACC equation

𝑊𝐴𝐶𝐶, 𝑟𝐴 = 𝑟𝐷 (𝐷/ 𝑉) + 𝑟𝐸( 𝐸/ 𝑉)

 Solving for cost of equity: 𝒓𝑬 = 𝒓𝑨 + (𝒓𝑨 – 𝒓𝑫) (𝑫/ 𝑬)

Observations:  𝑟𝐸 is linear function of 𝐷/𝐸 ratio, expressed in MVs  Slope intercept, 𝑟𝐴  Slope
coefficient equal to positive quantity 𝑟𝐴 − 𝑟𝐷 , spread  𝑟𝐴 − 𝑟𝐷 is positive ‘coz 𝑟𝐸 must be an
increasing function of 𝐷/𝐸 ratio for WACC to be unchanged as use of debt increases Dr. Kulbir Singh
(IMT-N) CF-II (Flexicore) 2021-22 26 MM Proposition II without Taxe

𝒓𝑬 = 𝒓𝑨 + (𝒓𝑨 – 𝒓𝑫)( 𝑫/ 𝑬)

 MM’s Proposition II

Expected rate of return on equity of a levered firm increases in proportion to DebtEquity ratio; the
rate of increase depends on spread between 𝑟𝐴, the expected return on a portfolio of all the firm’s
securities and 𝑟𝐷, the expected return on debt.

 Example Equity investors’ return for unlevered firm Premium for extra risk in levered firm If
Operating income falls from Rs. 1,500 To Rs. 500 Change

No Debt: Earnings Per Share Rs. 1.50 Rs. 0.50 -Rs. 1.00

Return 15% 5% -10% 50% Debt: Earnings Per Share Rs. 2.00 0 -Rs. 2.00

Return 20% 0 -20%

 Due to this, Investors require higher returns on levered equity

(Problem written in book )

Corporate taxes

• Tax shields can be valuable assets! • Assuming debt to be fixed & permanent, tax rate to be same,
and the firm is able to earn enough to cover interest payments, then, interest tax shield can be a
permanent source of CF stream.

𝑃𝑉 𝑡𝑎𝑥 𝑠ℎ𝑖𝑒𝑙𝑑 = 𝑅𝑠. 28 0.08 = Rs. 350

PV tax shield = (Corporate Tax rate × Interest Paymen)/ Expected Return on Debt

𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐏𝐚𝐲𝐦𝐞𝐧𝐭 = 𝐫𝐞𝐭𝐮𝐫𝐧 𝐨𝐧 𝐝𝐞𝐛𝐭 × 𝐀𝐦𝐨𝐮𝐧𝐭 𝐁𝐨𝐫𝐫𝐨𝐰𝐞𝐝 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐩𝐚𝐲𝐦𝐞𝐧𝐭 = 𝐫𝐃 × 𝐃

𝐏𝐕 𝐭𝐚𝐱 𝐬𝐡𝐢𝐞𝐥𝐝 = 𝐓𝐂 𝐫𝐃𝐃/ 𝐫𝐃 = 𝐓𝐜D

MM Propositions with Taxes

How does INT tax shields contribute to the value of EQSHs?  Pie’s third slice - government (see
fig next slide) MM’s Proposition I with Taxes:

𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐟𝐢𝐫𝐦 = 𝐕𝐚𝐥𝐮𝐞, 𝐢𝐟 𝐚𝐥𝐥- 𝐞𝐪𝐮𝐢𝐭𝐲- 𝐟𝐢𝐧𝐚𝐧𝐜𝐞𝐝 + 𝐏𝐕 𝐭𝐚𝐱 𝒔𝒉𝒊𝒆𝒍𝒅

𝑽𝑳 = 𝑽𝑼 + 𝐏𝐕 𝐭𝐚𝐱 𝒔𝒉𝒊𝒆𝒍𝒅

𝑽𝑳 = 𝑽𝑼 + 𝐓𝐜𝐃

In presence of corporate taxes, the value of the firm with debt is greater than that of the all-equity
firm by an amount equal to tax rate multiplied by value of debt.

MM Propositions with Taxes

𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝒇𝒊𝒓𝒎 = 𝒗𝒂𝒍𝒖𝒆 𝒊𝒇 𝒂𝒍𝒍 − 𝒆𝒒𝒖𝒊𝒕𝒚 − 𝒇𝒊𝒏𝒂𝒏𝒄𝒆𝒅 + 𝑷𝑽 𝒕𝒂𝒙 𝒔𝒉𝒊𝒆𝒍𝒅

𝒓𝑬 = 𝒓𝑨 + (𝒓𝑨 − 𝒓𝑫 )(𝟏 – 𝒕) (𝑫/ 𝑬)

Observations:  Cost of equity increases as company increases amount of debt , but cost of equity
does not rise as fast as it does in the no-tax case

(see calculations on next slide).  WACC for levered company falls, as debt increases and overall
company value increases. How?

Rise in Cost of Equity is faster under No Taxes when compared to Under Tax Proposition

The value of motors increase and wacc decrease with the amount of debt in the capital structure.
The calculation assume that the cost of debt remains constant regardless of the amount of leverage .

PERSONAL TAXES

 When personal taxes are introduced, the firm’s objective is no longer to minimize corporate tax
bill, the firm should try to minimize the PV of all taxes paid on corporate income.  “All taxes”
include personal taxes paid by bondholders and stockholders.  Figure on next slide illustrate how
corporate & personal taxes are affected by leverage.  Tp is personal tax rate on interest, TpE is
effective personal tax rate on equity income, and Tc is corporate tax rate

CORPORATE & PERSONAL TAXES

.As of 2019, companies pay dividend distribution tax (DDT) of 15% (effective rate = 20.35%) before
distributing the dividends.  Investors pays securities transaction tax (STT) of 0.1% on any purchase
or sale of shares.  The Short-term Capital Gains tax is 15%, and  Long-term Capital Gains tax is
10% if gain > Rs. 1.0 Lakhs.  So, effective personal tax rate is much lower than 20.35%.  Personal
Tax rate depends on the personal tax bracket of the tax payer & can be as high as 33.99% (incld.
10% surcharge & 3 education cess)  TpE can be lower than TP depending on the mix of dividends
& CGs realized by shareholders.  So, on average, returns on stocks are taxed at lower effective
rates (Ts ) than returns on debt (TD )

