Financial Management Notes by Sachin Arora Bcom-2

Sachin Education Hub
Sources of finance Notes

Short term sources of finance
1. Trade Credit:
• Meaning: Trade credit is a form of financing where a
supplier allows the buyer to purchase goods or services on
credit. The buyer agrees to pay the supplier at a later
date, often within a specified period, without incurring
any interest.
• Advantages: Convenient and flexible financing, builds
good relationships with suppliers, and provides a short-
term cash flow solution.
2. Bank Overdrafts:
• Meaning: A bank overdraft is a short-term credit facility
provided by a bank, allowing an account holder to
withdraw more money than the account holds, up to a
predetermined limit.
• Advantages: Offers flexibility to manage cash flow
fluctuations, quick and easy to arrange, and interest is
typically charged only on the overdrawn amount.
3. Short-Term Loans:
• Meaning: Short-term loans are borrowings that are
repaid within a relatively short period, usually one year or
less. These loans provide businesses with a fixed amount
of capital for specific short-term needs.
• Advantages: Provides a fixed sum of capital for short-
term needs, straightforward repayment terms, and a
quicker approval process compared to long-term loans.
4. Commercial Paper:
• Meaning: Commercial paper is a short-term debt
instrument issued by corporations with strong credit
ratings. It represents a promise to repay a specific amount
within a short timeframe, typically 270 days or less.
• Advantages: Offers lower interest rates, provides a way

for creditworthy corporations to raise short-term funds,
and enhances financial flexibility.
5. Factoring:
• Meaning: Factoring is a financial arrangement where a
business sells its accounts receivable (invoices) to a third
party, known as a factor, at a discount. The factor then
assumes responsibility for collecting the receivables.
• Advantages: Converts accounts receivable into
immediate cash, reduces the risk of bad debts, and
improves liquidity and working capital.
6. Inventory Financing:
• Meaning: Inventory financing involves using a company's
inventory as collateral to secure a short-term loan. This
allows the business to access funds tied up in inventory.
• Advantages: Enables businesses to use inventory for
short-term financing, optimizes cash flow by unlocking
inventory value, and is useful for managing seasonal
variations.
7. Customer Advances:
• Meaning: Customer advances involve receiving payment
from customers before delivering goods or services. This
can provide a short-term cash inflow for businesses.
• Advantages: Improves cash flow, reduces the need for
external financing, and can be negotiated in various
industries.
8. Supplier Credit:
• Meaning: Similar to trade credit, supplier credit involves
negotiating extended payment terms with suppliers,
allowing the business to delay payment for goods or
services.
• Advantages: Improves working capital, provides a source
of short-term financing without interest charges.
9. Short-Term Leasing:
• Meaning: Leasing assets or equipment for a short
duration can be a source of short-term financing. It allows
the business to use assets without committing to long-
term ownership.
• Advantages: Avoids the need for large upfront payments,
provides flexibility in using assets for specific projects or
periods.
10. Inter-Corporate Deposits (ICDs):
• Meaning:
• ICDs refer to short-term deposits made by one company in
the form of a deposit with another corporate entity. The
company with surplus funds acts as the lender, while the
company in need of funds acts as the borrower. This
arrangement is a type of short-term loan but is distinct
from traditional loans or debt securities.
• Key Features:
• Duration: ICDs are usually short-term in nature, with
maturities ranging from a few days to a few months.
• Interest Rates: The interest rates on ICDs are agreed
upon by the two corporate entities involved in the
transaction.
Long term Sources of finance

1. Equity Financing:
• Meaning: Equity financing involves raising capital by
issuing shares of the company's ownership (equity) to
investors. This can be done through an Initial Public
Offering (IPO) or by selling shares to private investors.
• Advantages: No obligation to repay, potential for
additional expertise and networking from investors, and
no interest payments.
2. Debt Financing (Bonds and Loans):
• Meaning: Debt financing involves borrowing money that

needs to be repaid with interest over a specified period.
This can be in the form of bank loans or bonds issued to
investors.
• Advantages: Provides a fixed amount of capital, interest
payments are tax-deductible, and ownership and control
remain with existing shareholders.
3. Venture Capital:
• Meaning: Venture capital is a type of equity financing
where investors provide funds to startups and small
businesses in exchange for ownership equity. Venture
capitalists often take an active role in the companies they
invest in.
• Advantages: Beyond financial support, venture
capitalists offer expertise and mentorship, and there is no
obligation to repay the invested capital.
4. Retained Earnings:
• Meaning: Retained earnings are profits that a company
has earned and kept, rather than distributing them as
dividends. These earnings can be reinvested in the
business for growth.
• Advantages: No cost of external financing, demonstrates
financial stability, and allows for internal reinvestment.
5. Long-Term Loans from Financial Institutions:
• Meaning: Companies can secure long-term loans from
banks or other financial institutions to fund projects,
expansions, or acquisitions.
• Advantages: Fixed repayment terms provide stability,
and interest rates are often lower than short-term
financing options.
Feature Shares Debentures
Nature of Represents ownership in Represents a debt

