Financial Management II CH 1-5

Course Title: Financial Management-II
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Chapter 1
Leverage and Capital Structure Policy
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Chapter Outline
 Meaning of capital structure
 The capital structure question
 Factors that influence capital structure decisions
 Business and financial risk:
• Business risk and operating leverage
• Financial risk and financial leverage
 Determining the optimal capital structure
• EBIT/EPS analysis
• The effect of capital structure on stock price and the cost of capital
 Introduction to the theory of capital structure
• Modigliani and Miller Propositions, Trade-off theory, Signaling theory
• Using debt financing to constrain managers
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Meaning of capital structure
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Meaning of Capital Structure
 Capital structure (What?)

• Refers to the mix (or proportion) of a firm’s permanent long-term source of
financing represented by debt, preferred stock, and common equity that is used
to finance the firm’s assets.
• Represent the proportionate relationship between debt and equity (i.e. debt-
equity mix or ratio): where equity includes paid-up share capital, share premium
and reserves and surplus (retained earnings).
• The percentage of each type of investor-supplied capital, with the total being
100%.
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Meaning of Capital Structure
• The term capital refers to investor-supplied funds—debt, preferred stock, common
stock, and retained earnings and excludes current liabilities (except short-term
borrowings though traditionally excluded) such as accounts payable and accruals
because they come from normal operations, not as investments by investors.
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The Capital Structure Question
1. Why should the shareholders in the firm care about maximizing the value
of the entire firm (the sum of both the debt and the equity)? Instead, why
should the shareholders not prefer the strategy that maximizes their
interests only? Why should financial managers choose the capital
structure that maximizes the value of the firm?
2. How should a firm go about choosing its debt-equity ratio? Can financing
decisions create value?
3. What is an optimal capital structure or What is the ratio of debt to equity
that maximizes the shareholders’ interests?
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The Capital Structure Question…
• Suppose the market value of the Sprint Company is Br1,000. The company
currently has no debt, and Sprint’s 100 shares sell for Br10 each. Further suppose
that Sprint restructures itself by borrowing Br500 and then paying out the
proceeds to shareholders as an extra dividend of Br500/100 = Br5 per share.
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 What will be the final impact of the restructuring?
 Change in the value of the firm is the same as the net effect on the
stockholders
 Sprint should borrow Br500 if it expects Scenario I
 The capital structure that maximizes the value of the firm is the one financial
managers should choose for the shareholders.
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• The objective of a company is to maximize the value of the company and it is
prime objective while deciding the capital structure.
• Capital structure decisions refers to deciding:
1. the forms of financing (which sources to be tapped);
2. their actual requirements (amount to be funded); and
3. their relative proportions (mix) in total capitalization.
• Capital structure decision will decide weight of debt and equity and ultimately
overall cost of capital as well as the value of the firm. So capital structure is
relevant in maximizing value of the firm and minimizing overall cost of capital.
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Factors that influence capital structure
decisions/design – Determinants of
Capital Structure – Checklist of Items
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Factors that influence capital structure decisions
 Choice of source of funds
 a firm has the choice to raise funds for financing its investment proposals from
different sources in different proportions. It can:
a) exclusively use debt (in case of existing company), or
b) exclusively use equity capital, or
c) exclusively use preference share capital (in case of existing company), or
d) use a combination of debt and equity in different proportions, or
e) use a combination of debt, equity and preference capital in different
proportions, or
f) use a combination of debt and preference capital in different proportions (in
case of existing company).
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 Choice of source of funds…
 the choice of the combination of these sources is called capital structure
mix. But the question is which of the pattern should the firm choose?
 the capital structure of a firm depends on a number of factors and these
factors are of different importance.
 moreover, the influence of individual factors of a firm changes over a
period of time.
 generally, the following factors should be considered while determining
the capital structure of a company.
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• Sales growth and stability
 a firm whose sales are relatively stable can safely take on more debt and incur
higher fixed charges than a company with unstable sales.
