Corporate Finance Compendium

FINANCE COMPENDIUM
CORPORATE FINANCE
STAY INVESTED!
TEAM NIVESHAK
Table of Contents
1 What is Corporate Finance? ............................................................................ 2
2 Capital Budgeting ............................................................................................. 4
2.1 Introduction ............................................................................................................ 4
2.2 Principles of Capital Budgeting .............................................................................. 4
2.3 Decision Criteria..................................................................................................... 5
2.3.1 Net Present Value (NPV) .................................................................................................. 5
2.3.2 Internal Rate of Return (IRR) ............................................................................................ 5
2.3.3 Payback Period ................................................................................................................. 6
2.3.4 Discounted Payback Method ............................................................................................ 6
2.3.5 Profitability Index (PI) ........................................................................................................ 6
3 Cost of Capital .................................................................................................. 7
3.1 Introduction ............................................................................................................ 7
3.2 Optimal Capital Structure ....................................................................................... 7
3.3 Cost of Debt ........................................................................................................... 7
3.4 Cost of Preferred stock .......................................................................................... 8
3.5 Cost of Equity......................................................................................................... 8
3.5.1 Capital Asset Pricing Model .............................................................................................. 8
3.5.2 Dividend Discount Model .................................................................................................. 8
4 Measures of leverage ....................................................................................... 9
4.1 Introduction ............................................................................................................ 9
4.2 Degree of operating leverage ............................................................................... 10
4.3 Degree of financial leverage................................................................................. 10
4.4 Total Leverage ..................................................................................................... 10
4.5 Breakeven quantity of sales ................................................................................. 11
4.5.1 Breakeven Point .............................................................................................................. 11
4.5.2 Operating breakeven point .............................................................................................. 11
5 Dividends......................................................................................................... 11
........................................................................................................................................ 12
5.1 Models of Dividend Policy .................................................................................... 12
5.1.1 Walter’s Model: ............................................................................................................... 12
5.1.2 Modigliani and Miller’s Model (MM Model): .................................................................... 13
5.2 Signaling Hypothesis............................................................................................ 13
5.3 Clientele Effect ..................................................................................................... 14
5.4 Bad Reasons for Paying Dividends ...................................................................... 14
6 Working capital Management ........................................................................ 14
6.1 Overview .............................................................................................................. 14
6.2 Types of Working Capital Management Ratios..................................................... 15
6.2.1 Current Ratio ................................................................................................................... 15
6.2.2 Collection Ratio ............................................................................................................... 15
6.2.3 Inventory Turnover Ratio ................................................................................................ 16
6.3 Cash Conversion Cycle (CCC) ............................................................................. 16
6.3.1 Days of Inventory Outstanding (DIO) .............................................................................. 16
CORPORATE FINANCE
6.3.2 Days Sales Outstanding (DSO) ...................................................................................... 17
6.3.3 Days Payables Outstanding (DPO) ................................................................................ 17
7 Stock Repurchases......................................................................................... 17
7.1 Introduction .......................................................................................................... 17
7.2 Reasons for Repurchase ..................................................................................... 17
7.3 Advantages of Repurchase .................................................................................. 17
7.4 Disadvantages of Repurchase ............................................................................. 18
7.5 Stock Dividend vs. Stock Split .............................................................................. 18
8 Pecking Order Theory .................................................................................... 18
NIVESHAK – FINANCE & INVESTMENT CLUB 1

CORPORATE FINANCE
1 What is Corporate Finance?
The broadest definition of Corporate Finance perhaps comes from Prof. Aswath Damodaran, who defines
it to include any action taken by a business that involves money. Since every business decision has
financial implications, this definition would include essentially everything. It seems self-serving for a finance
professor to claim this, but this broad view of the world has some merits.
From this lens, we can apply the principles of corporate finance to every business decision. Should the
business choose investment A or investment B? How much debt should the business raise, and of which
duration? What should the business do with excess cash? All these decisions are at the core of corporate
finance: we will learn a simple framework to go about these decisions.
What do we aim to achieve as the managers of an organization? The aim of corporate finance is to
maximize shareholder wealth. This objective has increasingly come under fire for being too narrow-
minded, and there is a debate about the maximization of stakeholder value (which includes employees,
customers, governments, lenders, and society at large) versus shareholder value. While it sounds good to
consider everyone and work for their benefit, interests often conflict: what might be good for employees
may not always be good for lenders or shareholders, what might be good for society may not always be
good for lenders or shareholders, and so on. We do encourage you to explore this idea further, but for
now, we will stick to our stated objective: maximizing shareholder wealth. We will realize later from the
Modigliani-Miller propositions that maximizing shareholder wealth is same as maximizing the value of the
business; these are interchangeable goals.
We can summarize the entirety of corporate finance in one diagram, adapted from Prof. Damodaran:
Objective: Maximize value of the business
Investment Decision Dividend Decision:

