FINANCIAL MGT- NOTES PREPARED BY HILAL AHMED AND XOOM COMMERCE

SUBJECT – MANAGEMENT
SUBJECT CODE – 17 UNIT
- IV

9906837425

[2]
Chapters Contents Pages

1 Financial Management 3-13

2 Valuation Concepts and Valuation of Securities 1-8

3 Capital Budgeting 1-12

4 Capital Structure and Cost of Capital 1-12

5 Dividend Policy 1-12

6 Long Term and Short Term Financing Instruments 1-8

7 Mergers and Acquisition 1-5

[3]
 CHAPTER 1

FINANCIAL MANAGEMENT – NATURE AND SCOPE

Concept and Definition

The term Financial management has been defined differently by different authors.
According to Solomon “Financial Management is concerned with the efficient use of an
important economic resource, namely capital funds”.
Phillippatus has given a more elaborate elaborate definition of the term Financial
Management. According to him “Financial Management is concerned with the managerial
decisions that result in the acquisition and financing of short term and long term credits for
the firm”
By S.C. Kuchhal is that “Financial
“Financial management deals with procurement of funds and
their effective utilisation in the business”.

Procurement of Funds:
Since funds can be obtained from different sources therefore their procurement is
always considered as a complex problem by business concerns. concerns. Funds procured from
different sources have different characteristics in terms of risk, cost and control.
The funds raised by the issue of equity shares are the best from the risk point of view
for the company, since there is no question of repayment
repayment of equity capital except when the
company is under liquidation. From the cost point of view, however, equity capital is usually
the most expensive source of funds. This is because the dividend expectations of
shareholders are normally higher than prevalent
prevalent interest rate and also because dividends are
an appropriation of profit, not allowed as an expense under the Income Tax Act. Also the
issue of new shares to public may dilute the control of the existing shareholders.
There are thus risk, cost and control
control considerations which a finance manager must
consider while procuring funds. The cost of funds should be at the minimum level for that a
proper balancing of risk and control factors must be carried out.
Funds can be raised indigenously as well as from abroad.
abroad. Foreign Direct investment
(FDI) and Foreign Institutional Investors (FII) are two major routes for raising funds from
foreign sources besides ADR’s (American depository receipts) and GDR’s (Global depository
receipts).
Procurement of funds inter alia includes:
 Identification of sources of finance
finance
 Determination of finance mix
mix
  Raising of funds
 Division of profits between dividends and retention of profits i.e. internal fund
generation.

Effective Utilisation of Funds

The finance manager is also responsible
responsible for effective utilisation of funds. He has to
point out situations where the funds are being kept idle or where proper use of funds is not
being made. All the funds are procured at a certain cost and after entailing a certain amount
of risk. If these
hese funds are not utilised in the manner so that they generate an income higher
than the cost of procuring them, there is no point in running the business. This is also an
important consideration in dividend decision. Hence, it is crucial to employ the fu funds
properly and profitably.

[4]
Scope of Financial Management
The approach to the scope and functions of financial management is divided, for
purpose of exposition, into two broad categories:
(a) The Traditional Approach
(b) The Modern Approach

(a) The Traditional Approach:

The scope of the finance function was treated by the traditional approach in the narrow
sense of procurement of funds by corporate enterprise to meet their financing needs.
The term ‘procurement’ was used in a broad sense so as to include the whole gamut of
raising funds externally. Thus, defined the field of study dealing with finance was treated
as encompassing three interrelated aspects of raising and administering resources from
outside:
i. The institutional arrangement in the form of financial institutions which comprise the
organisation of the capital market
ii. The financial instruments through which funds are raised from the capital markets and
the related aspects of practices and the procedural aspects of capital markets; and
iii. The legal and accounting relationships between a firm and its sources of funds.

Criticism of Traditional Approach:

(1) The traditional treatment of finance was criticised because the finance function was
equated with the issues involved in raising and administering funds, the theme was
woven around the viewpoint of the suppliers of funds such as investors, investment
bankers and so on, that is, the outsiders. It implies that no consideration was given to the
viewpoint of those who had to take internal financial decisions. The traditional treatment
was, in other words, the outsider-looking-in-approach. The limitation was that internal
decision making (i.e insider-looking-out) was completely ignored.
(2) The second ground of criticism of the traditional treatment was that the focus was on
financing problems of corporate enterprises. To that extent the scope of financial
management was confined only to a segment of the industrial enterprises, as non-
corporate organisations lay outside its scope.
(3) Another basis on which the traditional approach was challenged was that the treatment
was built too closely around episodic events, such as promotion, incorporation, merger,
consolidation, reorganization and so on. Financial management was confined to a
description of these infrequent happenings in the life of an enterprise. As a logical
corollary, the day-to-day financial problems of a normal company did not receive much
attention.
(4) Lastly, the traditional treatment was found to have a lacuna to the extent that the focus
was on long-term financing. Its natural implication was that the issues involved in
working capital management were not in the purview of the finance function.

b. Modern Approach:
The modern Approach views the term financial management in a broad sense and
provides a conceptual and analytical framework for financial decision making. According
to it, the finance function covers both acquisition of funds as well as their allocations.
Thus, apart from the issues involved in acquiring external funds, the main concern of
financial management is the efficient and wise allocation of funds to various uses. Thus,
financial management, in the modern sense of the term, can be broken down into three
major decisions as functions of finance:
i. The investment decision
ii. The financing decision
iii. The dividend policy decision