 So, a firm’s objective should be to arrange its CS to max. after-tax income.  From fig., corporate
borrowing is better if 1 − 𝑇𝑃 > 1 − 𝑇𝑝𝐸 1 − 𝐓𝐶 ; otherwise it is worse.  The relative tax advantage of
debt over equity is: Relative Tax Advantage of debt = (1 − TP ) 1 − TpE 1 − TC  This suggests two
special cases.
 Case (i): Suppose Debt & Equity income are taxed at the same effective personal rate. That is, TP =
TpE. Relative Advantage = (1 − TP ) 1 − TpE 1 − TC = 1 1 − TC  With TP = TpE, the relative advantage
depends only on the corporate rate.  Here, tax advantage of corporate borrowing is exactly as MM
calculated.  They do not have to assume away personal taxes,  Their theory of debt & taxes
requires only that debt & equity be taxed at the same rate

 Case (ii): When corporate & personal taxes cancel to make debt policy irrelevant. This requires: 1 −
TP = 1 − TpE 1 − TC Relative Advantage = (1 − TP ) 1 − TpE 1 − TC = 1  This can happen only if  TC <
TP and  TpE is small

 Consider the case of a typical Indian investor in the top tax bracket.  Tax on interest income 35%
 Tax on Dividend income 15%  Tax on Capital Gain 15% (ST), 10% (LT)  If the investor invests in
the stock of a company with 50% payout, the tax on each Re 1.00 of equity income is: TpE = 0.5 ×
15% + 0.5 × 10% = 12.5%  Now we calculate the effect of shunting a Rupee of income down on
each of the two branches on figure (slide #3) Interest Equity Income Income before Tax (Rs.) 1.00
1.00 Less: Corporate Tax at Tc = 0.35 0 0.35 Income after corporate tax 1.00 0.65 Personal Tax at Tp
= 0.35 & TpE = 0.1250 0.35 0.081 Income after all taxes (Rs.) 0.65 0.569 Advantage of tax = Rs. 0.081

 Thus, Miller pointed out, 1. The deductibility of interest favors the use of debt financing, but 2. The
more favorable tax treatment of income from stock lowers the required return on stock and thus
favors the equity financing.  Miller showed that the net impact of corporate and personal taxes is
given by the equation: 𝑉𝐿 = 𝑉𝑈 × 1 − 1 − 𝑇𝐶 (1 − 𝐓𝑆 ) 1 − 𝑇𝐷 × 𝐷

 Miller argued that marginal tax rates on stock and debt balance out in such a way that the
bracketed term in equation above is zero, so, 𝑉𝐿 = 𝑉𝑈.  But most observers believe that there is
still a tax advantage to debt. Example: 𝑇C = 40%, 𝑇D = 30%, 𝑎𝑛𝑑 𝑇S = 12% 𝑚𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒𝑠,
the advantage of debt financing is: 𝑉𝐿 = 𝑉𝑈 × 1 − 1 − 0.40 (1 − 0.12 ) 1 − 0.30 × 𝐷 𝑉𝐿 = 0.25𝐷  Thus,
it appears, as though the presence of personal taxes reduces but does not completely eliminate the
advantage of debt financing.

BENEFITS OF DEBT

 Cost of raising debt from capital markets (Underwriting spreads and out-of-pocket costs) are more
than three times as large for stock sales.  Debt is used by management to discipline the managers,
as managers have to focus on maximizing the cash flows so as to atleast cover interest and principal
payments.  Failing to do so, firms may face the prospect of bankruptcy, thereby also can destroy a
manager’s career.  Debt can be used to limit the ability of bad managers to waste the stockholders’
money on things such as fancy jet aircraft, plush offices, and other negative-NPV projects that
benefit the managers personally.

COSTS OF DEBT

Bankruptcy costs, also referred to as costs of financial distress, are costs associated with financial
difficulties that a firm might get into because it uses too much debt financing  Term bankruptcy
cost is used rather loosely in capital structure discussions to refer to costs incurred when a firm gets
into financial distress Firms can incur bankruptcy costs even if they never actually file for
bankruptcy Direct Bankruptcy Costs are out-of-pocket costs that a firm incurs as a result of financial
distress.  They include things such as fees paid to lawyers, accountants, and consultants.

Indirect Bankruptcy Costs are costs associated with changes in the behavior of people who deal
with a firm in financial distress. Some of this firm’s potential customers will decide to purchase a
competitor’s products because of:  Concerns that the firm will not be able to honor its warranties.
 Parts or service will not be available in the future

Some customers will demand a lower price to compensate them for these risks When suppliers
learn that a firm is in financial distress, they will worry about not being paid; to protect against losses
for future shipments, they often begin to require cash on delivery Employees at a distressed firm
will worry that their jobs or benefits are in danger, and some start looking for new jobs Example:
Jet Airways

TRADE-OFF THEORY

 The trade-off theory of capital structure says that managers choose a specific target capital
structure based on the trade-offs between the benefits and the costs of debt.  The theory says that
managers will increase debt to the point at which the costs and benefits of adding an additional
dollar of debt are exactly equal because this is the capital structure that maximizes firm value

PECKING ORDER THEORY Information Asymmetry  Unequal distribution of information  Managers

have more information about company’s performance and prospectus (incld. Future investment
opportunities) than investors  Companies have more information asymmetry in  Complex
products like high-tech companies  Companies with little transparency in financial accounting
information  Companies with lower levels of institutional ownership  Some degree of information
asymmetry always exist .