Financing Decision: If you cannot find
(Capital Budgeting):
Find the right kind of debt for investments that meet your
Invest in assets that earn a
your firm and the right mix of minimum acceptable rate,
return greater than the
debt and equity to fund your return the cash to the owners
minimum acceptable hurdle
operations of your business
rate
How you
The hurdle rate The return How much
choose to
should reflect should reflect The optimal cash can you
The right kind return cash to
the riskiness of the magnitude mix of debt and return depends
of debt matches the owners will
the investment and the timing of equity is one upon current &
the tenor of your depend on
and the mix of the cash flows that maximizes potential
assets whether they
debt and equity as well as all the firm value investment
prefer dividends
used to fund it side effects opportunities
or buybacks

CORPORATE FINANCE
In the financing decision, you consider the right way to finance the company (which proportion through
shares, bonds, loans, and so on). Each financing instrument has some characteristics in cost, terms,
duration that must be coherent with the cash flows that will generate the investments. In the investment
decision, you look at the risk and profitability profile of the projects you want to tackle.
Corporate finance involves analyzing investment projects. An investment project is any business unit or
specific endeavor (new product, process improvement, new plant) that requires an investment and the can
generate returns and requires capital. The idea is to set up an optimal portfolio of investment projects in
your firm considering your objectives- that is supported by an appropriate capital structure. In the end,
most of corporate finance relates to balancing the cash flow profile of your sources of capital and your
projects. If they are imbalanced, you are going to run into problems.
The idea is simple: the firm raises money (from shareholders and creditors), invests in projects to get
returns, pays back the money to its providers (dividends, interests, debt service) and pockets the difference
(company value).
In corporate finance you use certain tools:
Financial accounting, to prepare reports about the impact in the past of the financial decisions on the
company stakeholders (creditors, shareholders, and the government). It is the one that prepares the
balance (what the company owns and owes), Profit and Loss (if it earns money) and Cash Flow (how
much money goes in and out the company) statements. These statements are prepared following certain
standards (the Generally Accepted Accounting Principles).
Managerial accounting is used by the managers of the company to analyze and control decisions with
the goal of estimating the costs or performance (of products, services, processes, Departments, projects).
Financial modeling, to analyze the impact of different financing and investment decisions. It is a future
oriented use of the statements from financial accounting so that different scenarios are considered.
Valuation - It is usually the main outcome of financial modeling. It provides the impact on the company
value of diverse decisions. In coming up with an estimated valuation it considers the issues of revenue
growth, margins, tax rates, financing mix and the weighted average cost of capital, capital investment and
project duration.
Financial planning and control is the establishment of targets for some financial metrics and the
reporting of the progress towards them, so that corrective action can be taken to assure proper
accomplishment. It is commonly considered part of managerial accounting. Financial control not only is
about the effective use of the company assets but also considers some organizational procedures so that
financial information is reliable, and money is used with integrity. Here you find auditing, budgeting
(including capital budgeting, that is the one of specific new projects), risk management, and other
techniques.
Financial instruments - To raise capital and make certain investments – whether short or long term,
companies must consider the full range of financial instruments (shares, bonds, loans, cash and its
equivalents, derivatives (such as options, futures, forwards, swaps, etc.) and the possibilities in terms of
risk, flexibility, cash flows and terms.
All these tools are interrelated. A certain knowledge of corporate finance and, mostly, its principles is
important for any senior executive that is involved in making key strategic decisions such as:

CORPORATE FINANCE
• Set objectives that improve your company valuation, make your investors happy and probably
your bonus too.
• Make strategic growth or restructuring decisions that impact a mix of geographies, business
units, products/services of the company in order to improve its valuation.
,
• Raise capital for expansion or restructuring projects and deal with investors.
• Merge with or acquire other businesses, or the negotiate the best price and terms for your
company if you are the acquired one.
• Avoid or manage risks for your company, whether they come from your project mix or your
selected financing mix.
But if you think that corporate finance is a perspective unrelated to the real operations of your company,
you’d better think twice. The best finance people understand a company as a precision machinery and are
very good at linking the strategy to the operations. They come up to relevant project results in innovation,
marketing, sales, and operations that improve metrics that correlate with increased company value.
So, if you want to manage well your company through the lens of corporate finance you must:
1. Seek profitable, capital-efficient growth to increase your company value.
2. Model, plan and control your decisions focusing in the right metrics (and almost always in cash
flows).
3. Consider both sides of the coin i.e., are your financing consistent with the capital requirements and
returns from your operations?
2 Capital Budgeting
2.1 Introduction
Capital Budgeting is undertaken to evaluate the returns from a potential investment. The decision involves
comparing the future inflows from the investment with its outflows to ascertain its profitability. Since the
capital available with the businesses is limited, the management uses the capital budgeting techniques to
find out the investment with the best yield over the concerned time period, among the available options.
Simply put, it tries to answer the question- “Is the investment worth its cost?”
2.2 Principles of Capital Budgeting

The following are the principles of capital budgeting:
• Decisions are made on the basis of cash flows and not net income
• Cash flows are based on opportunity cost
• Timing of the Cash flows is imperative, as decision is based on the Time Value of Money
• ‘After tax’ cash flows are considered, as the firm value is based on the cash that the firm gets to
keep
• The discount rate in calculation considers the firm’s cost of capital
• Externality effect of the investment is also taken into consideration during evaluation. For
instance, whether the investment affects the cash flow of any other part of the business