[5]
1. Investment Decision:
The investment decision relates to the selection of assets in which funds will be invested
by a firm. The assets which can be acquired fall into two broad groups:
(i) Long-term assets which yield a return over a period of time in future
(ii) Short-term or current assets, defined as those assets which in the normal course of
business are convertible into cash without dimunition in value, usually within a year.
The first of these involving the first category of assets is popularly known in
financial literature as capital budgeting. The aspect of financial decision making
with reference to current assets or short-term assets is popularly termed as
working capital management.
a. Capital Budgeting:
It is probably the most crucial financial decision for a firm. It relates to the selection of an
asset or investment proposal or course of action whose benefits are likely to be available
in future over the lifetime of the project. The long-term assets can be either new or old /
existing ones. The first aspect of the capital budgeting decision relates to the choice of
the new asset out of the alternatives available or the reallocation of capital when an
existing asset fails to justify the funds committed. Whether an asset will be accepted or
not will depend upon the relative benefits and returns associated with it. The
measurement of the worth of the investment proposals is, therefore, a major element in
the capital budgeting exercise. This implies a discussion of the methods of appraising
investment proposals.
b. Working Capital Management
It is concerned with the management of current assets. It is an important and integral
part of financial management as short-term survival is a prerequisite for long-term
success. One aspect of working capital management is the trade-off between profitability
and risk (liquidity). There is a conflict between profitability and liquidity. If a firm does not
have adequate working capital, that is, it does not invest sufficient funds in current
assets, it may become illiquid and consequently may not are too large, profitability is
adversely affected. Thus, the management of working capital has two basic ingredients:

1. An overview of working capital management as a whole

2. Efficient management of the individual current assets such as cash, receivables
and inventory.
2. Financing Decision:
The second major decision involved in financial management is the financing decision.
The investment decision is broadly concerned with the asset-mix or the composition of
the assets of a firm. The concern of the financing decision is with the financing-mix or
capital structure or leverage. The term capital structure refers to the proportion of debt
(fixed-interest sources of financing) and equity capital (variable-dividend securities /
source of funds). The financing decision of a firm relates to the choice of the proportion
of these sources to finance the investment requirements.
3. Dividend Policy Decision:
The third major decision of financial management is the decision relating to the dividend
policy. The dividend should be analysed in relation to the financing decision of a firm.
Two alternatives are available in dealing with the profits of a firm: they can be distributed
to the shareholders in the form of dividends or they can be retained in the business itself.
The decision as to which course should be followed depends largely on a significant
element in the dividend decision, the dividend payout ratio, that is, what proportion of
net profits should be paid out to the shareholders. The final decision will depend upon
the preference of the shareholders and investment opportunities available within the
firm. The second major aspect of the dividend decision is the factors determining
dividend policy of a firm in practice.
…………………

[6]
 CHAPTER 2
VALUATION CONCEPTS AND VALUATION OF SECURITIES

Concepts:

Valuation is the process of determining the worth of an assets either physical asset
 
(tangible asset) or financial asset (financial claim).
 
Valuation of securities refers to the process of estimating the value of the financial

assets.
Assets may be valued differently with different perspectives.
a) Book Value (BV): The book value of an asset is an accounting concept based on
the historical data given in the balance sheet of the firm.

b) Market value (MV): The market value of an assets is defined as the price for
which the assets can be sold.MV of a financial asset refers to the price prevailing
at the stock exchange.

c) Going Concern Value (GV): GV refers to the value of the business as an

operating, performing and running business unit. This is the value which a
prospective buyer of a business may be ready to pay.

d) Liquidating value (LV): The LV refers to the net realizable value and is equal to
the difference between the value of all assets and the sum total of external
liabilities. This net difference belongs to the owners/ shareholders and is known
as the LV.

e) Capitalized Value (CV): The CV of financial assets is defined as the sum of the
present value of cash flows from an asset. In order to find out CV, the future
expected benefits are discounted for the time value of money.

1. Required Rate of Return:

→ The application of the concept of CV requires in the first instance, the determination of
the discount rate or the required rate of return of the investors for a specific security
being valued. The required rate of return may be defined as the minimum rate of return
necessary to induce an investor to hold or to buy the security

 The minimum rate of return is consisting of two parts i.e. risk free rate (which is equal for
all the securities) and the risk premium (which depends upon the risk associated with a
security. This can be stated as:

k = If + rp
where,

[7]
 k= required rate of return
If = risk free rate
rp = risk premium

2. Bond Valuation :
In order to understand the valuation of bond, understanding of following terms is required
(a) Par Value: The par value / face value/ nominal value is the principal amount of a
bond and is stated on the face of the bond security. The issue price and the
redemption price may be less than, equal to or more than the issue price.
(b) Coupon Rate: This is the rate at which interest on the par value of the bond is
payable as per the payment schedule.

(c) Maturity: The maturity of the bond refers to the period from the date of issue, after
the expiry of which the redemption repayment will be made to the investor by the
borrower firm.

3. Assumption : An assumption which may be required while valuing a bond is that the first
interest payment shall become due for payment after one year from the date of
purchase/ issue of the bond.
4. Valuation Model: The value of a bond may be defined as the sum of the present value of
the future interest payment plus the present value of the redemption repayment.
Bo = Ii (PVAF)r,n + RV (PVIF)r,n
Bo = Value of bond at present

Ii = Annual interest payment starting one year from now till the
end RV=Redemption value

PVAF= Present Value Annuity

Factor PVIF= Present Value Interest
Factor r= required rate of return
n= maturity period
5. Yield To Maturity (YTM)
The rate of return kd’ which makes the discounted value of cash flows (regular
interest payments) equal to the bond’s market value is known as YTM of the bond
 A bond YTM may be defined as internal rate of return (IRR) for a given level
of risk.