Developed by Myers and Majluf (1984) suggests  Manager choose methods of financing according
to a hierarchy that gives  First preference to methods with least potential information content 
internally generated funds, and  Lowest preference to form with greatest potential information
content  public equity offering  MAANGERS TEND ISSUE EQUITY WHEN IT OVERVALUED AND NOT
WHEN UNDERVALUED

Implications:  Firms prefer internal finance  Adapt target dividend payout ratios to their
investment opportunities, avoid sudden changes in dividends  Prefer sticky dividend policies due
unpredictable fluctuations in profitability and investment opportunities (internal financing is used
more)  If external finance required, issues safest security first  Debt first, and then  Equity

Implications:  Profitable firms generally borrow less …  Not ‘coz of low target D/E, but  ‘coz they
don’t want outside money  Less profitable firms issue debt,  ‘coz insufficient internal funds  Debt
financing is first on pecking order of external finance

TWO THEORIES OF CAPITAL STRUCTURE

More general evidence also indicates that the more profitable a firm is, the less debt it tends to
have, which is exactly opposite what the trade off theory suggests. ⤖ Both the trade-off theory and
the pecking order theory offer some insights into how managers choose the capital structures for
their firms but neither is able to explain all of the capital structure choices one observes. ⤖
Managers don’t think only in terms of a trade-off or a pecking order but are concerned with how
their financing decisions will influence the practical issues that they must deal with when managing a
business, for instance the credit rating of their exiting or new debt
 DIVIDEND POLICY

Introduction

A firm with free cash flow (FCF) or excess cash has following choices:

1)Grow its existing business faster 2) Acquire new business 3) Pay down its debt 4) Buy non-
operating assets such treasury bills or marketable securities 5) Pay (higher) dividends 6) Buy back
stock

A firm with free cash flow (FCF) or excess cash has following choices…  First two choices or
solutions are product market solutions  The last four are financial solutions.  The third choice is
determined by the capital structure choice the firm has made/makes  The firm’s working capital
policies determine the level of marketable securities (choice four).

 The remaining FCF choice is determined by dividend policies of the firm with only choice:

 How to much to distribute in form of dividends (cash) versus

 Stock repurchases (buyback of stocks)

→ However, this is a simplification since companies 1. sometimes scale back their operating plans
for sales and asset growth if such reductions are needed to maintain an existing dividend 2.
temporarily adjust their current financing mix in response to market conditions, & 3. often use
marketable securities as shock absorbers for fluctuations in short-term cash flows  Still, there is
interdependence among • shareholder distributions, • operating plans (which have the biggest
impact on tree cash flow), • financing plans (which have the biggest impact on the cost of capital), &
• WC policies (which determine the target level of marketable securities).

Level of Distributions and Firm Value

→ Central Issues in Dividend Policy of a firm is concerned with Can a firm increases its value through:
1) Its choice of distribution policy, defined as the level of distributions, 2) The form of distributions
(cash dividends vs. stock repurchases), & 3) The stability of distributions?

 The answer depends in part on investors’ preferences for returns as dividend yields versus capital
gains  The mix of yield return vs. gains return is determined by the  Target distribution ratio 
Target payout ratio

Level of Distributions and Firm Value

 Distribution Ratio

𝐷𝑖𝑠𝑡 𝑅𝑎𝑡𝑖𝑜 = 𝐶𝑎𝑠ℎ 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 + 𝑆𝑡𝑜𝑐𝑘 𝐵𝑢𝑦𝑏𝑎𝑐𝑘 /𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒

Payout Ratio

𝑃𝑂 𝑅𝑎𝑡𝑖𝑜 = 𝐶𝑎𝑠ℎ 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑/ 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒

 PO Ratio < DR Ratio

 High Dist. Ratio & a high PO Ratio mean that a firm pays large dividends & a small, zero, stock
repurchases.  Here Dividend Yield is relatively higher & expected CG is low.  If a firm has large
Dist. Ratio, but a small PO ratio, then it pays  Low dividends but regularly repurchases stock,
resulting in  Low dividend yield but a relatively high expected CG yield.  If a firm has low Dist.
Ratio, then it must also have  Low PO ratio, again resulting in a  Low dividend yield & hopefully a
relatively high CG.  Hence, a firm’s Optimal Distribution Policy must strike a balance between cash
dividends and capital gains so as to maximize the stock price.

Standard Method of Cash Dividend

25 Oct. 1 Nov. 2 Nov. 5 Nov. 7 Dec. Declaration Date Cumdividend Date Exdividend Date Record
Date Payment Date

Declaration Date: The Board of Directors declares a payment of dividends.

Record Date: The corporation prepares a list of all stockholders as of this date who will be eligible to
get the dividend

Cum-Dividend Date: The last day that the buyer of a stock is entitled to the dividend.

On or After the Ex-Dividend Date: The first day that the seller of a stock is entitled to the dividend
(2 business days before Record Date). Buyer does not receive the dividend .

Price Behavior

In a world without taxes, the stock price will fall by the amount of the dividend on the ex-dividend
date.

$P $P - div Exdividend Date The price drops by the amount of the cash dividend. -t … -2 -1 0 +1 +2 …
Taxes complicate things a bit. Empirically, the price drop is less than the dividend and occurs within
the first few minutes of the ex-date

Theories of Investor Preference for Dividend Yield vs. Capital Gains

 Dividend Irrelevance Theory  Bird-in-the-Hand Theory, &  Tax Preference Theory

Other Dividend Theories

 Clientele Effect  Information Content, or Signaling Hypothesis

Dividend Irrelevance Theory

 Principal proponents of the dividend irrelevance theory are Merton Miller and Franco Modigliani
(MM) (1961).  They argued that the firm’s value determined only by its basic earning power and its
business risk.  That is, they argued that the value of the firm depends only on the income produced
by its assets, not on how this income is split between dividends and retained earnings.  Dividend
policy has no effect on either the price of a firm’s stock or its cost of capital (especially its cost of
equity Ke )

 Any shareholder can in theory construct his or her own dividend policy.

 Example:  If a firm does not pay dividends, a shareholder who wants a 5% dividend can “create”
it by selling 5% of his or her stock.  Conversely, if a company pays a higher dividend than an
investor desires, the investor can use the unwanted dividends to buy additional shares of the
company’s stock.

 If investors could buy and sell shares and thus create their own dividend policy without incurring
costs, then the firm’s dividend policy would truly be irrelevant.

 Relaxing the efficient market assumptions of MM, however

  Investors who want additional dividends must incur brokerage costs to sell shares and pay taxes
on any capital gains.  Investors who do not want dividends incur brokerage costs to purchase
shares with their dividends.  Because taxes and brokerage costs certainly exist, dividend policy
may well be relevant.