Instrument the company. owed by the company.
Debenture holders do
Ownership Shareholders have voting not have ownership
Rights rights and ownership. rights.
Returns are fixed

Returns are in the form of interest payments
Returns dividends (variable). (coupon).
Lower risk, fixed

Risk and Higher risk and potential returns, priority in
Reward for higher returns. repayment.
Debenture holders
Priority in Shareholders are paid after have priority in
Payment all debts. repayment.
Common shares may be Some debentures may

convertible into preference be convertible into
Convertibility shares or debentures. shares.
Debenture holders
Common shareholders have generally do not have
Voting Rights voting rights. voting rights.
Feature Owned Funds Borrowed Funds
Represents the capital

contributed by the Represents external funds
owners, such as equity raised through borrowing,
Ownership capital. such as loans or bonds.
Feature Owned Funds Borrowed Funds
Originates from the

owners' investments in Originates from external
Source the business. lenders or creditors.
Owners typically have Lenders do not have

voting rights and control voting rights or control
Control over the business. over business operations.
Generally, more flexible

in terms of usage and
Flexibility repayment. Not flexible
Involves interest
No explicit cost (except payments or other costs,
for opportunity cost in depending on the terms of
Cost the case of equity). borrowing.
Borrowed funds often

Priority in Owners are repaid after have a specified order of
Repayment all obligations. repayment.
Owners' funds are

considered a permanent
Permanence part of the business. Temporary.
Theories on Capital Structure:

• Net Income (NI) Approach
• Net Operating Income (NOI) Approach
• Traditional Theory Approach
• Modigliani-Miller (MM) Approach
Net Income (NI) Approach
Net Income (NI) Approach suggests that the value of the firm
changes with the change in cost of capital.
Use of debt instruments will reduce the cost of capital increasing the
value of the firm.
Debt is considered as a cheaper source of financing.
Assumptions
1. Debt is the cheaper source of funds.
2. There is no corporate tax.
3. Investors are indifferent to the use of debt.
Value of the Firm (V) = Market Value of Equity Share (S)+ Market
Value of Debt (D)
S = ESH/ Equity Capitalization Rate (Ke)
Cost of Capital (Ko) = EBIT/V
Net Operating Income (NOI) Approach

Net Operating Income (NOI) Approach advocates that the debt-
equity mixer is not important as the market itself capitalizes the
value of the firm as a whole. It means that the advantage of using
debt instruments to lower the cost of capital is offset by the increased
risk perception due to the use of debt instruments i.e. increased the
required rate of return by Equity investors.
NOI approach suggests that every capital structure is optimal capital
structure.
Assumptions
1. Market capitalizes the value of the firm as a whole.
2. The business risk remains constant at every level of debt-equity
mix
3. There are no corporate taxes.
V = EBIT/ Ko
Ke = ESH/ S
S=V–D
Traditional Theory Approach

Traditional Theory Approach is also considered as an intermediate
Approach as this approach explains the capital structure and the
value of firm remaining in the ground between the NI approach and
NOI approach.
The basic idea about the value of firm in this approach is that, at a
certain point, the debt-equity mix will positively impact the value of
firm i.e. debt instrument will reduce the cost of capital. Once the
optimum level of debt equity-mix is attained, any additional debt will
cause decrease in the market value and increase the cost of capital.
After the optimum level of the mix, the risk factor of debt is more
evident than the benefit of using the debt instrument.
Assumptions
1. Cost of capital remains more or less constant for a certain level
and rises thereafter.
2. Cost of equity remains more or less constant for a certain level
and rises rapidly thereafter.
3. Average cost of capital decreases for a certain level, remains

unchanged and rises thereafter.
Modigliani-Miller (MM) Approach

Modigliani-Miller builds the relationship among the cost of capital,
capital structure and the valuation of the firm. MM approach
generally advocates that the market value of any firm is irrelevant to
its capital structure. For the same level of business risk, the market
value of the levered firm is indifferent from the market value of the
levered firm. The valuation of any form is irrelevant to its capital
structure.
Assumptions
1. There are no taxes.
2. Transaction costs for buying and selling securities and
bankruptcy is zero.
3. There is a symmetry of information.
4. The cost of borrowing is the same for investors and companies.
5. There is no corporate dividend tax.
MM Approach: (With NO Taxes)