 While finding out YTM , an implied assumption is that all interest received
are reinvested at a rate of return equal to bond’s YTM

YTM = I + RV- B0 /n

[8]
 (RV+Bo )/2

YTM= Yield To Maturity

I = Interest payment
RV= Redemption Value B0
= Bond Value at present
6. Valuation of Convertible Debenture
→ The convertible debenture is a debenture whose face value is fully or partially converted
into equity shares. Conversion may be compulsory or at the option of the debenture
holders.

a) Valuation of compulsorily convertible debentures (CCD):In case of CCD,

debenture holders get interest at a specified rate for a specified period after
which a part or full value of the CCD is converted into specific number of equity
shares. Value of CCD can be found out by the following equation
n
Bo (CCD) = = ∑ Di Ii / (1+ kd )i + mPt / (1+ ke) + RV / (1+kd )n
i=1
where,
Bo (CCD)= Value of CCD
ke = Required rate of return on equity component
m= Number of shares received on conversion Pt =
Share price at the conversion time
RV= Redemption value
n= life of the debentures
kd = Rate of discount
7. Valuation of Optionally Convertible Debentures (OCD)
a) In case of OCD, the debenture holders may or may not opt for conversion. So two
options are available with debenture holders
b) To continue as debenture holder: In this case the value could be ascertained by the
following formula
Bo OCD= [Straight debenture value or value as CCD(whichever is higher)+ Value of
the
option]
c) To opt for conversion: In this case, OCD becomes CCD and the above mentioned
equation will be applicable

[9]
8. Valuation of Deep Discount Bonds (DDB)

The valuation of deep discount bonds can be made on the same lines as the ordinary
bonds are valued. Since DDB generate only one cash flow at the time of maturity, the
value of DDB may be taken as equal to the present value of this future cash flow
discounted at the required rate of return of the investor for number of years of life of DDB
Bo DDB = FV / (1+r)n
Bo DDB = Value of the DDB
FV= Face value of DDB payable at maturity
r= required rate of return
n= life of DDB
9. Valuation of Preference Shares
Two assumptions are relevant while ascertaining the value of preference shares as
follows

a) The dividends on preference are received once a year and that the first
dividend is received at the end of one year from the date of acquisition/
purchase
b) The company always intends to pay the preference dividend so that the
stream of preference dividend is considered to be known with certainty.
10. Redeemable Preference shares
The value of redeemable preference shares may be defined as the present value of the
future cash flows expected from the company.
n
PO = ∑ Di / (1+ Kp )i + RV/(1+
Kp)n i= 1

where
PO = value of preference shares
Di = Annual fixed dividend
RV= Redemption value of preference shares
n= life of the preference shares
Kp = Required rate of return of preference shareholders

…………………..

[10]
 CHAPTER 3
CAPITAL BUDGETING

WHAT IS CAPITAL BUDGETING?


The investment decisions of a firm are generally known as the capital budgeting or
capital expenditure decisions. A capital budgeting decision may be defined as the firms
decision to invest its current funds most efficiently in the long term assets in anticipation
 of an expected flow of benefits over a series of years.
A. Capital budgeting may also be defined as “The decision making process by which a
firm evaluates the purchase of major fixed assets.”

B. Opportunity Cost of capital: The investments should be evaluated on the basis of a

criterion, which is compatible with the objective of the shareholders wealth
maximization. An investment will add to the shareholders wealth if it yields benefits in
excess of the minimum benefits as per the opportunity cost of capital.

 In other words, the system of capital budgeting is employed to evaluate expenditure

decisions which involve current outlays, but likely to produce benefits over a period of
time longer than one year. The basic features of capital budgeting are:
1. Potentially large anticipated benefits;
2. A relatively high degree of risk and
3. A relatively long time period between initial outlay and anticipated returns.

I. Importance:
Capital budgeting is of paramount importance in financial decision making. Special
care should be taken in making these decisions on account of the following reasons:

1. Such decisions affect the profitability of the firm. They also have bearing on the
competitive position of the enterprise. This is mainly because of the fact that they
relate to fixed assets. The fixed assets represent in a sense, the true earning assets
of the firm.
2. Capital budgeting is of utmost importance to avoid over-investment and under-
investment in fixed assets.

3. A capital expenditure decision has its effect over a long time span and inevitably
affects the company's future cost structure. In short, a firm's future costs, break-even
point, sales and profits will all be determined by the firm's selection of assets i.e.,
capital budgeting.

[11]
 4. Capital investment decision once made is not easily reversible without much financial
loss to the firm. It is because there may be no market for second hand plant and
equipment and their conversion to other uses may not be financially feasible.

5. Capital investment involves cost and the majority of the firms have scarce capital
resource. This underlines the need for thoughtful, wise and correct investment
decisions as an incorrect decision would not only result in losses but also prevent the
firm from earning profits from other investments which could not be undertaken for
want of funds.

II. Capital Budget Decision:

1) Accept / Reject decision: This is the fundamental decision in capital budgeting. If the
project is accepted, the firm invests in it. If the proposal is rejected the firm does not
invest. In general all those proposals which yield a rate of return greater than a
certain required rate of return or cost of capital are accepted and the rest are
rejected.

2) Mutually exclusive project decision: Mutually exclusive projects are projects which
compete with other projects in such a way that the acceptance of one will exclude the
acceptance of other projects. The alternatives are mutually exclusive and only one
may be chosen.

3) Capital rationing decision: In a situation where the firm has unlimited funds, capital
budgeting becomes a very simple process. In that, independent investment proposals
yielding a return greater than some predetermined level are accepted. However, this
is not the situation prevailing in most of the business firm's of real world. They have
fixed capital budget. A large number of investment proposals compete in these
limited funds. The firm allocates funds to projects in a manner that it maximizes long
run returns. Thus capital rationing refers to the situation where the firm has more
acceptable investments requiring a greater amount of finance than is available with
the firm.