Bird-in-the-Hand Theory

 MM’s argument that dividend Policy does not affect the required rate of return on equity, re ,

 was challenged by Myron Gordon (1963) and John Lintner (1962).

 Myron Gordon & John Lintner argued that re decreases as the dividend payout is increased
because

 investors are less certain of receiving the capital gains that are supposed to result from retaining
earnings than they are of receiving dividend payments.  They argued, in effect, that investors value
a dollar of expected dividends more highly than a dollar of expected capital gains because the
dividend yield component is less risky than the expected capital gain

 MM disagreed! They argued that  re is independent of dividend policy, which implies that
investors are indifferent between dividends and capital gains.  MM called the Gordon-Lintner
argument the bird-in-the-hand fallacy because, in MM’s view,  most investors plan to reinvest
their dividends in the stock of the same or similar firms, and,  the risk of the firm’s cash flows to
investors in the long run is determined by the risk of operating cash flows, not by dividend payout
policy

Tax Preference Theory: Capital Gains are Preferred

 What if dividends and capital gains are taxed equally?

 First, due to time value effects, a Rupee of taxes paid in the future (on CG) has a lower effective
cost than a dollar paid today.

 Second, if a stock is held by someone until he or she dies, no capital gains tax is due at all—the
beneficiaries who receive the stock can use the stock’ value on the death day as their cost basis and
thus completely escape the capital gains tax.

 Thus, stock appreciation i.e., CG is taxed more favorably than dividend income.  Because of
these tax advantages, investors may prefer to have companies minimize dividends.  If so, investors
would be willing to pay more for low-payout companies than for otherwise similar high-payout
companies.

Clientele Effect

 Different groups, or clienteles, of stockholders prefer different dividend payout policies.  Eg.
retired individuals, pension funds, & university endowment funds generally prefer cash income, so
they may want the firm to pay out a high percentage of its earnings.  Such investors are often in
low or even zero tax brackets, so taxes are of no concern.  On the other hand, stockholders in their
peak earning years might prefer reinvestment, because they have less need for current income &
would simply reinvest dividends, after first paying income taxes on those dividends.  Conflict
between the clienteles and the firm’s dividend policy  Can clienteles switch firms? Frequent
switching would be inefficient because of 1. brokerage costs, 2. the likelihood that stockholders who
are selling will have to pay capital gains taxes, and 3. a possible shortage of Investors who like the
firm’s newly adopted dividend policy.  Thus, management should be hesitant to change its
dividend policy, because a change might cause current shareholders to sell their stock, forcing the
stock price down.  Such a price decline might be temporary, but it might also be permanent—  if
few new investors are attracted by the new dividend policy, then the stock price would remain
depressed.  Of course, the new policy might attract an even larger clientele than the firm had
before, in which case the stock price would rise.

Information Content, Signaling, Hypothesis

 A firm paying a dividend or repurchasing shares, sends a signal to the market that the firm has
enough cash flow to pay shareholders  What if a firm wants to send a positive signal and pays
dividends or does a repurchase without actually having excess cash flows?  Firstly, the firm will
incur a cost, and it will need to find the cash elsewhere, usually through additional financing. 
Doesn’t this send a wrong signal, paying dividends with borrowed funds!  No. It sends a strong
signal about the firm’s faith in its earning power – both to repay the loan and pay dividends.  So, if
share repurchases and dividends are alternative methods of returning cash to stockholders, and
share repurchases are taxed as capital gains than dividend income does, why not have more
frequent repurchases?

 According to SECURITIES AND EXCHANGE BOARD OF INDIA (BUY BACK OF SECURITIES)

REGULATIONS, 1998 Act, there should be atleast 12 months gap between any two buybacks.  Are
share repurchases as reliable a signal as dividends?  Not really, since share repurchases are not as
regular as dividends.  Also, dividends are sticky (once paid, rarely reduced) while stock repurchases
are not (eg., management can announce a repurchase program and then delay it).  Signaling is the
primary theoretical explanation for dividend policy

Empirical Evidence

1.Dividends are sticky. 2. When dividends do change, they tend to follow a step function.  They will
be flat for a number of years, then go up, then stay flat for a number of years. Then go up, and so on.
3. Not only do firms tend to have sticky dividends, they also rarely cut dividends.  Dividend
reductions are rare, and if a firm does reduce its dividends, it sends a very strong negative signal to
the market—empirically, it is found that the firm’s stock price dramatically.  Thus, dividends are
generally stable, and firms are very reluctant to cut them.

 Studies have shown that if a firm  increases its dividends by 1%, its stock price rises about 3% on
average.  cuts its dividends by 1%, its stock price falls about 7% on average.  Thus, the market
penalizes a cut in dividends more than it rewards an increase.

 Why?  One way to explain this is that the market believes that firms only cut dividends when
they are in trouble.  Cutting dividends signals the market that the firm has insufficient cash flow to
maintain the dividend, and  as dividends are typically not that large a part of the cash flow, the
market views the reduction as a very negative signal.

 Alternative explanations proposed for why firms pay dividends is given by CATERING THEORY OF
DIVIDENDS postulates that  Firms pay dividends when market investors want them and don’t pay
dividends when the market does not want them.  Another empirical fact is that the percentage of
firms paying dividends has decreased over time.  According Fama and French (2001) studies, “the
percent of firms paying cash dividends falls from 66.5% in 1978 to 20.8% in 1999.”  Also, Firms that
paid dividends didn’t stop paying them!  Furthermore, the amt. paid out in dividends, in aggregate,
has gone up.  The firms that paid dividends are still paying dividends and are doing so in the higher
amounts.

 What Happened???

 Now it is relatively easier to list on exchanges.  Earlier, firms had to be fairly large and well
established to become listed on exchanges such as NYSE, BSE, etc.  Now, even smaller and younger
firms can get listed on these Xges.  These may eventually pay dividends, if they too become large!
 Another possible explanation is newly listed firms that don’t pay dividends come from different
industries from those in the past.  These firms are high-tech, growth companies, dot-coms, and so
on.  High-tech firms have high cash flow needs, and firms don’t pay dividends when they need the
cash for growth purposes.