• Asset structure (Cash flow ability)
 holding other factors constant, a company is able to take on more debt if it
has more cash on the balance sheet.
• Operating leverage/business risk
 other things the same, a firm with less operating leverage is better able to
employ financial leverage because it will have less business risk.
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Factors that influence capital structure decisions…
• Trading on equity and EBIT - EPS analysis (Financial risk)
 the use of long - term debt and preference share capital, which are fixed income
- bearing securities, along with equity share capital is called financial leverage or
trading on equity.
 the use of long-term debt capital increases the earnings per share (eps) as long
as the return on investment (roi) is greater than the cost of debt.
 preference share capital will also result in increasing EPS. But the leverage effect
is more pronounced in case of debt because of two reasons : i) cost of debt is
usually lower than the cost of preference share capital, and ii) the interest paid
on debt is tax deductible.
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• Trading on equity and EBIT - EPS analysis (Financial risk)…

 leverage is a two edged sword (needs caution) –producing highly favorable
results when things go well (i.e. the firm yields a return higher than the cost of
debt), and quite the opposite under unfavorable conditions (i.e. the rate of
return on long-term loan is more than the expected rate of earnings of the firm).
 the companies with high level of Earnings Before Interest and Taxes (EBIT) can
make profitable use of the high degree of leverage to increase the return on the
shareholders' equity.
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• Size of the firm
 Small firms
 find it very difficult to mobilise long - term debt, as they have to face higher rate of
interest and inconvenient terms; make their capital structure very inflexible and
depend on share capital and retained earnings for their long - term funds; cannot go to
the capital market frequently for the issue of equity shares, as it carries a greater
danger of loss of control over the firm to others; sometimes limit the growth of their
business and any additional fund requirements met through retained earnings only.
 Large firms
 has relative flexibility in capital structure designing; has the facility of obtaining long -
term debt at relatively lower rate of interest and convenient terms; have relatively an
easy access to the capital market.
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• Profitability.
 firms with very high rates of return on investment use relatively little debt, i.e.
their high rates of return enable them to do most of their financing with
internally generated funds.
• Growth rate.
 other things the same, faster-growing firms must rely more heavily on
external capital.
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• Taxes.
 interest is a deductible expense, and deductions are most valuable to firms
with high tax rates. Therefore, the higher a firm’s tax rate, the greater the
advantage of debt.
• Management attitudes.
 some managers tend to be relatively conservative and thus use less debt than
an average firm in the industry, whereas aggressive managers use a relatively
high percentage of debt in their quest for higher profits.
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• Market conditions.
 in the case of depressed conditions in the share market, the firm should not
issue equity shares but go for debt capital. On the other hand, under boom
conditions, it becomes easy for the firm to mobilise funds by issuing equity
shares.
• Control
 control considerations can lead to the use of debt or equity because the type
of capital that best protects management varies from situation to situation. In
any event, if management is at all insecure, it will consider the control situation
(e.g. risk of dilution, risk of bankruptcy and loss of job, risk of takeover, etc.).
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• Financial flexibility.
 flexibility means the firm's ability to adapt its capital structure to the needs of the
changing conditions.
 which from an operational viewpoint means maintaining adequate “reserve
borrowing capacity.”
 capital structure should be flexible enough to raise additional funds whenever
required, without much delay and cost.
 the capital structure of the firm must be designed in such a way that it is possible to
substitute one form of financing for another to economise the use of funds.
 preference shares and debentures offer the highest flexibility in the capital structure,
as they can be redeemed at the discretion of the firm.
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• Cost of capital
 an ideal pattern of capital structure is one that minimises cost of capital
structure and maximises earnings per share (EPS). The overall cost of capital
depends on the proportion in which the capital is mobilised from different
sources of finance.
• Legal requirements
 the various guidelines issued by the government from time to time regarding
the issue of shares and debentures should be kept in mind while determining
the capital structure of a firm.
 these legal restrictions are very significant as they give a framework within
which capital structure decisions should be made.