III. Kinds of Capital Budgeting Proposals:

1. Replacement / modification of fixed assets: e.g. worn out, obsolete are replaced at
appropriate time.
2. Expansion: involves an addition of capacity to existing production facilities.
3. Modernization of investment expenditure: They make it easier for a firm to reduce
cost and may coincide with replacement decision.

[12]
4. Strategic investment proposal: These are capital budgeting decisions which do not
assume that the return will be immediate or measured over a long period of time.
5. Diversification of business: Means operating in several markets or firm one market
into another market. It may even amount to changing product lines.

6. Research and development: Where the technology is rapidly changing, research and
development area is a continuous activity in any firm. Usually large sums of money
are invested in research and development activities which lead to capital budgeting
decisions.
7. Related expansion / diversification: A company may add capacity to its existing
product lines to expand existing operations.

8. Unrelated diversification: A firm may expand its activities in a new business.

Expansion of a new business requires investment in new products and a new kind of
production activity within the firm.

9. Revenue expansion investments: Sometimes a company acquires existing firms to

expand its business. In either case, the firm makes investment in the expectation of
additional revenue.

10. Replacement and Modernization: The main objective of modernization and

replacement is to improve operating efficiency and reduce costs. Cost savings will
reflect in the increased profits, but the firms revenue may remain unchanged. Assets
become outdated and obsolete with technological changes. The firm must decide to
replace those assets with new assets that operate more economically

i. Mutually Exclusive Investments: Mutually exclusive investments serve the same

purpose and compete with each other. If one investment is undertaken, others
will have to be excluded.

ii. Independent Investments: Independent investments serve different purposes and

do not compete with each other. Depending on their profitability and availability of
funds, the company can undertake both investments.

iii. Contingent Investments: Contingent investments are dependent projects the

choice of one investment necessitates undertaking one or more other
investments.

…………………..

[13]
 CHAPTER – 4

CAPITAL STRUCTURE AND COST OF CAPITAL

Capital Structure
Capital structure is the proportion of debt and preference and equity shares on a firm's balance sheet.
Optimum capital structure is the capital structure at which the weighted average cost of capital is
minimum and thereby maximum value of the firm.

Capital Structure Theories

Before going into the capital structure theories, we should first understand the need of these theories.
We all know that the objective of financial management is maximisation of shareholders wealth in the form of
the value of the firm. Value of the firm is derived by capitalizing the earnings at the rate of cost of capital.
Value of the firm =
We can say that value of the firm depends upon two factors, first is earnings and second is cost of
capital.
Earning is the subject matter of investment decision because investment decision decides level of
earnings.
Cost of capital or WACC, depends upon the proportion of individual sources in capital structure and
their individual cost of capital.
As we change the proportion of different sources in capital structure, WACC also changes.
Now we can say that with every change in capital structure, WACC also changes and due to change in
WACC, value of the firm also changes. Now the key issue here is, "Is there any relationship between value of
the firm and its capital structure."?
This understanding of the relationship between value of the firm and its capital structure is explained
through these capital structure theories.
There are two extreme and dramatically opposite viewpoints of capital structure theories.
On one hand there is a view of "relevance" which says that capital structure does affect the value of a
firm.
The other extreme is "Irrelevance" which says that capital structure does not affect the value of a firm.
Capital structure theories include the following assumptions:
 There is no corporate tax.
 There are only two long term sources of finance viz. equity and debt.
 All the earnings are distributed among shareholders.
 Capital Markets are perfect.
 There is no change in the total assets of the firm.

Net Income Theory (Approach) (Relevance)

This theory works on the assumption that Kd (cost of debt) is less than Ke (cost of equity). Now if a
firm starts increasing low cost debt financing then return to the shareholders will result increase in value of
equity. Due to introduction of more low cost debt, WACC will also decrease and decrease WACC means
increase in the value of the firm.
Now if, we reverse the situation, the WACC will increase resulting a decrease in the value of the
firm. WACC / Cost o capital =
According to NI Approach value of the firm and value of equity are determined as follows:
Value of the firm, V = E + B
where E = Value of equity, B = Value of debt.
where Market value of Equity = E =
where, Net Income = Earnings available to share holders.
Ke = Cost of equity.

Illustration
A company's expected EBIT is Rs. 50,000. The company has Rs. 2,00,000, 10% debentures. The
equity capitalisation rate is 12.5%, with no taxes, calculate the value of the firm and WACC.

[14]
 Value of the firm (NI Approach) Amt.

Net Operating Income (EBIT) 50,000

Less: Interest on Debentures (I) 20,000

Earning available to shareholders (NI) 30,000

Cost of equity (Ke) 0.125

Market value of Equity (E) 2,40,000

Market value of Debt (B) 2,00,000

Value of the Firm (V) 4,40,000

WACC / Cost of capital EBIT / V 11.36%

Increase in Value
Now if the firm increase its debt by Rs. 1,00,000 the value of the firm and WACC will be:
Net Operating Income EBIT Rs. 50,000
Less : Interest (1) 30,000
Earnings Available to 20,000
Equity shareholders (NI)
Cost of Equity (Ke) 0.125
Market value of Equity (E) 1,60,000
Market value of Debt (B) 3,00,000
Value of the firm (V) 4,60,000
WACC / Cost of capital
EBIT / V 10.9%

Traditional Approach
It is also a relevance theory. According to this
approach, a firm can achieve an optimal capital
structure level by choosing the rational mix of equity
and debt.
AAs per this approach, as the proportion of
debt in the capital structure is increased value of the
firm also increases and there will be a point where
WACC will be minimised and value of a firm will
maximum. This is the point of optimal capital structure.