CORPORATE FINANCE
2.3 Decision Criteria
A Capital Budgeting criterion is needed to decide whether a particular project should be undertaken or not.
The following criterion are used:
• Net Present Value (NPV)

• Internal Rate of Return (IRR)
• Payback Period
• Discounted Payback Method
• Profitability Index (PI)
2.3.1 Net Present Value (NPV)

The NPV is the sum of present values of all expected incremental cash flows of the project. The cash flows
are discounted using the firm’s cost of capital. For a normal project with an initial cash outflow, flowed by
a series of cash inflows (after tax), the NPV is given by:
𝐴1 𝐴2 𝐴3 𝐴𝑛
𝑁𝑃𝑉 = [ ] + [ ] + [ ] + ⋯ + ⋯ + [ ]−𝐶
(1 + 𝑘)1 (1 + 𝑘)2 (1 + 𝑘)3 (1 + 𝑘)𝑛
𝐴1
= ∑[ ]−𝐶
(1 + 𝑘)1
=𝑡=1
Where A1, A2,...,An represent Cash Flows
K is the firm’s cost of capital

n is the expected life of proposal
C is the initial investment
Decision Rule:
If NPV > 0, accept the project
If NPV < 0 reject the project
Choose the project with the highest positive NPV.
2.3.2 Internal Rate of Return (IRR)

It is the rate of return at which the NPV is zero. The discounted cash inflows is equal to the discounted
cash outflows.
It can be calculated using the following formula:

𝐴1 𝐴2 𝐴3 𝐴𝑛
𝐶=[ 1 ]+[ 2 ]+[ 3 ] +⋯+ ⋯+ [ ]
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟) (1 + 𝑟)𝑛

CORPORATE FINANCE
𝑛
𝐴𝑛
𝐶 = ∑[ ]
(1 + 𝑟)𝑛
𝑡=1
𝑛
𝐴𝑛
0 = ∑[ ]−𝐶
(1 + 𝑟)𝑛
𝑡=1
Decision Rule:
let k be the required rate of return
If IRR > k, Accept the project
If IRR < k, Reject the project
Choose the project with the highest IRR greater than k.
2.3.3 Payback Period

Payback period refers to the time it takes to recover the initial cost of investment. This criterion is useful
when the firm doesn’t want to lock in their money for long periods of time.
Payback Period = Initial investment / Cash Flow per year
Decision Rule:
The project with the least Payback period is accepted.
Payback Period have few limitations such as it does not take time value of money and the cash flows
beyond the payback period into consideration which gives an inaccurate picture of the return on the
investment.
2.3.4 Discounted Payback Method

The discounted payback period is the amount of time it takes for the discounted value of expected cash
flows to be equal to the initial cash flow. It is calculated as:
Discounted Payback Period = No. of years before the discounted payback period occurs + (Cumulative
CF in the year before recovery/Discounted CF in the year after recovery)
Decision Rule:
The project with the least Discounted Payback period is accepted.
2.3.5 Profitability Index (PI)

Profitability Index represents the ratio of the benefits and the cost of the proposed investment. It is
calculated as:
PI = PV of Future Cash Flows / Initial Investment
or
PI = 1 + (Net Present Value / Initial Investment)

CORPORATE FINANCE
Decision Rule:
If PI > 1, Accept the Project (NPV is positive)
If PI < 1, Reject the Project (NPV is negative)
Choose the project with the highest PI greater than 1
3 Cost of Capital
3.1 Introduction
The cost of capital is the rate of return (%) expected by investors who provide capital for a business. Once
this amount is paid for, the remaining amount is profit.
For investors, the cost of capital represents the degree of perceived risk. An investor always wants to put
his/her money into a company that would generate revenues that exceeds the cost of capital and generate
returns that are proportionate with the risk.
The Weighted Average Cost of Capital (WACC)
It shows a firm’s blended cost of capital across all the sources, including both the debt and the equity.
It is calculated as the weighted average of the required returns of the securities that are used to finance
the firm.
𝐸 𝐷
𝑊𝐴𝐶𝐶 = ∗ 𝑅𝐸 + ∗ 𝑅𝐷 ∗ (1 − 𝑇)
𝐸+𝐷 𝐸+𝐷
Where:
• E is the market value of Equity;

• D is the market value of Debt;
• RE is the required rate of return on equity;
• RD is the cost of debt, or the yield to maturity on existing debt;
• T is the applicable tax rate.
3.2 Optimal Capital Structure

The optimal capital structure is the optimal mix of the debt and equity financing that maximizes a
company’s market value and simultaneously decreasing its cost of capital.
Decreasing the weighted average cost of capital (WACC) is one of the ways to optimize for the lowest cost
mix of financing.
The optimal capital structure can be estimated by calculating the mix of debt and equity that will be able
to minimize the weighted average cost of capital (WACC) of a company while simultaneously maximizing
its market value. The lower the cost of capital, the higher is the present value of the firm’s future cash
flows, discounted by the WACC.
3.3 Cost of Debt