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• Other considerations
 Other factors such as nature of industry, timing of issue and competition in the
industry should also be considered. Industries facing sever competition also
resort to more equity than debt.
Hence, a finance manager in designing a suitable pattern of capital structure

must bring about satisfactory compromise among the foregoing factors. The
compromise can be reached by assigning weights to these factors in terms of
various characteristic of the firm.
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Leverage: Business Risk and Financial Risk
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I. Leverage
 Leverage & Capital Structure
• a sound financial decision must consider the broad coverage of the financial
mix (capital structure), total amount of capital (capitalization) and cost of
capital.
• deciding the debt-equity mix plays a major role in the part of the value of the
company and market value of the shares.
• the debt equity mix of the company can be examined with the help of
leverage.
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I. Leverage
 Meaning/Definition of Leverage
• in general it refers to an increased means of accomplishing some
purpose, e.g. is used to lifting heavy objects, which may not be
otherwise possible.
• in the financial point of view, leverage refers to furnish the ability to use
fixed cost assets or funds to increase the return to its shareholders.
• “the employment of an asset or fund for which the firm pays a fixed cost
or fixed return - James Horne
• influenced by managers choice of a specific capital structure.
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I. Leverage
 Meaning/Definition of Leverage…
• refers to the effects that fixed costs have on the returns that shareholders
earn.
• a firm with higher fixed costs has greater leverage, and vice versa.
• is the use of fixed costs in an attempt to increase (or lever up) profitability, i.e.
magnifies both returns and risks.
• a firm with more leverage may earn higher returns on average than a firm
with less leverage, but the returns on the more leveraged firm will also be
more volatile.
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I. Leverage
 Types of Leverage
• Leverage can be classified into three major headings according to the nature
of the finance mix of the company.
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I. Leverage
 Fixed costs
 Costs that do not rise and fall with changes in a firm’s sales.
 Must be paid irrespective of whether business conditions are good or bad.
 May be operating costs, such as the costs incurred by purchasing and operating
plant and equipment, or they may be financial costs, such as the fixed costs of
making debt payments.
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II. Business Risk and Operating Leverage
1. Meaning of Business Risk
 is the risk a firm’s common stockholders would face if the firm had no debt or
is debt-free or unlevered.
 is the risk inherent in the firm’s operations, which arises from uncertainty
about future operating profits and capital requirements.
 depends on a number of factors, beginning with variability in product demand
and production costs.
is the riskiness of the firm’s assets if no debt is used.
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II. Business Risk and Operating Leverage…
1. Meaning of Business Risk…
 the equity risk that comes from the nature of the firm’s operating activities.
 the variability of EBIT that has two components: variability of sales and
variability of expenses.
 operating risk is an unavoidable risk.
 the risk to the firm of being unable to cover its operating costs.
 in general, the greater the firm’s operating leverage—the use of fixed
operating costs—the higher its business risk.
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2. Factors that affect Business Risk
a.Competition - other things held constant, less competition lowers business risk.
b.Demand variability - the more stable the demand for a firm’s products, other
things held constant, the lower its business risk.
c. Sales price variability - firms whose products are sold in volatile markets are
exposed to more business risk than firms whose output prices are stable, other
things held constant.
d.Input cost variability - firms whose input costs are uncertain have higher
business risk.
e. Product obsolescence - the faster its products become obsolete, the greater a
firm’s business risk.
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2. Factors that affect Business Risk…
e. Foreign risk exposure - firms that generate a high percentage of their earnings
overseas are subject to earnings declines due to exchange rate fluctuations.
f. Regulatory risk and legal exposure - Firms that operate in highly regulated
industries such as financial services and utilities are subject to changes in the
regulatory environment that may have a profound effect on the company’s
current and future profitability.
g. The extent to which costs are fixed: operating leverage - if a high percentage
of its costs are fixed and thus do not decline when demand falls, this
increases the firm’s business risk.