Net Operating Income Approach (NOI)

This approach proclaims that there is no relationship between capital structure and the value of the
firm. According to this approach the value of the firm depends upon the net operating profit (EBIT) of the firm.
This means that WACC and value of the firm are independent.
This approach works on the assumption that cost of debt and overall cost of capital (WACC) are
constant. As the debt financing increases or the financial leverage increases cost of equity also increases. In case
of all equity firm K0 = Ke or Ke = K0 and when debt is introduced cost of equity increases but over all of cost of
debt remains constant or unchanged because increase in cost of equity is offset by benefit of low cost debt
financing.
In this approach the value of the firm is
EBIT = Net Operating Income
Ko = Overall cost of capital
Also:
E = V – B, E = Market Value of Equity
V = Value of the firm
B = Market value of debt

[15]
Also:
or

where I = Interest on debt.

Assume the previous example of NI approach operating Income of Rs. 50,000, Cost of debt 10%, and
outstanding debt Rs. 2,00,000. If the overall capitalisation rate is 12.5%. What would be the total value of the
firm and the equity capitalisation rate?

Value of the Firm (NOI Approach) Amt.

Net Operating Income (EBIT) 50,000
Overall Capitalisation (Ko) 0.125
Value of the firm (V) 4,00,000
Less: Total Market Value of Debt (B) 2,00,000
Total Market Value of Equity (E) 2,00,000

Equity capitalisation Rate Ke =

=
The WACC to verify the validity of the NOI Approach.
Ko = Ki (B/V) + Ke (E/V)
= = 0.125 or 12.5%
In order to study the effect of leverage let us assume that the firm increases the amount of debt from
Rs. 2,00,000 to Rs. 3,00,000.

Value of the Firm (NOI Approach) Amt.

Net Operating Income (EBIT) Rs. 50,000
Overall Capitalisation Rate (Ke) 0.125
Value of the firm (V) 4,00,000
Less: Total Market Value of Debt (B) 3,00,000
Total Market Value of Equity (E) 1,00,000
Equity capitalisation Rate Ke =

=
WACC to verify the validity of NOI.
Ko = 0.10 (3,00,000/4,00,000) + 0.2 (1,00,000/4,00,000)
= 0.075 + 0.05 = 0.125 or 12.5%
Let us further suppose the firm retires debt by Rs. 1,00,000 by issuing fresh equity share capital of the
same amount.

Net Operating Income (EBIT) Rs. 50,000

Overall Capitalisation Rate (Ke) 0.125
Value of the firm (V) 4,00,000
Less: Total Market Value of Debt (B) 1,00,000
Market Value of Equity (V-B) = (E) 3,00,000

Equity capitalisation Rate Ke =

[16]
 =
WACC to verify the validity of NOI.
Ko = 0.10 (1,00,000/4,00,000) + 0.1333 (3,00,000/4,00,000)
= 0.025 + 0.010 = 0.125 or 12.5%

Modigliani – Miller (MM) Approach

MM Approach recognise the irrelevance of the capital structure and thus is similar to NOI approach.
While NOI approach fails to give any operational justification for irrelevance of the capital structure on the
value of the firm, the MM approach provides behavioural justification for this. It has used arbitrage method to
justify the crux of its arguments.

Basic Proportion of MM Approach

(i) The overall cost of capital (Ko) and the value of the company (V) are independent of the capital
structure.
(ii) The cost of equity (Ke) is equal to the capitalisation rate for a pure equity plus premium for financial
risk, which increase with the increase in the proportion of debt in the capital structure of the company.
(iii) The cutoff rate for investment purpose is completely independent of the way in which an investment is
financed.

Arbitrage Process / Method

Arbitrage means simultaneously buying and selling the same commodity in two different markets with
a view to earn profit.
Let us illustrate this. Suppose commodity X is available in market A for Rs. 100 and the same
commodity is available for Rs. 150 in market B.
Now this difference in price of the commodity would give rise to arbitrage process. One would tend to
buy it from market A at Rs. 100 and sell it in market B for Rs. 150 and thus would earn a profit of Rs. 50.
Gradually, the number of persons adopting this practice would go on increasing. In the ultimate result one may
find that the supply of commodity in market B will increase accompanied by increased demand for the
commodity in Market A. The result will be: decline in price in market Band rise in price in market A. This
process of buying and selling simultaneously would continue till the price in both the markets become equal or
the same. This is the crux of arbitrage process.

Ex – Two companies X Ltd. (levered) and Y Ltd. (Unlevered) are identical in all respect expect the equal
structure. Their details are under:
X Ltd. Y Ltd.

EBIT Rs. 4,00,000 Rs. 4,00,000

Debt 10,00,000 -

Rate of interest on Debt 14% -

Equity Capitalisation Rate 20% 17.5%

Find out the value of both the companies:

Solution
Since both the companies are identical in all respects, they should have the same value, and if in any
case and at any time there is any difference in their values, the same as per MM approach would be eliminated
through arbitrage process.

Let us calculate the value of two companies

X Ltd. Y Ltd.