The cost of debt is the rate of return the firm’s lenders demand when they loan money to the firm.
𝐴𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐷𝑒𝑏𝑡 = (1 − 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒) ∗ 𝐵𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔 𝑟𝑎𝑡𝑒

CORPORATE FINANCE
The cost of debt helps understand the overall rate being paid by a company to use different types of debt
financing. This can also give investors an idea of the company's risk level when compared to the others
because riskier companies tend to have a higher cost of debt.
3.4 Cost of Preferred stock

The cost of preferred stock is the rate of return, which is required by the holders of a company's preferred
stock. It can be calculated by dividing the annual preferred dividend payment by the preferred stock's
current market price.
𝐷𝑝
𝐾𝑝 =
𝑃𝑝𝑠
3.5 Cost of Equity

The cost of common equity is the rate of return investors expect to receive from investing in firm’s stock.
The cost of equity can be calculated by using the Capital Asset Pricing Model or Dividend Discount Model
3.5.1 Capital Asset Pricing Model

The Capital Asset Pricing Model (CAPM) gives the relationship between systematic risk and expected
return for assets, particularly stocks. CAPM is widely used throughout finance to price risky securities and
generate the expected returns for the assets given the risk of those assets and the cost of capital.
KE = E(Ri) = RF + βi [E(RM) − RF ]
KE = Cost of Equity
E(Ri) = Expected return on Equity
βi = The return sensitivity of stock i to changes in the market return
E(RM) = the expected return on the market
RF = Risk free rate
E(RM) − RF = the expected market risk premium
A risk-free asset is defined as an asset that has no default risk. An example can be a default-free
government debt instrument.
E(RM − RF) is the expected market risk premium, is the premium that investors demand for investing in a
market portfolio relative to the risk-free rate.
βi (beta) of a potential investment is a measure of how much risk the investment will add to a portfolio that
looks like the market. If a stock is riskier than the market, it will have a beta greater than one. If a stock
has a beta of less than one, it will reduce the risk of a portfolio.
3.5.2 Dividend Discount Model

DDM states that the intrinsic value of a share of stock is the present value of the share’s expected future
dividends.
Assuming that dividends are expected to grow at a constant rate (g) and that price reflects intrinsic value
we can write the value of a stock as:

CORPORATE FINANCE
𝐷1
P0 =
𝑟𝑒 − 𝑔
Rearranging for expected return on equity:

𝐷1
𝑘𝑒 = 𝑟𝑒 = +𝑔
𝑃0
𝐷1 = Expected dividend per share
P0 = Current share price
g = Dividend growth rate
ke = cost of equity
4 Measures of leverage
4.1 Introduction
Leverage results from the use of fixed-cost assets or funds to magnify returns to the firm’s owners.
Generally, increases in leverage result in increased return and risk, whereas decreases in leverage result
in decreased return and risk. The amount of leverage in the firm’s capital structure – the mix of long-term
debt and equity maintained by the firm – can significantly affect its value by affecting return and risk. Unlike
some causes of risk, there can be almost complete control over the risk introduced through the use of
leverage. Because of its effect on value, we must understand how to measure and evaluate leverage,
particularly when making capital structure decisions.
The three basic types of leverage can best be defined with reference to the firm’s income statement
1) Operating leverage is concerned with the relationship between the firm’s sales revenue and its
earnings before interest and taxes, or EBIT
2) Financial leverage is concerned with the relationship between the firm’s EBIT and its common
stock earnings per share (EPS)
3) Total leverage is concerned with the relationship between the firm’s sales revenue and EPS
LEVERAGE
Sales Revenue
Less: Cost of Goods Sold
Operating Leverage
Gross Revenue
Less: Operating Expenses
Earnings before interest and tax Total Leverage
Less: Interest
Net profit before taxes Financial Leverage
Less: Taxes
Net profit after taxes
Less: Preferred stock dividends
Earnings available for common stockholders
Earnings per share

CORPORATE FINANCE
4.2 Degree of operating leverage
Operating leverage results from the existence of fixed operating costs in the firm’s income stream. we can
define operating leverage as the potential use of fixed operating costs to magnify the effects of changes
in sales on the firm’s earnings before interest and taxes.
The degree of operating leverage (DOL) is the numerical measure of the firm’s operating leverage.
DOL = Percentage change in EBIT/ Percentage change in Sales
𝑄∗(𝑃−𝑉𝐶)
DOL at base level sales =
𝑄∗(𝑃−𝑉𝐶)−𝐹𝐶
Changes in fixed operating costs affect operating leverage significantly. Firms sometimes can incur fixed
operating costs rather than variable operating costs and at other times may be able to substitute one type
of cost for the other.
For example, a firm could make fixed-dollar lease payments rather than payments equal to a specified
percentage of sales. Or it could compensate sales representatives with a fixed salary and bonus rather
than on a percent-of-sales commission basis.
4.3 Degree of financial leverage