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3. Meaning of Operating Leverage
 the extent to which fixed costs are used in a firm’s operations.
 a high degree of operating leverage, other factors held constant, implies that a
relatively small change in sales results in a large change in return on invested
capital (ROIC).
 other things held constant, the higher a firm’s operating leverage, the higher
its business risk.
 is associated with investment activities of the company.
 not affected by tax rate and interest rate.
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3. Meaning of Operating Leverage…
 is concerned with the relationship between the firm’s sales and its earnings
before interest and taxes (EBIT) or operating profits.
 when costs of operations (such as cost of goods sold and operating expenses)
are largely fixed, small changes in revenue will lead to much larger changes in
EBIT.
 the use of fixed operating costs to magnify the effects of changes in sales on
the firm’s earnings before interest and taxes.
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4. Measuring operating breakeven point
P = average sale price per unit;
Q = sales quantity in units;
FC = fixed operating cost per period;
VC = variable operating cost per unit
• where Q is the firm’s
operating breakeven point.
• Operating breakeven point
(in dollars/birr -
multiproduct firms is: (NB.
VC% total sales)
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4. Measuring operating breakeven point…
 Firms use breakeven analysis, also called cost-volume-profit analysis, to
1) determine the level of operations necessary to cover all costs, and
2) evaluate the profitability associated with various levels of sales.
 The firm’s operating breakeven point is the level of sales necessary to cover
all operating costs. At that point, earnings before interest and taxes (EBIT)
equals zero.
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4. Measuring operating breakeven point…
Example
Assume that ABC Co. has fixed operating costs of Birr2,500. Its sale price is
Birr10 per unit, and its variable operating cost is Birr5 per unit.
Q = 2,500__ = 500 units
Br10 - Br5
At sales of 500 units, the firm’s EBIT should just equal Br0. The firm will have
positive EBIT for sales greater than 500 units and negative EBIT, or a loss, for
sales less than 500 units.
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5. Measuring the Degree of Operating Leverage (DOL)
the degree of operating leverage (DOL) is a numerical measure of the firm’s
operating leverage. It can be derived using the equation:
a more direct formula for calculating the degree of operating leverage at a base
sales level, Q, is
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5. Measuring the Degree of Operating Leverage…
Example
Given the data for ABC Co. (sale price, P = Birr10 per unit; variable operating
cost, VC = Birr5 per unit; fixed operating cost, FC = Birr2,500) consider the
following two cases using the 1,000-unit sales level as a reference point:
Case 1 A 50% increase in sales (from 1,000 to 1,500 units) results in a 100%
increase in earnings before interest and taxes (from Birr2,500 to Birr5,000).
Case 2 A 50% decrease in sales (from 1,000 to 500 units) results in a 100%
decrease in earnings before interest and taxes (from Birr2,500 to Birr0).
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5. Measuring the Degree of Operating Leverage…
• Substituting Q = 1,000, P = Birr10,

VC = Birr5, and FC = Birr2,500
 the DOL value of 2.0 means that at

ABC a change in sales volume results
in an EBIT change that is twice as large
in percentage terms, e.g. a 50% change
in sales would lead to a 100% (50% * 2.0)
change in EBIT.
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III. Financial Risk and Financial Leverage
1. Financial risk
is the additional risk placed on the common stockholders as a result of
using debt or an increase in stockholders’ risk, over and above the firm’s
basic business risk, resulting from the use of financial leverage.
is an avoidable risk if the firm decides not to use any debt in its capital
structure, i.e. a totally equity financed firm will have no financial risk.
the variability of EPS caused by the use of financial leverage.
the equity risk that comes from the financial policy (the capital structure)
of the firm.
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2. Financial Leverage (Trading on Equity)
• is the use of fixed financial costs to magnify the effects of changes in earnings
before interest and taxes on the firm’s earnings per share, i.e. represents the
relationship between EBIT and EPS.
• refers to the extent to which a firm relies on debt, i.e. the more debt financing
a firm uses in its capital structure, the more financial leverage it employs.
• the two most common fixed financial costs are
1) interest on debt and
2) preferred stock dividends.
• is associated with financing activities of the company.
• will change due to tax rate and interest rate.