Summarizing

 M&M (1961) is a solid theory but it does not hold under real-world conditions.  Empirically, we
find that a lot of firms pay dividends and that when dividends are initiated or increased, the firm’s
stock price increases.  Also, when firms cut their dividends, their stock prices decrease.  It is
widely believed that the best theory for dividends is signaling.  Unfortunately, signaling does not
explain why the percentage of firms paying dividends has fallen so sharply.

WORKING CAPITAL BUDGITING

 A CFO must make: How firms obtain and use capital.

 The primary functions of corporate finance can be categorized into three main tasks:

1) How to make good investment decisions

2) How to make good financing decisions

3) How to manage the firm’s cash flows while doing the first two.

4) Cash is essential to a firm’s survival, in fact, cash flow is much more important than
earnings!

 Every firm operates in two primary markets:

1) product market &

2) capital market.

 A firm’s role in

1) Product Market: to produce and sell goods or services at a price above cost.

2) Capital Market: to raise and invest funds to directly facilitate its activities in the
product market.

 Supply-side – securities exchanges for bonds, stocks, and options

 Demand-side – users of capital, firms themselves

 A crucial lesson when doing corporate finance is that financial strategy and product market
strategy need to be consistent with one another.
 Also, corporate finance its investment decisions and the capital market through its financing
decisions.

 When thinking about corporate finance, a firm must first determine its product market
goals.

 Only then, once the product market goals are set, can management set its financial strategy
and determine its financial policies.

 Financial policies include the:

1) Capital structure decision (i.e., the level of debt financing),

 term structure of debt,

 amount of secured and unsecured debt,

 whether the debt will have fixed or floating rates,

 covenants attached to the debt,

2) amount (if any) of dividends it will pay,

3) amount and timing of equity issues and stock repurchases, and so on.

 Financial policies include firm’s

1) Investment policies

2) (e.g., to build or acquire, to do a leveraged buyout, a restructuring, a tender; a

merger, etc.)

3) are set in concert with the firm’s product market strategy.

 While it is critical for a firm to have a good product market strategy, its financial operations
can also clearly add or destroy value.

 Value is created through the exploitation of a market imperfection in one of three markets:

1) Product market imperfections include entry barriers, costs advantages, patents, etc.

2) Capital market imperfections involve financing at below-market rates, using

innovative securities, reaching new investing clienteles, etc.

3) Managerial market imperfections include agency costs (costs from the separation of
ownership and control) and managers who are not doing a good job or self-dealing,
etc.

 Profitability Ratios
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 $83,000
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠 𝑀𝑎𝑟𝑔𝑖𝑛 = = = 3.8%
𝑆𝑎𝑙𝑒𝑠 $2,200,000
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 $83,000
𝑅𝑂𝐴 = = = 7.89%
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 $1,052,000
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 $83,000
𝑅𝑂𝐸 = ′
= = 23.45%
𝑂𝑤𝑛𝑒𝑟𝑠 𝐸𝑞𝑢𝑖𝑡𝑦 $354,000
 1) The most important rule in using ratio analysis is to make sure that you are
consistent across the firm and across the industry.

Sources and Uses of Funds

 If PIPES is profitable, why does it need to borrow money?

 PIPES needs to borrow money because it is not generating enough profits to finance its
growth. Is this a bad things?

 It is neither good nor bad. At some point, most successful firms grow faster than they are
able to finance through internally generated funds.

 That’s why capital markets exist - Debt and equity markets would not be required if all firms
could finance themselves out of retained earnings.

 PIPES needs to borrow funds because it is growing faster than it can internally sustain.

▪ Sources are: Assets  or Liabilities  or Net Worth 

 What are the uses of funds for a firm?

▪ Uses are: Assets  or Liabilities  or Net Worth 

Ratio Analysis

▪ How can the banker determine if the firm is well run?

▪ There are four main categories of ratios:

✓ Profitability ratios

✓ Activity ratios

✓ Liquidity ratios

✓ Debt ratios

✓ Activity Ratios (also known as operating ratios or turnover ratios)

𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑖𝑒𝑣𝑎𝑏𝑙𝑒
𝐷𝑎𝑦𝑠 𝑅𝑒𝑐𝑖𝑒𝑣𝑎𝑏𝑙𝑒 =
(𝑆𝑎𝑙𝑒𝑠⁄365)

𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
𝐷𝑎𝑦𝑠 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 =
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑⁄
( 365)
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒
𝐷𝑎𝑦𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒 =
(𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠⁄365)

 We often calculate all our ratios as a percentage of sales which are called common sized
ratios, and all components of the Income Statement and Balance Sheet are presented as a
percentage of sales. (Excel 3A & 3B)

 This allows for comparisons over time (both to itself as well as to other firms), eliminating
the impact of differences in size, and provides a starting point for pro forma forecasts.
 As can be seen in Excel 3A & 3B, the components of PIPES’s Income Statement and Balance
Sheet have been very consistent over time as a percentage of sales.

 All activity ratios can be translated into one another.

 Receivables as a percentage of sales (i.e., % receivables) is calculated (in 2012) as:

𝑨𝒄𝒄𝒐𝒖𝒏𝒕𝒔 𝑹𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆𝒔 $𝟐𝟏𝟏, 𝟎𝟎𝟎
= = 𝟗. 𝟓𝟗%
𝑺𝒂𝒍𝒆𝒔 $𝟐, 𝟐𝟎𝟎, 𝟎𝟎𝟎
 Receivables turnover is calculated as:
𝑺𝒂𝒍𝒆𝒔 $𝟐, 𝟐𝟎𝟎, 𝟎𝟎𝟎
= = 𝟏𝟎. 𝟒𝟑
𝑨𝒄𝒄𝒐𝒖𝒏𝒕𝒔 𝑹𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆𝒔 $𝟐𝟏𝟏, 𝟎𝟎𝟎
1 1
 These two are simply inverses of each other (9.59% = 10.43, 𝑎𝑛𝑑 10.43
= 9.59%)

 Days receivables can be calculated as:

𝑨𝒄𝒄𝒐𝒖𝒏𝒕𝒔 𝑹𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆𝒔 $𝟐𝟏𝟏, 𝟎𝟎𝟎
= = 𝟑𝟓. 𝟎𝟏
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑫𝒂𝒊𝒍𝒚 𝑺𝒂𝒍𝒆𝒔 $𝟐, 𝟐𝟎𝟎, 𝟎𝟎𝟎
( )
𝟑𝟔𝟓
 Days receivable is also 365 times the % receivables (365 * 0.0959 = 35.01) or 365 divided by
the receivable turnover (365/10.43 = 35.01).