Financial leverage results from the presence of fixed financial costs in the firm’s income stream. We can
define financial leverage as the potential use of fixed financial costs to magnify the effects of changes in
earnings before interest and taxes on the firm’s earnings per share.
The two fixed financial costs that may be found on the firm’s income statement are (1) interest on debt and
(2) preferred stock dividends. These charges must be paid regardless of the amount of EBIT available to
pay them.
The degree of financial leverage (DFL) is the numerical measure of the firm’s financial leverage.
DFL = Percentage change in EPS / Percentage change in EBIT

𝐸𝐵𝐼𝑇
DFL at base level EBIT = 𝑃𝐷
𝐸𝐵𝐼𝑇−𝐼−(1−𝑇)
Where,
I = Interest paid on debt
PD = Preferred Dividend paid
T = Tax rate
4.4 Total Leverage

We can also assess the combined effect of operating and financial leverage on the firm’s risk by using a
framework similar to that used to develop the individual concepts of leverage.
This combined effect, or total leverage, can be defined as the potential use of fixed costs, both operating
and financial, to magnify the effect of changes in sales on the firm’s earnings per share (EPS). Total
leverage can therefore be viewed as the total impact of the fixed costs in the firm’s operating and financial
structure.

CORPORATE FINANCE
DTL = DOL * DFL
DTL = Percentage change in EPS / Percentage change in Sales

𝑄∗(𝑃−𝑉𝐶)
DTL at base level sales (Q) = 𝑃𝐷
𝑄∗(𝑃−𝑉𝐶)−𝐼−(1−𝑇)
4.5 Breakeven quantity of sales

4.5.1 Breakeven Point
The breakeven point, QBE, is the number of units produced and sold at which the company’s net income
is zero or that is the revenues are equal to costs.
At this number of units, the company goes from being unprofitable to being profitable.
𝐹+𝐶
𝑄𝐵𝐸 =
𝑃−𝑉
QBE = Breakeven number of units
F = Fixed operating cost
V = Variable operating cost
C = Fixed financial cost
P = Price per unit
4.5.2 Operating breakeven point

At the operating breakeven point revenues are set equal to operating costs.
𝐹
𝑄𝑂𝐵𝐸 =
𝑃−𝑉
QOBE = Operating breakeven number of units
F = Fixed operating cost
V = Variable operating cost
P = Price per unit
5 Dividends
If you cannot find investments that make your minimum acceptable rate, return the cash to owners of your
business:
a) How much cash you can return depends upon current & potential investment opportunities.
b) How you choose to return cash to the owners will depend on whether they prefer dividends or
buybacks
Dividend can be paid in terms of:
(a) Cash Dividend – Reduces corporate cash and retained earnings.

- Reduces capital in case of liquidating dividend.

CORPORATE FINANCE
(b) Stock Dividend – Not a true dividend (no cash leaves the firm)
- Increases outstanding shares.
- Reduces value of each share
- Example: Issue of bonus shares
Dividend is measured in the following ways:
(a) Dividend per share: Money returned per share.

(b) 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑌𝑖𝑒𝑙𝑑 = 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒
𝑃𝑟𝑖𝑐𝑒 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒
(c) 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑃𝑎𝑦𝑜𝑢𝑡 𝑅𝑎𝑡𝑖𝑜 = 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒
Dividends have the following characteristics:
a) They are sticky – companies cannot change their policy swiftly and are often locked into paying it
even if it leads to borrowings to do so.
b) They follow earnings – following the first characteristics companies do not quickly change their
policy in light of one good or bad year, instead this happens after a few cycles and thus dividends
tend to lag the trend of earnings for a company.
c) They are impacted by taxes (capital gains tax vs tax on dividends)
The dividend decision flow-chart
5.1 Models of Dividend Policy

5.1.1 Walter’s Model:
According to Walter, dividend decision is significant as it impacts the value of the company.
If r = rate of return on equity and k = cost of capital, then according to Walter:

CORPORATE FINANCE
a) r > k => growth firm: value of a growth firm is maximized if payout (dividend or repurchase)
=0
b) r = k => normal firm: value of the firm is unaffected by payout
c) r < k => declining firm: value of firm is maximized if payout = 100%
Assumptions –
a) Debt or new equity is not issued for financing investments,
b) r & k are constant.
c) All earnings are either distributed as dividend or reinvested internally immediately.
d) The company has a very long or infinite life.
5.1.2 Modigliani and Miller’s Model (MM Model):

Value of a company depends on its investments in positive NPV projects and is in no way dependent on
its dividend policy (Assumption: Perfect capital market & no taxes)
Life cycle analysis of dividend policy-
5.2 Signaling Hypothesis

Increase in dividends leads to market drawing inference that there will be an increase in earnings and
cashflows of the company and a decrease in dividends leads the market to infer that there will be a
decrease in earnings and cash the company. This is known as the dividend signaling and the consequent
increase or decrease in stock price following the increase or decrease in dividends (or the dividend signal)
is called the information content effect of the dividend.