Proposition I
Proposition I suggests that with an assumption of “no taxes”, the
capital structure doesn’t influence the valuation of the firm. The
future cash flows determine the value of a company, therefore,
capital structure doesn’t affect it. Also, we assume the market to be
perfect which means companies do not pay any taxes i.e. company
doesn’t have any tax benefit.
VU=VL
In case of Unlevered firm ke = ko
MM Approach: (With Taxes)

Proposition I suggests that the tax shields from deductible interest
payments make the value of the levered firm higher than the market
value of the unlevered firm. The tax deductibles positively reflect the
value of the firm.
• VL=VU + Tc*D
• Tc = Tax Rate
• D= Debt
Time Value of Money Notes
The time value of money (TVM) is a financial concept which means

money that we hold in present have worth than the same money we
hold in future. This is because of the potential earning capacity of
money over time due to interest, inflation, or other factors.
TVM is a fundamental principle in finance and is used in various
calculations, such as present value, future value, and annuities.
Techniques/Methods to measure of TVM

Aspect Compounding Discounting
The process of calculating The process of

the future value of a sum of determining the present
money, taking into account value of a sum of money,
the interest earned over considering the time
Definition time. value of money.
To find the future value of a To find the present value

Objective present sum of money. of a future sum of money.
Present Value (PV) =

Future Value (FV) =
Future Value (FV) / (1 +
Present Value (PV) * (1 + r)^n, r)^n,
where r is the interest rate where r is the discount

and n is the number of rate and n is the number
Formula compounding periods. of discounting periods.
Concerned with reducing

Relationship Concerned with the growth the value of a future sum
to Time of an investment over time. to its present value.
Used in valuation,
determining the current
Used for investment and value of future cash
Usage savings calculations. flows.
Aspect Compounding Discounting
Discounting future cash

flows, valuing bonds,
Compound interest on determining the present
Common savings accounts, value of an investment,
Scenarios investments, loans, etc. etc.
Importance of TVM or Why there is need of Time

in measure money:
1. Comparing Cash Flows Over Time: TVM is essential for

comparing cash flows that occur at different points in time. It
allows individuals and businesses to make informed decisions
by bringing all cash flows to a common point, usually the
present or future.
2. Investment Decision-Making: Investors use TVM to
evaluate the potential return on investment. By discounting
future cash flows back to the present value, they can assess the
attractiveness of an investment.
3. Cost of Capital: TVM is used to determine the cost of capital,
which is the rate of return required by an investor to invest in a
particular project or business. The cost of capital reflects the
time value of money.
4. Budgeting and Planning: TVM is crucial in budgeting and
long-term financial planning. It helps in estimating the future
value of savings, retirement funds, and other financial goals.
5. Loan and Mortgage Calculations: When individuals or
businesses borrow money, TVM is used to calculate the equated
monthly installments (EMI) or the periodic payments needed to
repay the loan. It helps in understanding the total cost of
borrowing.
How TVM helps in determining Sinking fund

and capital recovery:
1. Sinking Fund:
Purpose:
• Sinking funds are commonly established to ensure that there is
a sufficient amount of money available to cover a future
financial obligation, such as the repayment of a loan or the
replacement of a depreciating asset.
• Sinking funds provide financial flexibility, allowing individuals
or organizations to plan for known future expenses
systematically.
• A sinking fund is established to set aside money regularly
to meet a future obligation, such as repaying a loan or
replacing an asset.
• TVM is crucial in calculating the amount to be contributed
to the sinking fund regularly.
• It helps in determining how much money needs to be set
aside at regular intervals to accumulate a targeted future
sum.
2. Capital Recovery:
Capital recovery is the process of recovering the initial investment
made in a project or asset over its useful life. It involves recouping
both the principal amount and an acceptable rate of return.
 In the context of depreciable assets, capital recovery methods
ensure that the costs associated with the asset are spread over
its useful life, aligning with accounting principles.
• Capital recovery involves recouping the initial investment
made in a project or asset over its useful life.
• TVM is employed to calculate the periodic payments
needed to recover the initial capital investment.
• This ensures that the investor recovers the invested
capital along with an acceptable rate of return over time.
Perpetuity vs Annuity
A series of equal cash A series of equal cash flows
flows that continues that occur for a fixed
Definition indefinitely, with no end. number of periods.
Limited duration, cash

Infinite duration, never- flows occur for a specific
Duration ending cash flows. number of periods.
Ending Point No defined ending point Has a defined ending point;
Present Value (PV) = Present Value

Present
Value Cash Flow / Discount (PV) = CF * [(1 - (1 + r)^(-
Formula Rate n)) / r],
Future Value (FV) =

Future Value (FV) =
Future Value Cash Flow / Discount
Formula Rate CF * [((1 + r)^n - 1) / r],
Mortgage payments, lease