EBIT Rs. 4,00,000 Rs. 4,00,000

[17]
 Less : Interest 1,40,000 -

Earning to Equity holders 2,60,000 4,00,000

Equity capitalisation Rate (Ke) 20% 17.5%

Market value of Equity (E) 13,00,000 22,85,714

Market value of Debt (B) 10,00,000 -

Total Market value of (V) 23,00,000 22,85,714

Company (B + E) = V

Thus, we notice that there is difference in the values of two companies. According to MM theory this
difference should not be there. If it occurs, arbitrage process will set in and will make the values of two
companies equal. The process of arbitrage is described as under:
Let us assume that Me X is holding 10% shares of X Ltd. and therefore his dividend income will be Rs.
26000 (ie: 10% of Rs/ 2,60,000). Since both the companies have equal EBIT but the market value of Y Ltd. is
lower than the market value of X Ltd., Mr. X would tend to switch over their investment from X Ltd. to Y Ltd.
Mr. X would sell his holdings in X Ltd. for Rs. 1,30,000 (10% of 13,00,000). Just to acquire 10% shares in Y
Ltd., he will be in need Rs. 2,28,571.40. But he would have only Rs. 1,30,000. In order to meet the short fall he
will have to borrow the funds. Although he will require only Rs. 98,571.40 (2,28,571.40 – 1,30,000), yet he will
borrow Rs. 1,00,000 @ 14% just to maintain the same financial risk which he was exposed to as investor in X
Ltd.
As an investor in X Ltd. Mr. X was sharing the interest burden of Rs. 14000 (10% of total interest of Rs.
1,40,000). This activity is referred to 'substitution of corporate leverage to personal leverage. Now Mr. X will be
having total funds amounting to Rs. 1,30,000 + 1,00,000 = Rs. 2,30,000, whereas he needs only Rs. 2,28,571.4 thus
leaving a surplus of Rs. 1,428.60. After the acquisition of shares in Y Ltd. Mr. X's dividend
income (net) will be:
Dividend Rs. 40,000
Less: Interest on Loan 14% of Rs. 1,40,000 Rs. 14,000
Rs
. 26,000
Thus, Mr. X would earn Rs. 26000 by investing only Rs. 2,28,571.4. On the remaining (surplus) funds
of Rs. 1,428.60, he will have additional income of Rs. 250 =

Other shareholders of X Ltd. would also follow the same suit / practice, ie; purchasing the shares of Y
Ltd. and selling the shares of X Ltd. This will being an increase in demand for shares of Y Ltd. and also increase
in the supply of shares of X Ltd. Consequently, the price of shares of Y Ltd. will rise and that of shares of X
Ltd. will decline. A stage will come when the market value of both the companies would be equal leading no
opportunities for further arbitrage.

…………………….

[18]
 CHAPTER 5
DIVIDEND POLICY

Concept and Significance

→ The dividend decision is one of the three basic decisions which a financial manager may
be required to take, the other two be investment decisions and the financing decisions. In
each period any earning that remains after satisfying obligations of the creditors, the

government and the preference shareholders can either be retained or paid out as
dividends or bifurcated between retained earnings and dividends.
In dividend decision, a financial manager is concerned to decide one or more of the
following:
 Should the profits be ploughed back to finance the investment decisions?

 Whether any dividend be paid? If yes how much dividends be paid?

 When these dividends be paid? Interim or final?

 In what form the dividend be paid? Cash dividend or bonus shares?

A. Relevance of Dividend Policy:

 Dividends paid by the firms are viewed positively both by the investors and the firms.
The firms which do not pay dividends are rated in oppositely by investors thus
affecting the share price. The people who support relevance of dividends clearly state
that regular dividends reduce uncertainty of the shareholders i.e. the earnings of the
firm is discounted at a lower rate, ke thereby increasing the market value. However,
it’s exactly opposite in the case of increased uncertainty due to non-payment of
dividends.

 Two important models supporting dividend relevance are given by Walter and
Gordon.
B. Walter's Model:
James E. Walter's model shows the relevance of dividend policy and its bearing on the value
of the share
1. Assumptions of the Walter Model
i. Retained earnings are the only source of financing investments in the firm, there
is no external finance involved.

ii. The cost of capital, k e and the rate of return on investment, r are constant i.e.
even if new investments decisions are taken, the risks of the business remains
same.

[19]
 iii. The firm's life is endless i.e. there is no closing down.
Basically, the firm's decision to give or not give out dividends depends on whether it
has enough opportunities to invest the retain earnings i.e. a strong relationship
relationship between
investment and dividend decisions is considered.

2. Model Description:

→ Dividends paid to the shareholders are re-invested

re invested by the shareholder further, to get
higher returns. This is referred to as the opportunity cost of the firm or the cost of capital,
ke for the firm. Another situation where the firms do not pay out dividends, is when they
invest the profits or retained earnings in profitable opportunities to earn returns on such
investments. This rate of return r, for the firm must at least be equal to ke. If this happens
then the returns of the firm is equal to the earnings of the shareholders if the dividends
were paid. Thus, its clear that if r, is more than the cost of capital ke, then the returns
from investments is more than retur
returns
ns shareholders receive from further investments.

→ Walter's Model says that if r<ke then the firm should distribute the profits in the form of
dividends to give the shareholders higher returns. However, if r>ke then the investment
opportunities reap better returns for the firm and thus, the firm should invest the retained
earnings. The relationship between r and k are extremely important to determine the
dividend policy. It decides whether the firm should have zero payout or 100% payout.
In a nutshell :
 If r>ke, the firm should have zero payout and make investments.

 If r<ke, the firm should have 100% payouts and no investment of retained earnings.

 If r=ke, the firm is indifferent between dividends and investments.

Walter has given a mathematical model for the above made statements:

where,
 P = Market price of the share

 D = Dividend per share

 r = Rate of return on the firm's investments

 ke = Cost of equity

 E = Earnings per share'

[20]
The market price of the share comprises of the sum total of:
 the present value if an infinite stream of dividends

 the present value of an infinite stream of returns on investments made from retained
earnings.
Therefore, the market value of a share is the result of expected dividends and capital gains
according to Walter.