CORPORATE FINANCE
Managers sometimes get carried away or due to selfish motive (example: cashing out the stock option)
may send out a false signal by paying increased dividends by reducing capital expenditure, just to boost
the stock price of the company. However, due to the information flow, market eventually realizes and once
it has realized that the cash flows were held constant and capital expenditure reduced, stock price will fall
below the value it would have reached had the dividend not been increased. The manager must tackle
this trade of maximizing intrinsic value vs increasing stock price even if it does not reflect the true value.
This is the essence of signaling of dividend.
5.3 Clientele Effect

Investors may form clienteles based upon their tax brackets. Investors in high tax brackets may invest in
stocks which do not pay dividends and those in low tax brackets may invest in dividend paying stocks.
Once payout of companies conforms to the desires of stockholders, no single firm can affect its market
value by switching from one dividend policy/strategy to another policy/strategy, this is known as clientele
effect.
5.4 Bad Reasons for Paying Dividends

i. The firm has excess cash on its hands this year, no investment projects this year and wants to
give the money back to stockholders.
Counter: So why not just repurchase stock? If this is a one-time phenomenon, the firm must consider future
financing needs. The cost of raising new financing in future years, especially by issuing new equity, can
be staggering (Recall: dividends are sticky & on the contrary stock repurchases are not)
ii. Dividends now are more certain than capital gains later. Hence dividends are more valuable than
capital gains. Stocks that pay dividends will therefore be more highly valued than stocks that do
not.
Counter: The appropriate comparison should be between dividends today and price appreciation today.
The stock price drops on the ex-dividend day.
6 Working capital Management

6.1 Overview
Working capital management is the study to understand how a company operates efficiently by monitoring
and using its current assets and liabilities to the best effect. The primary purpose of working capital
management is to enable the company to maintain sufficient cash flow to meet its short-term operating
costs and short-term debt obligations.
A company's working capital is the combination of current assets and current liabilities.
Working capital = Current Assets – Current Liabilities
Current assets include everything that can be easily converted into cash in the next 12 months. These
are the company's highly liquid assets. Some of the current assets are cash, accounts receivables,
inventory, and short-term investments.
Current liabilities are the obligations due in the next 12 months. These include operating expenses, short-
term and long-term debt payments.

CORPORATE FINANCE
Management of working capital includes management of inventory, accounts receivables, and accounts
payables. The primary objectives of the working capital management study are to ensure that the company
has enough cash to cover its expenses and debt, thereby minimizing the cost of money spent on working
capital and maximizing the return on asset investments.
Inadequate access to cash could lead to a severe restructuring of a company by selling off assets,
reorganization via bankruptcy proceedings, or final liquidation of the company. On the other hand,
excessive investment in cash and liquid assets may not be the best use of company resources.
6.2 Types of Working Capital Management Ratios

Three ratios are important in working capital management:
1) The working capital ratio or current ratio
2) The collection ratio
3) The inventory turnover ratio
6.2.1 Current Ratio
Current Ratio = Current Assets / Current Liabilities
The working capital ratio or current ratio is the ratio of current assets to current liabilities. It is a key indicator
of a company's financial health as it demonstrates its ability to meet the short-term financial obligations of
the company.
A working capital ratio < 1.0 generally indicates that a company is having trouble meeting its short-
term obligations. Such a scenario implies that the company’s liquid assets would not cover the company’s
debts due in the upcoming year. In this case, the company may have to resort to selling off assets, securing
long-term debt, or using other financing options to cover its short-term debt obligations.
Working capital ratios of 1.2 to 2.0 are considered desirable.
A working capital ratio > 2.0 suggests that the company is not effectively using its assets to
increase revenues. A high ratio may indicate that the company is not securing financing appropriately or
managing its working capital efficiently.
6.2.2 Collection Ratio
Collection Ratio = No. of days * Average Accounts Receivable / Net Credit Sales
The collection ratio is a measure of how efficiently a company manages its accounts receivables.
The collection ratio is calculated as the product of the number of days in an accounting period and the
average amount of outstanding accounts receivables and divided by the total amount of net credit sales
during the accounting period.
The collection ratio calculation provides the average number of days it takes a company to receive
payment after a sales transaction on credit. If a company's billing department is effective at collections
attempts and customers pay their bills on time, the collection ratio will be lower. Therefore, the lower the
company's collection ratio, the more efficient its cash flow.

CORPORATE FINANCE
6.2.3 Inventory Turnover Ratio
Inventory Turnover Ratio = Revenue / Inventory Cost
To operate with maximum efficiency and maintain a comfortably high level of working capital, a company
must keep sufficient inventory on hand to meet customers' needs while avoiding unnecessary inventory
that ties up working capital.
Companies typically measure how efficiently that balance is maintained by monitoring the inventory
turnover ratio. The inventory turnover ratio, calculated as the ratio of revenues to inventory cost, reveals
how rapidly a company's inventory is being sold and replenished.
A relatively low ratio compared to industry peers indicates inventory levels are excessively high, while a
relatively high ratio may indicate inadequate inventory levels. Also known as the stock turnover ratio,
this ratio monitors the time a company takes to converts its goods into cash. The lower the time taken,
the higher is the company’s stock efficiency.
6.3 Cash Conversion Cycle (CCC)