Dividend payments from payments, and some types
Examples certain types of stocks. of bond interest payments.
Working Capital Notes
Working capital is a fundamental concept in finance and

accounting that represents the difference between a company's
current assets and current liabilities.
It refers to the capital required to meet the day to day expenses
of the business.
It reflects the operational liquidity and short-term financial
health of a business. The formula for working capital is:
Working Capital=Current Assets−Current Liabilities
Components of Working Capital:
1. Current Assets: It refers to the assets which can be converted
into cash within a year. Such examples are:
• Cash and Cash Equivalents: Currency, bank accounts,
and other highly liquid assets.
• Accounts Receivable: Amounts owed to the company by
customers for goods or services provided on credit.
• Inventory: Raw materials, work-in-progress, and finished
goods held for production and sales.
• Short-Term Investments: Investments with maturities of
less than one year.
2. Current Liabilities: It refers to that liabilities which can be
paid be within a year. Such liabilities may be:
• Accounts Payable: Amounts owed by the company to
suppliers for goods and services.
• Short-Term Debt: Borrowings with maturities of less than
one year.
• Accrued Liabilities: Expenses that have been incurred but
not yet paid.
Types of Working Capital:

1. Gross Working Capital:
• Gross working capital refers to the total current assets of
a company. It represents the absolute liquidity available
to meet short-term obligations.
• Formula: Gross Working Capital=Total Current Assets
2. Net Working Capital:
• Net working capital is the more commonly used measure
and represents the excess of current assets over current
liabilities.
• Formula:
Net Working Capital=Current Assets−Current liabilities
• Interpretation:
• A positive net working capital suggests that a
company has enough assets to cover its short-term
liabilities.
• A negative net working capital may indicate
potential liquidity issue
Difference between Matching, Aggressive and Conservative

approach:
Matching Aggressive Conservative
Maximize Ensure safety by

Match maturities returns by maintaining
of assets and minimizing higher levels of
Objective liabilities. current assets. current assets.
Risk Moderate risk Higher risk Low risk

Tolerance exposure. tolerance. tolerance.
Lower liquidity
Balanced liquidity due to Higher liquidity
with a focus on minimized with excess
Liquidity matching. current assets. current assets.
Emphasis on
Balanced stability over
approach for Potential for maximum
Profitability stable returns. higher returns. returns.
Moderate Limited flexibility

flexibility in High flexibility due to
resource for growth conservative
Flexibility allocation. opportunities. stance.
Resources Resources held

Use of Efficient use of actively invested for safety and
Resources resources. for returns. stability.
Need for Working Capital:

1. Smooth Operations:
• Working capital ensures day-to-day operational activities
can be conducted smoothly by covering short-term
expenses and obligations.
2. Maintaining Liquidity:
• It provides the necessary liquidity to meet short-term
financial obligations, preventing disruptions in business
operations.
3. Seasonal Fluctuations:
• Helps businesses cope with seasonal fluctuations in
demand and production by providing funds for increased
inventory or operational needs.
4. Cash Flow Management:
• Supports effective cash flow management, ensuring that

inflows and outflows are balanced for sustainable
business activities.
5. Facilitating Growth:
• Adequate working capital is essential for seizing growth
opportunities, whether through increased production,
expansion, or market penetration.
6. Creditworthiness:
• Demonstrates financial health and stability, enhancing a
company's creditworthiness and ability to negotiate
favorable credit terms with suppliers.
7. Inventory Management:
• Allows businesses to maintain optimal levels of inventory,
preventing stockouts or excessive holding costs.
8. Customer Credit Terms:
• Enables businesses to offer reasonable credit terms to
customers, attracting and retaining clients without
impacting cash flow negatively.
Issues with Inadequate Working Capital:

1. Liquidity Problems:
• Insufficient working capital may lead to liquidity
problems, hindering the ability to meet short-term
obligations.
2. Operational Disruptions:
• Businesses may face disruptions in day-to-day operations,
impacting production, sales, and overall efficiency.
3. Missed Opportunities:
• Inability to seize growth opportunities due to a lack of
funds for expansion, marketing, or capitalizing on
favorable market conditions.
4. Supplier Relations:
• Strained relationships with suppliers due to delayed
payments or the inability to take advantage of early
payment discounts.
5. Increased Borrowing Costs:
• Companies may resort to expensive short-term borrowing,
increasing overall financing costs and reducing
profitability.
6. Risk of Bankruptcy:
• Prolonged inadequacy in working capital may pose a risk
of financial distress and bankruptcy if the company
cannot meet its financial obligations.
7. Reduced Competitiveness:
• Competitiveness may be compromised as competitors with
better working capital management can respond more
effectively to market demands.
8. Impact on Credit Rating:
• Inadequate working capital may negatively impact a
company's credit rating, limiting its ability to secure
favorable financing terms.
Sources of Working Capital – How to earn