3. Criticism:

→ Although the model provides a simple framework to explain the relationship between
the market value of the share and the dividend policy, it has some unrealistic
assumptions.
1. The assumption of no external financing apart from retained earnings, for the firm
make further investments is not really followed in the real world.
2. The constant r and ke are seldom found in real life, because as and when a firm
invests more the business risks change.

C. Gordon's Model:
 Myron J. Gordon has also supported dividend relevance and believes in regular
dividends affecting the share price of the firm


1. Assumptions of the Gordon Model:

 Gordon's assumptions are similar to the ones given by Walter. However, there are
two additional assumptions proposed by him:

i. The product of retention ratio b and the rate of return r give us the growth
rate of the firm g.
ii. The cost of capital ke, is not only constant but greater than the growth rate
i.e. ke>g.

…………………

[21]
 CHAPTER 6
LONG TERM AND SHORT TERM FINANCING INSTRUMENTS

I. Long Term Sources (Domestic):

a) Ordinary Shares/ Equity Shares: Equity share capital presents the basic source of
finance to any company. The holders of these shares are the real owners of the
company. These are the real risk bearing shares of the company. Equity shareholders
control the business. They have voting right to elect directors of the company and
the directors control the business. Earlier all equity shares had equal voting rights.
But the recent amendment in the companies Act 2000, permits companies to issue
equity shares with differential voting rights.

Features:
1) Different values: Equity shares contains face value which is also called normal
value. Depending upon the instrinsic value of the shares, the market fluctuates.
Market value is the value at which the shares are traded in the stock exchange.
2) Permanent source of Capital:It’s a permanent source of funds as it does not
need to be reimbursed during the life of the company.
3) No Security required: No security is required to be offered to shareholders in
return of their investment in company’s shares.
4) Residual claim on income: Equity shareholders are paid dividend only after
claim of all the parties has been settled and paid.
5) No Fixed Rate of Return
6) No Obligation to Pay Dividend.
7) Residual Claim to Assets.
8) Right to control: Equity share holders have voting rights and they elect board of
directors who controls the affairs of the company. Thus the equity shareholders
are collectively responsible for efficient management of the company.
9) Pre emptive Rights: Any share holders owning 2% of the existing issued capital
is entitled to a preemptive rights to acquire 2% of additional shares issued by the
company. He can exercise or sell or renounce this right.
10) Limited Liability: In the case of companies where the liability is limited by shares
the liability of the share holders is limited only upto the unpaid value of shares.

[22]
 He is not personally responsible for the liability of the company as in the case of
sole trading concern and partnership firm.

b) Preference Shares: Preference shares allow an investor to own a stake at the issuing
company with a condition that whenever the company decides to pay dividends, the
holders of the preference shares will be the first to be paid.
→ Dividend payment of the preference shareholders is fixed and if somehow company
liquefies, the owners of the preference shares will be the first one to get their money
back after the company has paid back its debt.
i. Types of Preference Shares:
a. Cumulative Preference Shares: When unpaid dividends on preference shares
are treated as arrears and are carried forward to subsequent years, then such
preference shares are known as cumulative preference shares. It means unpaid
dividend on such shares is accumulated till it is paid off in full.
b. Non-cumulative Preference Shares: Non-cumulative preference shares are
those type of preference shares, which have right to get fixed rate of dividend out
of the profits of current year only. They do not carry the right to receive arrears of
dividend. If a company fails to pay dividend in a particular year then that need
not to be paid out of future profits.
c. Redeemable Preference Shares: Those preference shares, which can be
redeemed or repaid after the expiry of a fixed period or after giving the
prescribed notice as desired by the company, are known as redeemable
preference shares. Terms of redemption are announced at the time of issue of
such shares.
d. Non-Redeemable Preference Shares: Those preference shares, which cannot be
redeemed during the life time of the company, are known as non-redeemable
preference shares. The amount of such shares is paid at the time of liquidation of
the company.
e. Participating Preference Shares: Those preference shares, which have right to
participate in any surplus profit of the company after paying the equity
shareholders, in addition to the fixed rate of their dividend, are called
participating preference shares.
f. Non-participating Preference Shares: Preference shares, which have no right to
participate on the surplus profit or in any surplus on liquidation of the company,
are called non-participating preference shares.
g. Convertible Preference Shares: Those preference shares, which can be
converted into equity shares at the option of the holders after a fixed period
according to the terms and conditions of their issue, are known as convertible
preference shares.
h. Non Convertible Preference Shares: Preference shares, which are not
convertible into equity shares, are called non-convertible preference shares.
a. Debentures and Loans:
 In corporate finance, a debenture is a medium- to long-term debt instrument used by
 large companies to borrow money, at a fixed rate of interest.
 The legal term "debenture" originally referred to a document that either creates a
debt or acknowledges it, but in some countries the term is now used interchangeably
with bond, loan stock or note. A debenture is thus like a certificate of loan or a loan
bond evidencing the fact that the company is liable to pay a specified amount with
interest and although the money raised by the debentures becomes a part of the
company's capital structure, it does not become share capital.