The cash conversion cycle (CCC) expresses the time (measured in days) it takes for a company to convert
its investments in inventory and other resources into cash flows from sales. Also called the Net Operating
Cycle or simply Cash Cycle, CCC attempts to measure how long each net input currency is tied up in the
production and sales process before converting it into cash received.
It considers how much time the company needs to sell its inventory, how much time it takes to collect
receivables, and how much time it must pay its bills without incurring penalties.
Cash Conversion Cycle = DIO + DSO – DPO
where DIO = Days of inventory outstanding;
DSO = Days sales outstanding;
DPO = Days payables outstanding
DIO and DSO are associated with the company’s cash inflows, while DPO is linked to cash outflow.
Hence, DPO is the only negative figure in the calculation. Another way to look at the formula
construction is that DIO and DSO are linked to inventory and accounts receivable, respectively, which are
considered as short-term assets and are taken to be positive. DPO is linked to accounts payable, which is
a liability and thus assumed to be negative.
6.3.1 Days of Inventory Outstanding (DIO)

DIO measures the current inventory level and represents how long it will take for the business to sell its
inventory. A lower value of DIO is preferred, as it indicates that the company is making sales rapidly,
implying better turnover for the business.
DIO = Average Inventory / COGS * 365
where Average Inventory = (Opening Inventory + Closing Inventory) / 2 &
COGS = Cost of Goods Sold

CORPORATE FINANCE
6.3.2 Days Sales Outstanding (DSO)
This number focuses on the current sales and represents how long it takes to collect the cash generated
from the sales. A lower value is preferred for DSO, which indicates that the company is able to collect
capital quickly, in turn enhancing its cash position.
DSO = Average Accounts Receivable / Revenue * 365
where Average Accounts Receivable = (Beginning A/c Receivable + Closing A/c Receivable) / 2
6.3.3 Days Payables Outstanding (DPO)

This number focuses on the current outstanding payables for the business. It considers the amount of
money the company owes to suppliers for the raw materials purchased and represents the duration in
which the company must pay off those obligations. This figure is calculated by using the Days Payables
Outstanding (DPO), which considers accounts payable. A higher DPO value is preferred. By maximizing
this number, the company holds onto cash longer, increasing its investment potential.
DPO = Average Accounts Payable / COGS * 365
where Average Accounts Payable = (Beginning Accounts Payable + Closing Accounts Payable) / 2
CCC traces the lifecycle of cash used for business activity. It follows cash as its first converted into
inventory and accounts payable, then into expenses for product or service development, next to sales and
accounts receivable, and then back into cash in hand. Essentially, CCC represents how fast a company
can convert the invested cash from the start (investment) to the end (returns). The lower the CCC, the
better.
7 Stock Repurchases
7.1 Introduction
Stock repurchase is a transaction in which a company purchases its shares. This purchase can be directly
from the market or by offering a fixed price to the shareholders. Share buyback reduces the number of
outstanding shares, leading to an increase in earnings per share (EPS), leading to an elevation in share
prices.
7.2 Reasons for Repurchase

A share repurchase reduces the business's total assets so that its return on assets, return on equity, and
other metrics improve compared to not repurchasing shares. Reducing the number of shares means
earnings per share (EPS), revenue, and cash flow grow more quickly.
If the total dividend is kept constant, then the shareholders receive a more significant dividend. Buybacks
can also be used to maintain or elevate EPS even when the company's net income reduces. We can see
corporations undertaking stock repurchases when they feel that the stock is undervalued.
7.3 Advantages of Repurchase

Share Buyback gives a positive signal that the company has enough funds available to deal with
unfavorable scenarios. It can also signal that the company’s operations are running smoothly. Share
buyback boosts the EPS of a company and can also lead to a jump in share prices and make the financial
statement stronger. Measures such as ROA, ROE are boosted.

CORPORATE FINANCE
7.4 Disadvantages of Repurchase
When a company uses cash to repurchase its shares, it foregoes an opportunity to invest the same capital
in a profitable venture. This might signal to investors that the company does not have sustainable
expansion plans or any growth opportunities.
Timing of a share repurchase can also affect the company for the worse. For example, after repurchase,
if the economy takes a downturn, it might find itself cash-strapped to meet its financial obligations.
7.5 Stock Dividend vs. Stock Split

A stock dividend is a dividend payment to shareholders that is made in shares rather than as cash. The
stock dividend has the advantage of rewarding shareholders without reducing the company's cash
balance, although it can dilute earnings per share.
Such dividend is generally paid as a percentage of the existing number of shares. A 10% stock dividend
will lead to a 10% increase in the number of total shares outstanding. A stock dividend does not affect the
company's value, and generally, share price reduces after the stock dividend to account for additional
shares.
In Stock Split, the company divides existing stock into multiple new shares. This improves the liquidity of
the stock. A 4:1 split means each share will be split into four new shares, with each new share having 25%
of the value of the original share.
A stock split is usually carried out when a company’s share price gets too high for retail investors. It also
improves the liquidity of the stock allowing more retail investors to take part. Most of the blue-chip
companies undergo multiple stock splits in their lifetime.
8 Pecking Order Theory