 All three ratios are merely transformations of one another.

INVENTORY RATIO

 All Inventory ratios can be translated into one another.

 Inventory as a percentage of sales (i.e., % receivables) is calculated (in 2012) as:

𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 $𝟒𝟏𝟖, 𝟎𝟎𝟎
= = 𝟐𝟒. 𝟔𝟔%
𝑪𝑶𝑮𝑺 $𝟏, 𝟔𝟗𝟓, 𝟎𝟎𝟎
 Inventory turnover is calculated as:
𝑪𝑶𝑮𝑺 $𝟏, 𝟔𝟗𝟓, 𝟎𝟎𝟎
= = 𝟒. 𝟎𝟔
𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 $𝟒𝟏𝟖, 𝟎𝟎𝟎
 Days Inventory can be calculated as:
𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 $𝟒𝟏𝟖, 𝟎𝟎𝟎
= = 𝟗𝟎. 𝟎𝟏
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑫𝒂𝒊𝒍𝒚 𝑪𝑶𝑮𝑺 $𝟏, 𝟔𝟗𝟓, 𝟎𝟎𝟎
( )
𝟑𝟔𝟓
 Similar calculations can be done with accounts payable.

 Excel Sheet 4

 Cash Cycle

 At time t = 0 (say), when PIPES purchases some inventory?

 What happens to the inventory?

 Other than, perhaps, perishables in a supermarket, most firms do not sell their inventory the
day it is purchased & then is hopefully sold.

 How long does it take before PIPES sells its inventory on average? .

 However, selling the inventory is not the same as getting paid for the sale. In general PIPES
does not get paid at the time of sale, since it extends accounts receivable.

 How long does it take before PIPES gets paid?

 It took 125 days on average from the time PIPES purchased its inventory until it was sold and
paid for (90 days of inventory and 35 days of accounts receivable).

 If PIPES paid for its inventory on the day it purchased it, then the 125 days represents the
time period over which PIPES must finance its inventory & receivables.

 Table 1B shows that in 2012, inventory and accounts receivable totaled $629,000 at year-
end ($211,000 + $418,000).

 PIPES must finance this amount either from retained earnings or by borrowing.

 However, PIPES pay later for its inventory which is represented by accounts payable.

 What about PIPES’s accounts payable? How long does it take PIPES to pay off its accounts
payable?

 On average 46 days.

 Is this long? It depends.

 Cash Cycle

 PIPES’s suppliers would certainly like their funds sooner; however, PIPES would like to wait
to pay for the goods until it receives payment from its customers.

 In this sense, PIPES is using its accounts payable to help fund its receivables and inventory.

 If accounts payable > accounts receivable + inventory, then the firm is using the accounts
payable to fund other assets as well.

 In our case, PIPES uses accounts payable to finance 46 days of inventory and receivables.

 So accounts payable are also part of the cash cycle.

 Common discount is 2/10 net 30,

 which means if the firm pays in 10 days it can take 2% off of the price, otherwise the full
amount (net) is due by day 30.

 In 2012 PIPES’s purchases (as shown in Table 1) were $1,773,000.

 If PIPES was able to take a 2% discount on the purchases the savings would be $35,460.

 This means PIPES would have an extra $35,460 in PBIT.

 Is this a lot?

 YES! Since PIPES’s PAT was $83,000, an extra $35,460 is huge.

 However, that $35,460 is not free money.

 If PIPES reduces accounts payable from 46 to 10 days to take the discount, it will have to
finance the extra 36 days, which is a cost.

 Cost of payables vs. the cost of financing.

 If PIPES pays all its suppliers on day 11 instead of day 10, and loses the 2% discount by
paying one day late,

 this is the equivalent to an annual interest rate over 700% (annualize the daily rate of 2% by:
2% * 365 days).

 Of course, PIPES is not paying on day 11.

 Right now, the suppliers are allowing PIPES to take 46 days to pay (based on purchases) and
effectively are partially funding PIPES’s sales growth.

 This means the discount lost is 2% for 36 days (46 days — 10 days) or an annualized rate of
about 20% a year (2% x 365/36).

 Let’s say Payable Policy changes to 2/10 Net 30, instead of 2/10 Net 46.

 A 2% discount on purchases of $1,773,000 (2012) is $35,460.

 To obtain this discount, PIPES must pay on day 10 instead of day 30.

 To pay on day 10, PIPES will have to finance an extra 20 days of payables (the difference
between paying on day 30 and day 10).

 The amount of extra financing required is computed by multiplying the average daily
purchase by 20 days.

 The average daily purchase is $4,857 ($1,773,000/365).

▪ Let’s say Payable Policy changes to 2/10 Net 30, instead of 2/10 Net 46 …

▪ The purchase times 20 days = $97,151 ( = $4,857 x 20 days).

▪ Financing a $97,151 increase in payables at an assumed 7% interest rate will cost PIPES
$6,801 ($97,151 * .07).

▪ Clearly PIPES should pay on day 10, as it results in an increase of

▪ PBT of $28,659 ($35,460 - $6,801) or

▪ an increase in net profit of $18,628 ($28,659 * 65%).

 So why didn’t PIPES do this?

▪ PIPES simply did not have the funds to pay receivables on day 10 with a $350,000 bank line
of credit.