working capital?
1. Short-Term Bank Loans:
• Borrowing from banks for a short period to cover
temporary working capital needs.
2. Trade Credit:
• Negotiating extended payment terms with suppliers,
allowing the business to delay cash outflows.
3. Factoring and Accounts Receivable Financing:
• Selling accounts receivable to a third party (factor) at a

discount to receive immediate cash.
4. Commercial Paper:
• Issuing short-term unsecured promissory notes to raise
funds quickly from the capital markets.
5. Working Capital Loans:
• Specialized loans designed to provide working capital
support with flexible terms.
6. Inventory Financing:
• Securing financing based on the value of inventory,
allowing businesses to leverage their stock for cash.
7. Lines of Credit:
• Establishing a revolving line of credit with a financial
institution to access funds when needed.
8. Supplier Financing:
• Collaborating with suppliers for extended payment terms
or early payment discounts.
9. Government Grants and Subsidies:
• Exploring government programs that provide grants or
subsidies to support working capital needs, especially for
specific industries.
10. Angel Investors and Venture Capital:
• Attracting equity investment from angel investors or
venture capitalists to inject capital into the business.
11. Retained Earnings:
• Using profits retained within the business for
reinvestment in working capital.
12. Crowdfunding:
• Raising funds from a large number of individuals through
online platforms.
13. Asset-Based Lending:

• Using assets such as accounts receivable, inventory, or
equipment as collateral to secure a loan.
14. Peer-to-Peer Lending:
• Borrowing from individuals through online lending
platforms.
15. Convertible Debentures:
• Issuing debt instruments that can be converted into
equity if certain conditions are met.
Dividend Policy
A dividend is a distribution of profits by a corporation to its
shareholders. It represents a portion of the company's earnings that
is returned to its owners, the shareholders. Dividends are typically
paid in the form of cash, additional shares of stock, or other property.
Dividend Policy: Dividend policy refers to the set of guidelines and
decisions a company makes regarding the payment of dividends to its
shareholders. Companies may adopt various dividend policies based
on their financial condition, growth prospects, and the preferences of
their investors.
Main Types/kinds/Forms of Dividends:

1. Cash Dividends:
• The most common type of dividend, where shareholders
receive cash payments from the company's profits.
2. Stock Dividends:
• Instead of cash, shareholders receive additional shares of
the company's stock. This is a distribution of additional
ownership in proportion to existing holdings.
3. Scrip Dividends:
• Similar to stock dividends, but shareholders receive
promissory notes or "scrip" that can be exchanged for
shares at a later date.
4. Property Dividends:
• Shareholders receive non-cash assets, such as products or
services, as dividends.
5. Special Dividends:
• Occasional extra payments made by a company, often in
addition to regular dividends, usually prompted by
extraordinary profits or events.
6. Liquidating Dividends:
• Payments made when a company is in the process of

liquidating its assets and ceasing operations.
7. Regular Dividends:
• Consistent, periodic payments made by a company to its
shareholders, typically on a quarterly, semi-annual, or
annual basis.
8. Irregular Dividends:
• Payments that don't follow a set schedule and may be
influenced by varying earnings or business conditions.
9. Hybrid Dividends:
• Combining elements of different types, such as a mix of
cash and stock dividends.
Factors affecting / Determinants of

Dividend policy
1. Industry Stability:
• Industries with stable cash flows and predictable earnings
may be more inclined to have a consistent dividend policy.
2. Legal Restrictions:
• Some jurisdictions have legal restrictions on the payment
of dividends. Companies must comply with these
regulations when formulating their dividend policies.
3. Market Conditions:
• Economic and market conditions, including interest rates
and inflation, can impact a company's ability to pay
dividends and influence dividend policy decisions.
4. Investment Opportunities:
• The availability of attractive investment opportunities
and projects may affect a company's decision to retain
earnings for future expansion rather than paying

dividends.
5. Company's Life Cycle:
• Growth-stage companies may prioritize reinvesting profits
into the business, while mature companies may be more
inclined to distribute dividends.
6. Shareholder Expectations:
• The expectations of shareholders, including institutional
investors and individual investors, play a significant role
in shaping a company's dividend policy.
7. Management's Outlook:
• Management's assessment of the company's future
prospects and its outlook on future earnings growth can
influence dividend decisions.
8. Financial Flexibility:
• Companies that want to maintain financial flexibility for
unforeseen circumstances may choose to retain more
earnings rather than paying them out as dividends.
9. Dividend Stability:
• Companies may strive to maintain a stable dividend
policy to build investor confidence and attract long-term
investors.
10. Currency of Dividends:
• For multinational companies, the currency in which
dividends are paid may be influenced by currency
exchange rates and economic conditions in different
regions.
11. Dividend Payout Ratio:
• The percentage of earnings paid out as dividends, known
as the payout ratio, is a key metric considered in
determining the dividend policy.
12. Tax Efficiency:

• Tax considerations, both for the company and
shareholders, can impact decisions on the form and timing
of dividend payments.
Walter and Gordon Model assumptions and

theory of relevance
Walter's Approach
According to James Walter, dividend policy always affects
the goodwill of a company. Walter argued that dividend policy
reflects the relationship between the firm's return on
investment or internal rate of return and the cost of capital or
required rate of return.
Suppose that r is the internal rate of return and K is the cost of
equity capital. Then, for any given company, we have the following
cases:
Case 1: When r > k
Firms with r > k are termed growth firms. Their optimal dividend
policy involves ploughing back the company's entire earnings.
Thus, the dividend payment ratio would be zero. This would also
maximize the market value of the company's shares.
Case 2: When r < k
Firms with r < k do not offer profitable investment opportunities. For
these firms, the optimal dividend policy involves distributing the
entire earnings in the form of dividends.
Shareholders can use dividends to receive in other channels when
they can get a higher rate of dividends.
Thus, 100% dividend payout ratio in their case would result in
maximizing the value of the equity shares.
Case 3: When r = k
For firms with r = k, it does not matter whether the firm retains or
distributes its earnings. In their case, the share price would not
fluctuate with a change in dividend rates.
Thus, no optimal dividend policy exists for such firms.
Assumptions in Models Based on Walter's Approach
(i) The firm undertakes its financing entirely through retained
earnings. It does not use external sources of funds such as debts or
new equity capital.
(ii) The firm's business risk does not change with
additional investment. This means that the firm's internal rate of
return and cost of capital remain constant.
(iii) Initially, earnings per share (EPS) and dividend per share
(DPS) remain constant. The choice of values for EPS and DPS varies
depending on the model, but any given values are assumed to remain
constant.
(iv) The firm has a very long life.
Formula for Walter's Approach
The market value of a share (P) can be expressed as follows:
P = (D + r) (E - D) / KE
or
P = (D + (r / KE) E-D) / KE
where
• P = Market price of an equity share
• D = Dividend per share
• r = Internal rate of return
• E = Earnings per share
• KE = Cost of equity capital or capitalization rate
Example
Required: Based on the table shown below concerning companies A,

B, and C, calculate the value of each share using Walter's approach
when the dividend payment ratio is 50%, 75%, and 25%.
In addition,
• D = (50 x 8) / 100 = 4
• D = (75 x 8) / 100 = 6
• D = (25 x 8) / 100 = 2
• A Ltd. B Ltd. C Ltd.
r 15% 5% 10%
Ke 10% 10% 10%
e $8 $8 $8
Solution
Comment: A Ltd. is a growth firm because its internal rate of return

exceeds the cost of capital.
Here, it is better to retain the earnings rather than to distribute

them as dividends. As is shown, when the D.P. Ratio is 25%, the
share price is Rs. 110.
Criticisms:
• The assumption that investments are financed through
internal sources is not true. External sources are also used for
financing.
• The ratio between r and k is not constant in an organization. As
investment increases, r also increases.
• Earnings and dividends do not charge while determining the
value.
• The assumption that a firm will have a long life is difficult to
predict.
Gorden's Approach
Gorden proposed a model along the lines of Walter, suggesting that
dividends are relevant and that the dividends of a firm influence its
value.
The defining feature of Gorden's model is that the value of a dollar in
dividend income is greater than the value of a dollar in capital gain.
This is due to the uncertainty of the future and the shareholder's
discount future dividends at a higher rate.
According to Gorden, the market value of a share is equal to
the present value of the future stream of dividends.
Formula for Gorden’s Approach
The formula is given as follows:
P = E (1 - b) / (Ke - br)
or
P = D / (Ke - g)
where
• P = Share price
• E = Earnings per share

• b = Retention ratio
• Ke = Cost of equity capital
• br = g
• r = Rate of return on investment
• D = Dividend per share
OR
Gordon Growth Model (Dividend Discount Model or DDM):
Assumptions:
1. Constant Dividend Growth Rate (g): The model assumes a
constant growth rate in dividends indefinitely.
2. Dividends are the Main Source of Value: The model
assumes that dividends are the primary source of value for
shareholders.
3. Stable Business Environment: The model assumes a stable
business environment where the company can maintain a
consistent dividend growth rate.
4. Infinite Time Horizon: The model extends indefinitely into
the future, assuming perpetual growth in dividends.
Effect on Firm Value:

• The Gordon Growth Model suggests that the value of a firm is
directly influenced by the expected future dividends. Any
change in the expected growth rate or dividends can have a
significant impact on the calculated value.
Walter Model
Assumptions:
1. Internal Financing: The model assumes that firms can
finance their investments either through retained earnings or
external sources (no external equity).
2. No Dividend Payout Ratio: The model assumes that the
dividend payout ratio is not a relevant factor in determining the
firm's value.
3. Cost of Equity Equals Return on Investments: The
required rate of return for shareholders is assumed to be the
same as the rate of return on the firm's investments.
Effect on Firm Value:
• According to the Walter Model, under certain conditions, the
firm's value is not influenced by its dividend policy. The value
of the firm is determined by its ability to generate returns on
investments, regardless of how much is paid out as dividends.
Leverage Notes
In financial management, leverage refers to the use of borrowed funds or
financial techniques to potentially increase the returns to equity holders. It
involves using debt or other financial instruments to magnify the impact of an
investment's performance on the overall returns of the company.
Types of Leverage:
1. Operating Leverage: This type of leverage relates to a company's fixed
and variable costs. When a company has higher fixed costs and lower
variable costs, it has higher operating leverage. Operating leverage can
lead to higher profits when sales increase, as the fixed costs remain
constant while the variable costs rise only slightly. However, it can also
result in greater losses when sales decline.
It is the relationship between Sales and EBIT and indicates business risks.
2. Financial Leverage: Financial leverage involves using borrowed funds

(debt) to finance investments with the aim of increasing the potential
return on equity. When a company borrows money to invest in projects or
assets, it can amplify the returns for equity shareholders.
It is the relationship between EBIT and EPS and indicates financial risks
3. Combined Leverage:
It is the relationship between Sales and EPS and indicates Total Risks.
Relationship between all types of leverage:
I. Operating Leverage:
Degree of Operating Leverage (DOL) may be defined as % change in EBIT
with respect to % change in sales quantity.
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇
𝐷𝑂𝐿 =
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑆𝑎𝑙𝑒𝑠
Or
𝑪𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏 𝑪𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏
𝑫𝑶𝑳 = =
𝑬𝑩𝑰𝑻 𝑪𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏 − 𝑭𝒊𝒙𝒆𝒅 𝑪𝒐𝒔𝒕
𝟏
𝑫𝑶𝑳 =
𝑴𝒂𝒓𝒈𝒊𝒏 𝒐𝒇 𝑺𝒂𝒇𝒆𝒕𝒚 (𝑴𝑶𝑺)
Relationship in brief:
1. Firm with high leverage = Higher Break-even Point.

2. Firm with low leverage = Lower Break-even Point.
3. Higher Fixed Cost = Higher DOL.
4. Lower Fixed Cost = Lower DOL.
5. MOS is inversely related to OL.
For Example:
Sales 50000
Variable Cost 30000
Contribution 20000
Fixed Cost 15000
EBIT 5000
PV ratio (C/S) = (20000/50000* 100) = 40%
BEP in sales (BES) = FC/PV Ratio (15000/40%) 37500
MOS = (TS – BES)/Total Sales (50000 – 37500)/50000 0.25
DOL = 1/MOS 1/0.25 = 4
Aspect Business Risk Financial Risk
Uncertainty and potential Risk associated with the

for loss inherent in use of debt and financial
business operations and instruments to finance
Definition activities. operations.
Arises from the

Arises from external and structure of a company's
Nature of Risk internal factors capital
Debt obligations,
Market competition, interest rate
technological changes, fluctuations, credit risk,
economic conditions, and and currency exchange
Source of Risk regulatory factors. rates.
Impact on Can affect sales, Primarily affects the

Operations production, financial structure,
- Changes in consumer
Examples preferences. - Default risk on loans.
- Technological
disruptions. - Interest rate risk.
Aspect Business Risk Financial Risk
- Currency exchange
- Economic recessions. rate risk.
Management - Market research and - Optimal capital

Strategies strategic planning. structure decisions.
- Hedging against
- Innovation and interest rate or currency
adaptation. risks.
Primarily involves long-

Both short-term and long- term financial
Long-Term vs. term factors contribute to obligations and
Short-Term business risk. structures.
Businesses have some Management can make

control over certain decisions to alter the
Flexibility in internal factors affecting capital structure and
Control risk. financing mix.
Financial risk directly