As companies grow and continue to operate, they must decide how to fund their various projects and
operations and pay employees and keep moving the business. While sales revenues are vital sources of
income, most companies also seek capital from investors or lenders as well. But what is the right mix of
equity stock sold to investors and bonds sold to creditors? Capital structure theory is the analysis of this
crucial business question.
Pecking order theory provides a principled approach to this essential business question.
The pecking order theory states that a company should prefer to finance itself first internally through
retained earnings. If this source of financing is unavailable, a company should then finance itself through
debt. Finally, and as a last resort, a company should finance itself by issuing new equity.
The pecking order theory arises from the concept of asymmetric information. Asymmetric information, also
known as information failure, occurs when one party possesses more (better) information than another
party, which causes an imbalance in transaction power.
Company managers typically possess more information regarding the company’s performance, prospects,
risks, and future outlook than external users such as creditors (debt holders) and investors (shareholders).
Therefore, to compensate for information asymmetry, external users demand a higher return to counter
the risk they are taking. In essence, due to information asymmetry, external sources of finances demand
a higher rate of return to compensate for higher risk.
In the context of the pecking order theory, retained earnings financing (internal financing) comes directly
from the company and minimizes information asymmetry. As opposed to external financing, such as debt

CORPORATE FINANCE
or equity financing, where the company must incur fees to obtain external financing, internal financing is
the cheapest and most convenient source of financing.
When a company finances an investment opportunity through external financing (debt or equity), a higher
return is demanded because creditors and investors possess less information regarding the company, as
opposed to managers. In terms of external financing, managers prefer to use debt over equity – the cost
of debt is lower than the cost of equity.
The issuance of debt often signals an undervalued stock and confidence that the board believes the
investment is profitable. On the other hand, the issuance of equity sends a negative signal that the stock
is overvalued and that the management is looking to generate financing by diluting shares in the company.
When thinking of the pecking order theory, it is helpful to consider the seniority of claims to assets.
Debtholders require a lower return as opposed to stockholders because they are entitled to a higher claim
to assets (in the event of a bankruptcy). Therefore, when considering sources of financing, the cheapest
is through retained earnings, second through debt, and third through equity.
*************

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FINANCE COMPENDIUM

NIVESHAK – FINANCE & INVESTMENT CLUB 1

Objective: Maximize value of the business

Investment Decision Dividend Decision:

NIVESHAK – FINANCE & INVESTMENT CLUB 2

In corporate finance you use certain tools:

NIVESHAK – FINANCE & INVESTMENT CLUB 3

1. Seek profitable, capital-efficient growth to increase your company value.

2.2 Principles of Capital Budgeting

NIVESHAK – FINANCE & INVESTMENT CLUB 4

• Net Present Value (NPV)

2.3.1 Net Present Value (NPV)

Where A1, A2,...,An represent Cash Flows

K is the firm’s cost of capital

If NPV > 0, accept the project

If NPV < 0 reject the project

Choose the project with the highest positive NPV.

2.3.2 Internal Rate of Return (IRR)

It can be calculated using the following formula:

NIVESHAK – FINANCE & INVESTMENT CLUB 5

let k be the required rate of return

If IRR > k, Accept the project

If IRR < k, Reject the project

Choose the project with the highest IRR greater than k.

2.3.3 Payback Period

Payback Period = Initial investment / Cash Flow per year

The project with the least Payback period is accepted.

2.3.4 Discounted Payback Method

The project with the least Discounted Payback period is accepted.

2.3.5 Profitability Index (PI)

PI = PV of Future Cash Flows / Initial Investment

PI = 1 + (Net Present Value / Initial Investment)

NIVESHAK – FINANCE & INVESTMENT CLUB 6

If PI > 1, Accept the Project (NPV is positive)

If PI < 1, Reject the Project (NPV is negative)

Choose the project with the highest PI greater than 1

The Weighted Average Cost of Capital (WACC)

• E is the market value of Equity;

3.2 Optimal Capital Structure

3.3 Cost of Debt

𝐴𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐷𝑒𝑏𝑡 = (1 − 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒) ∗ 𝐵𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔 𝑟𝑎𝑡𝑒

NIVESHAK – FINANCE & INVESTMENT CLUB 7

3.4 Cost of Preferred stock

3.5 Cost of Equity

3.5.1 Capital Asset Pricing Model

E(Ri) = Expected return on Equity

βi = The return sensitivity of stock i to changes in the market return

E(RM) = the expected return on the market

RF = Risk free rate

E(RM) − RF = the expected market risk premium

3.5.2 Dividend Discount Model

NIVESHAK – FINANCE & INVESTMENT CLUB 8

Rearranging for expected return on equity:

𝐷1 = Expected dividend per share

P0 = Current share price

g = Dividend growth rate

Earnings per share

NIVESHAK – FINANCE & INVESTMENT CLUB 9

DOL = Percentage change in EBIT/ Percentage change in Sales

4.3 Degree of financial leverage

DFL = Percentage change in EPS / Percentage change in EBIT

I = Interest paid on debt

PD = Preferred Dividend paid

4.4 Total Leverage