RISK analysis in capital budgeting

Expected net present value (enpv)

 Expected NPV = Sum of PV of Expected Net Cash Flows

 𝑛
𝐸𝑁𝐶𝐹𝑡
𝐸𝑁𝑃𝑉 = ∑
(1 + 𝑘)𝑡
𝑡=0

 where 𝐸𝑁𝐶𝐹𝑡 is the expected net cash flows (including both inflows & outflows)

 𝐾 is the discount rate

 𝐸𝑁𝐶𝐹𝑡 = 𝑁𝐶𝐹𝑗𝑡 × 𝑃𝑗𝑡

 where 𝑁𝐶𝐹𝑗𝑡 is the net cash flow for 𝑗 𝑡ℎ event in period 𝑡, and

 𝑃𝑗𝑡 is probability of net cash flow for the 𝑗 𝑡ℎ event in the period 𝑡.
𝐸𝑁𝐶𝐹1 𝐸𝑁𝐶𝐹2 𝐸𝑁𝐶𝐹3
𝑃𝑉(𝐸𝑁𝐶𝐹) = 1
+ 2
+
(1 + 𝑘) (1 + 𝑘) (1 + 𝑘)3
3,000 2,400 2,100
𝑃𝑉(𝐸𝑁𝐶𝐹) = 1
+ 2
+
(1.10) (1.10) (1.10)3
 𝑃𝑉(𝐸𝑁𝐶𝐹) = 𝑅𝑠. 3,000 × 0.909 + 𝑅𝑠. 2,400 × 0.826 + 𝑅𝑠. 2,100 × 0.751
 𝑃𝑉(𝐸𝑁𝐶𝐹) = 𝑅𝑠. 6,286.50
 𝑵𝑷𝑽 = 𝑅𝑠. 6,286.50 − 𝑅𝑠. 6,000 = 𝑹𝒔. 𝟐𝟖𝟗. 𝟓𝟎
Variance or standard deviation: absolute measure of risk

 A better insight into risk analysis will be obtained through dispersion.

 DISPERSION of cash flow indicates the degree of risk.

 Standard deviation and Variance - common measure of risk.

 For Net Cash Flows:

𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝑜𝑓 𝑁𝑃𝑉
= (𝑁𝐶𝐹1 − 𝐸𝑁𝐶𝐹)2 𝑃𝑟𝑜𝑏1 + (𝑁𝐶𝐹2 − 𝐸𝑁𝐶𝐹)2 𝑃𝑟𝑜𝑏2 + …
+ (𝑁𝐶𝐹𝑛 − 𝐸𝑁𝐶𝐹)2 𝑃𝑟𝑜𝑏𝑛
𝑛

𝜎 (𝑁𝑃𝑉) = ∑(𝑁𝐶𝐹𝑡 − 𝐸𝑁𝐶𝐹)2 𝑃𝑟𝑜𝑏𝑡

2

𝑡=0

 Project Y is riskier as its SD is higher

 Dilemma - Project Y has not only a larger ENPV, but also a larger Std Dev. As compared to
Project X.

 How to resolve this dilemma?

 Instead of analyzing risk in absolute term, it can be measured in relative terms.

Coefficient of variation (CV) : relative measure of risk

𝑺𝒕𝒂𝒏𝒅𝒂𝒓𝒅 𝑫𝒆𝒗𝒊𝒂𝒕𝒊𝒐𝒏
𝑪𝑽 =
𝑬𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝑽𝒂𝒍𝒖𝒆
 CV is useful when comparing the projects which have:
1) Same Std. Dev. but different expected values, or

2) different Std. Dev. but same expected values, or

3) different Std. Dev. and different expected values.

 Project X:
1095.45
𝐶𝑉 = = 0.1826
6000
 Project X:
2097.62
𝐶𝑉 = = 0.2622
8000
 Which to select?

 Depends on attitude towards risk of the decision-maker:

 Risk taker vs. Risk averse

Conventional Techniques for Risk Analysis

 Payback

 Risk-Adjusted Discount Rate

 Certainty Equivalent

RISK Adjusted Discount Rate

 Risk Adjusted Discount Rate = Risk-free rate + Risk Premium

 Risk-Adjusted Discount Rate is different from CAPM rate

 Risk-adjusted discount rate accounts for risk by varying the discount rate depending on the
degree of risk of investment projects.

 Higher rate will be used for riskier projects and a Lower rate for less risky projects.

 NPV will decrease with increasing k, indicating that the riskier a project perceived, the less
likely it will be accepted.

 Certainty Equivalent

 Formally,
𝛼𝑡 𝑁𝐶𝐹𝑡
 𝑁𝑃𝑉 = ∑𝑛𝑡=0 𝑡
(1+𝑘𝑓 )

 where

 𝑁𝐶𝐹𝑡 = the forecasts of net cash flow without risk adjustment

 𝛼𝑡 = the risk-adjustment factor or the certainty equivalent coefficient

 𝑘𝑓 = risk-free rate assumed to be constant for all periods

  Certainty-equivalent coefficient can be determined as relationship between the certain cash
flows and the risky cash flows.
𝑁𝐶𝐹𝑡∗ 𝐶𝑒𝑟𝑡𝑎𝑖𝑛 𝑁𝐶𝐹
 𝛼𝑡 = 𝑁𝐶𝐹𝑡
= 𝑅𝑖𝑠𝑘𝑦 𝑁𝐶𝐹

 Eg. One expected a risky cash flow of Rs 80,000 in a period and considers a certain cash flow
of Rs 60,000 equally desirable, then
60.000
 𝛼𝑡 = 80,000 = 0.75

 RADR vs. CE RADR vs. CE

 RADR approach will yield the same result as the CE approach if

 the risk-free rate is constant and

 the risk-adjusted discount rate is the same for all future periods.

 Mathematically,
𝛼𝑡 𝑁𝐶𝐹𝑡 𝑁𝐶𝐹𝑡
 𝑡 = (1+𝑘)𝑡
(1+ 𝑘𝑓 )

 To solve for 𝛼𝑡 :
𝑡
 𝛼𝑡 𝑁𝐶𝐹𝑡 (1 + 𝑘)𝑡 = 𝑁𝐶𝐹𝑡 (1 + 𝑘𝑓 )

 Solving for 𝛼𝑡 :
𝑡 𝑡
𝑁𝐶𝐹𝑡 (1+ 𝑘𝑓 ) (1+ 𝑘𝑓 )
 𝛼𝑡 = =
𝑁𝐶𝐹𝑡 (1+𝑘)𝑡 (1+𝑘)𝑡

 For period t+1:

𝑡+1
(1+ 𝑘𝑓 )
 𝛼𝑡+1 = (1+𝑘)𝑡+1

 If 𝑘𝑓 and 𝑘 are constant for all future periods, then 𝑘 must be larger than 𝑘𝑓 to satisfy the
condition that 𝛼𝑡 varies between 0 and 1.