[23]
  Debenture holders have no rights to vote in the company's general meetings of
shareholders, but they may have separate meetings or votes e.g. on changes to the
 rights attached to the debentures.
 The interest paid to them is a charge against profit in the company's financial
statements

Types of Debentures:
a. Registered Debentures: These are those debentures which are registered in the
register of the company. the names, addresses and particulars of holdings of
debenture holders are entered in a register kept by the company. Such debentures
are treated as non-negotiable instruments and interest on such debentures are
payable only to registered holders of debentures. Registered debentures are also
called as Debentures payable to Registered holders.
b. Bearer Debentures: These are those debentures which are not registered in the
register of the company. Bearer debentures are like a bearer check. They are payable
to the bearer and are deemed to be negotiable instruments. They are transferable by
mere delivery. No formality of executing a transfer deed is necessary. When bearer
documents are transferred, stamp duty need not be paid. A person transferring a
bearer debenture need not give any notice to the company to this effect. The
transferee who acquires such a debenture in due course bonafide and for available
consideration gets good title not withstanding any defect in the title of the transfer-
or. Interest coupons are attached to each debenture and are payable to bearer.
c. Secured Debentures: These are those debentures which are secured against the
assets of the company which means if the company is closing down its business, the
assets will be sold and the debenture holders will be paid their money. The charge or
the mortgage may be fixed or floating and they may be fixed mortgage debentures
or floating mortgage depending upon the nature of charge under the category of
secured debentures. In case of fixed charge, the charge is created on a particular
asset such as plant, machinery etc. These assets can be utilized for payment in case of
default. In case of floating charge, the charge is created on the general assets of the
company.
The assets which are available with the company at present as well as the assets in
future are charged for the purpose. A mortgage deed is executed by the company.
The deed includes the term of repayment, rate of interest, nature and value of
security, dates of payment of interest, right of debenture holders in case of default in
payment by the company. The deed may give a right to the debenture holder to
nominate a director as one of the Board of Directors. If the company fails to pay the
principal amount and the interest thereon, they have the right to recover the same
from the assets mortgaged.
d. Unsecured Debentures: These are those debentures which are not secured against
the assets of the company which means when the company is closing down its
business, the assets will not be sold to pay off the debenture holders. These
debentures do not create any charge on the assets of the company. There is no
security for repayment of principal amount and payment of interest. The only security
available to such debenture holders is the general solvency of the company.
Therefore the position of these debenture holders at the times of winding up of the
company will be like that of unsecured debentures. That is they are considered with
the ordinary creditors of the company.

…………………

[24]
 CHAPTER 7

MERGERS AND ACQUISITION

→ The term Merger, Amalgamation, Takeover and Acquisition are often used interchangeably
to refer to a situation where two or more firms come together and combine into one to avail
the benefits of such combinations.
i. Mergers and acquisitions (abbreviated M&A) are both aspects of strategic management,
corporate finance and management dealing with the buying, selling, dividing and
combining of different companies and similar entities that can help an enterprise grow
rapidly in its sector or location of origin, or a new field or new location, without creating
a subsidiary, other child entity or using a joint venture.
ii. Mergers and acquisitions activity can be defined as a type of restructuring in that they
result in some entity reorganization with the aim to provide growth or positive value.
iii. The distinction between a "merger" and an "acquisition" has become increasingly blurred
in various respects (particularly in terms of the ultimate economic outcome), although it
has not completely disappeared in all situations.
iv. From a legal point of view, a merger is a legal consolidation of two companies into one
entity, whereas an acquisition occurs when one company takes over another and
completely establishes itself as the new owner (in which case the target company still
exists as an independent legal entity controlled by the acquirer).

A. Acquisition:
→ An acquisition or takeover is the purchase of one business or company by another company
or other business entity. Such purchase may be of 100%, or nearly 100%, of the assets or
ownership equity of the acquired entity.
i. Consolidation occurs when two companies combine together to form a new enterprise
altogether, and neither of the previous companies remains independently.
ii. Acquisitions are divided into "private" and "public" acquisitions, depending on whether the
acquire or merging company (also termed a target) is or is not listed on a public stock
market.
iii. "Acquisition" usually refers to a purchase of a smaller firm by a larger one. Sometimes,
however, a smaller firm will acquire management control of a larger and/or longer-
established company and retain the name of the latter for the post-acquisition combined
entity. This is known as a reverse takeover.
iv. Another type of acquisition is the reverse merger, a form of transaction that enables a
private company to be publicly listed in a relatively short time frame. A reverse merger
occurs when a privately held company (often one that has strong prospects and is eager to
raise financing) buys a publicly listed shell company, usually one with no business and
limited assets

1) Types of Amalgamation:
Accounting standard, AS-14, issued by the Institute of Chartered Accountants of India has
defined the term amalgamation by classifying (i) Amalgamation in the nature of purchase (ii)
Amalgamation in the nature of purchase
2) Amalgamation in the Nature of Merger: As per S- 14, an amalgamation is called in the
nature of merger if it satisfies the following conditions:
a) All the assets and liabilities of the transferor company should become, after
amalgamation, the assets and liabilities of other company.

[25]
b) Shareholders holding not less than 90% of the face value of the equity shares of the
transferor company (other than the equity shares already held therein, immediately
before the amalgamation, by the transferee company or the subsidiaries or their
nominees) become equity shareholders of the transferee company by the virtue of
amalgamation.
c) The business of the transferor company is intended to be carried on, after the
amalgamation by the transferee company.
d) No adjustment is intended to be made in the book values of the assets and liabilities of
the transferor company when they are incorporated in the financial statements of the
transferee company except to ensure uniformity of accounting policies
e) The consideration for the amalgamation receivable by those equity shareholders of the
transferor company who agree to become equity shareholders of the transferee company
is discharged by the transferee company wholly by the issue of equity shares in the
transferee company, except that cash may be paid in respect of any fractional shares.
An amalgamation that does not fulfill any of the above conditions is known as
amalgamation in the nature of purchase.

………………….

[26]