Business risk can impact influences the company's
Relation to overall profitability and profitability and return
Profitability long-term sustainability. on equity.
Why financial leverage is called double edge

sword?
Financial leverage is often referred to as a "double-edged sword"

because, while it has the potential to magnify returns and enhance
profitability, it also increases the risk of larger losses. Here's why it's
considered a double-edged sword:
1. Amplification of Gains: When a company uses financial

leverage, it can amplify returns on equity. If the returns on
investments exceed the cost of borrowing, shareholders' equity
can grow at a faster rate, leading to higher returns for
shareholders.
2. Amplification of Losses: On the flip side, if the returns on
investments or operations are lower than the cost of borrowing,
financial leverage can magnify losses. This means that
shareholders may experience larger declines in equity when
compared to a scenario without leverage.
3. Interest Costs: Financial leverage involves borrowing funds,
and interest must be paid on this debt. If the returns generated
from the use of borrowed funds are not sufficient to cover the
interest costs, it can negatively impact profitability and
financial stability.
4. Risk of Financial Distress: High levels of financial leverage
increase the risk of financial distress. If a company is unable to
meet its debt obligations, it may face serious financial
consequences, including bankruptcy.
In short:
ROI > Interest rate Favourable FL
ROI = Interest rate Indifferent
ROI < interest rate Unfavourable
Similarly:
ROI > preference dividend Favourable FL
ROI = Preference dividend Indifferent
ROI < Preference dividend Unfavourable
What is trading on equity?

Trading on equity" refers to the practice of using borrowed funds
(typically in the form of debt) to finance investments or operations
with the aim of increasing the return on equity for shareholders. This
strategy is based on the idea that if the return on assets or

investments funded by debt exceeds the cost of borrowing,
shareholders' equity will grow at a faster rate.
Importance of Leverage:
1. Amplification of Returns:
• Importance: Leverage has the potential to amplify
returns on equity. By using borrowed funds, a company
can invest in projects or assets that have the potential for
higher returns than the cost of borrowing.
• Impact: This amplification can lead to increased
profitability and higher returns for shareholders.
2. Capital Efficiency:
• Importance: Leverage allows companies to achieve a
higher level of capital efficiency by using debt to finance a
portion of their operations or investments.
• Impact: This can be particularly beneficial when the
return on assets or investments funded by debt exceeds
the cost of borrowing.
3. Business Expansion:
• Importance: Leverage facilitates business expansion by
providing additional funds for investment in new projects,
acquisitions, or market expansion.
• Impact: It allows companies to seize growth opportunities
that may not have been feasible with only equity
financing.
4. Tax Shield:
• Importance: Interest payments on debt are often tax-
deductible, providing a tax shield.
• Impact: This can lead to a reduction in the overall tax

liability of a company, enhancing its after-tax
profitability.
5. Shareholder Value Creation:
• Importance: When used judiciously, leverage can
contribute to the creation of shareholder value by
increasing the return on equity.
• Impact: Shareholders may benefit from higher earnings
and capital appreciate.

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Sources of finance Notes

• Advantages: Offers lower interest rates, provides a way

Long term Sources of finance

• Meaning: Debt financing involves borrowing money that

Feature Shares Debentures

Nature of Represents ownership in Represents a debt

Returns are fixed

Lower risk, fixed

Common shares may be Some debentures may

Feature Owned Funds Borrowed Funds

Represents the capital

Feature Owned Funds Borrowed Funds

Originates from the

Owners typically have Lenders do not have

Generally, more flexible

Borrowed funds often

Owners' funds are

Theories on Capital Structure:

S = ESH/ Equity Capitalization Rate (Ke)

Cost of Capital (Ko) = EBIT/V

Net Operating Income (NOI) Approach

Traditional Theory Approach

3. Average cost of capital decreases for a certain level, remains

Modigliani-Miller (MM) Approach

MM Approach: (With NO Taxes)

MM Approach: (With Taxes)

Time Value of Money Notes

The time value of money (TVM) is a financial concept which means

Techniques/Methods to measure of TVM

The process of calculating The process of

To find the future value of a To find the present value

Present Value (PV) =

where r is the interest rate where r is the discount

Concerned with reducing

Aspect Compounding Discounting

Discounting future cash

Importance of TVM or Why there is need of Time

1. Comparing Cash Flows Over Time: TVM is essential for

How TVM helps in determining Sinking fund

Limited duration, cash

Ending Point No defined ending point Has a defined ending point;

Present Value (PV) = Present Value

Future Value (FV) =

Mortgage payments, lease

Working Capital Notes

Working capital is a fundamental concept in finance and

Types of Working Capital:

Difference between Matching, Aggressive and Conservative

Matching Aggressive Conservative

Maximize Ensure safety by

Risk Moderate risk Higher risk Low risk

Moderate Limited flexibility

Resources Resources held

Need for Working Capital:

• Supports effective cash flow management, ensuring that

Issues with Inadequate Working Capital:

Sources of Working Capital – How to earn

• Selling accounts receivable to a third party (factor) at a

13. Asset-Based Lending:

Main Types/kinds/Forms of Dividends:

• Payments made when a company is in the process of

Factors affecting / Determinants of