 As a result, 𝛼𝑡+1 would be less than 𝛼𝑡 .

 Illustration: Let 𝑘 =10%, 𝑘𝑓 = 5%, and t = 1.

𝑡
(1+ 𝑘𝑓 ) (1.05)1
 𝛼1 = (1+𝑘)𝑡
= (1.10)1
= 0.955

 When 𝑡 = 2:
(1.05)2
 𝛼2 = (1.10)2
= 0.911

INVESTMENT IN FIXED ASSETS

 § Investments in fixed assets include items such as property, plant, and equipment.

§ Their book value is recorded in the balance sheet as net fixed assets, which is their purchase
price less accumulated depreciation.

§ Asian Paints’ FA (previous slide)

§ Decisions about the acquisition and disposal of long-term assets are part of the firm’s
strategic activities.

WORKING CAPITAL REQUIREMENT OR

OPERATING WORKING CAPITAL

§ FA alone cannot generate sales and profits!

§ The managerial activities required to operate these assets in order to generate sales and
profits are referred to as the firm’s Operating Activities.

§ These activities require investments in the form of inventories and trade receivables as
shown in the firm’s operating cycle, (next slide) for a manufacturing company.

§ An alternative way to describe the operating cycle is shown in Exhibit 4.

WCR=OPERATING ASSETS – OPERATING LIBRARIES

=(ACCOUNT RECEIVABLE + INVENTORIES+ PREPAID EXPENSE)-(ACCOUNT PAYABLE

+ACCURED EXPENSE)

§ WCR does not include the firm’s cash balance. WHY?

§ Two reasons

1) Firm holds cash not only to support its operating activities but also to meet future expenses.

2) Operating cash is a separate investment held for precautionary reasons to meet payment
obligations resulting from unexpected short-term changes in the components of WCR.

§ It may contribute to the financing of firm’s operating cycle, but is not a component of it.

§ For most firms, OA > OL, and WCR is positive,

§ meaning that the firm has to finance it.

§ When the opposite occurs, (OA<OL), WCR is negative, and the operating cycle becomes a
source of cash rather than a use of funds.

§ Firms with a negative WCR are found in the retail and service sectors of the
economy.

§ Such firms collect cash from their customers before they pay their suppliers.

§ Example: Large Supermarkets

§ Few receivables, low inventories, & large amounts of payables is the perfect recipe for
turning the firm’s OC into a source of cash
§ How can we explain this Growth?

§ A firm has a choice of alternative sources of capital, which can be classified either as

§ Equity and Debt (distinguishes the nature of the firm’s capital)

§ Short-term financing and Long-term financing (distinguishes its duration)

§ Firm’s managers must answer Two Questions when deciding which strategy should be
adopted to fund the firm’s investment.

1) What is the best combination of equity capital and debt capital?

2) What proportion of borrowed funds should be in the form of LT debt and what proportion in
the form of short-term debt?

§ The answer to the first question affects the firm’s profitability and financial risk.

§ The answer to the second question affects primarily the firm’s liquidity.

THE MATCHING STRATEGY

§ In deciding how much of the firm’s investment should be financed with LT funds & with ST
debt, most firms try to apply the Matching Strategy.

§ LT investments should be financed with LT funds, and

§ ST investments should be financed with ST funds.

§ By matching the life of an asset & the duration of its financing source, a firm can minimize
the risk of not being able to finance the asset over its entire useful life.

§ Consider the case of a piece of machinery with 5 year life financed with revolving 1-year
loan.

§ Firm faces two risks: financial cost risk, and refinancing risk.

§ These two risks are much lower in Matching Strategy.

§ Is Matching Strategy an optimal financing strategy for every firm at all times?

§ Some firms, at times, may be willing to carry some financial cost and refinancing risk, if they
expect ST Interest rates to go down.

§ Some firms, which are more risk averse, may choose to carry more LT funds than necessary
under the matching strategy!

Let’s explore whether OS Distributors has been applying matching strategy

THE MATCHING STRATEGY - OS DISTR.…

§ WCR is ST or LT investment?

§ The assets and liabilities which are classified as current, or short-term, they will be replaced
by new current assets and new current liabilities as the operating cycle repeats itself.

§ So, as long as the firm stays in business, WCR will remain in its (managerial) balance sheet
and, hence, is more permanent than transient in nature.
 § In other words, WCR is essentially a long term investment.

§ Under a matching strategy, WCR should be financed with long-term funds.

§ OS Distributors’ WCR financing?

§ FY 1997

§ LT funds: 155 – 53 (NFA) = 62

§ ST Funds: 23 – 8 (Cash) = 15

§ Total LT + ST Funds = 77 = WCR

§ Matching strategy is not followed. WHY?

§ Some firms can adhere to the matching strategy w/o entirely financing the WCR with LT
funds!

3 FINANCING STRATEGY

§ Three financing strategies for a firm with seasonal and growing sales.

§ Financing Investments Using a Matched Strategy

§ Financing Investments Using a Conservative Strategy

§ Financing Investments Using an Aggressive Strategy

IMPROVING LIQUIDITY

LIQUIDITY RATIO = LT FINANCING– NFA/WCR =NLF/WCR

§ What drives a firm’s liquidity?...

§ The lower the firm’s investment in its operating cycle, the lower its WCR and the higher
the firm’s liquidity.

§ Furthermore, the lower the frequency of unexpected changes in the firm’s WCR, the less
volatile the firm’s liquidity position and the easier it is to manage.

§ Clearly, control of the amount and fluctuations of a firm’s WCR is the key to the sound
management of the firm’s liquidity,

§ Controlling WCR requires identifying and understanding the factors that affect its size.

§ Five items make up a firm’s WCR: receivables, inventories, prepaid expenses, payables,
and accrued expenses.

§ The size of these five items depends on the following three basic factors:

i. The nature of the economic sector in which the firm operates,

ii. The degree of efficiency with which the firm manages its operating cycle, and

iii. The level and growth of sales