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3. Measuring the Degree of Financial Leverage (DFL)
 Whenever the percentage change in EPS resulting from a given percentage change
in EBIT is greater than the percentage change in EBIT, financial leverage exists. In
other words, whenever DFL is greater than 1, there is financial leverage.
 The effect of financial leverage is such that an increase in the firm’s EBIT results in a
more-than-proportional increase in the firm’s earnings per share, whereas a
decrease in the firm’s EBIT results in a more-than-proportional decrease in EPS.
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• Example
XYZ Co. expects EBIT of Birr10,000 in the current year. It has a Birr20,000 bond
with a 10% (annual) coupon rate of interest and an issue of 600 shares of Birr4
(annual dividend per share) preferred stock outstanding. It also has 1,000 shares
of common stock outstanding. The annual interest on the bond issue is Birr2,000
(0.10 * Birr20,000). The annual dividends on the preferred stock are Birr2,400
(Birr4.00/share * 600 shares). Consider the following two situations:
Case 1 A 40% increase in EBIT (from Birr10,000 to Birr14,000) results in a 100%
increase in earnings per share (from Birr2.40 to Birr4.80).
Case 2 A 40% decrease in EBIT (from Birr10,000 to Birr6,000) results in a 100%
decrease in earnings per share (from Birr2.40 to Birr0).
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 These calculations show that when XYZ Foods’ EBIT changes, its EPS changes
2.5 times as fast on a percentage basis due to the firm’s financial leverage. The
higher this value is, the greater the degree of financial leverage.
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• A more direct formula for calculating the degree of financial leverage at a base
level of EBIT is given by • Note that in the denominator the
term 1/(1 - T) converts the after-tax
preferred stock dividend to a before-
tax amount for consistency with the
• Example other terms in the equation.
Given: EBIT = Birr10,000, I = Birr2,000,
PD = Birr2,400, and the tax rate (T = 0.40)
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IV. Relationship of Operating and Financial Leverage
 Total (or Combined) Leverage
 the use of fixed costs, both operating and financial, to magnify the effects
of changes in sales on the firm’s earnings per share.
 the total impact of the fixed costs in the firm’s operating and financial
structure.
 is the combined effect of operating and financial leverage.
 concerned with the relationship between the firm’s sales revenue and EPS.
 Relationship of Operating, Financial, and Total Leverage
 the relationship between operating leverage and financial leverage is
multiplicative rather than additive.
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 Relationship of Operating, Financial, and Total Leverage…
 the relationship between the degree of total leverage (DTL) and the
degrees of operating leverage (DOL) and financial leverage (DFL) is given
by:
 a more direct formula for calculating the degree of total leverage at a
given base level of sales, Q, is given by the following equation.
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 Relationship of Operating, Financial, and Total Leverage…
Example
Given Q = 20,000, P = $5, VC = $2, FC = $10,000, I = $20,000, PD = $12,000, and
the tax rate (T = 0.40) yields DTL at 20,000 units is:
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Determining the optimal capital structure
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I. Definition of the Optimal Capital Structure
Capital Structure Decision
Designing an
Capital Structure Theories
Optimal Capital Structure
Modigliani- Miller (MM) theory
EBIT- EPS Analysis
Trade-off theory
Signaling theory
…
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• Definition
 an optimum capital structure may be defined as that combination of debt and
equity that maximize the total value of the firm or minimises the weighted
average cost of capital.
 the value of the firm is maximized when the cost of capital is minimized, i.e. the
present value of future cash flows is at its highest when the discount rate (the
cost of capital) is at its lowest.
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• Definition …
 the capital structure that maximizes a stock’s intrinsic value (the present value
of future cash flows).
 is the one that maximizes the price of the firm’s stock, and this generally calls
for a Debt/Capital ratio that is lower than the one that maximizes expected EPS.
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• Definition…
 a particular debt-equity ratio represents the optimal capital structure if it
results in the lowest possible WACC.
 this optimal capital structure is sometimes called the firm’s target capital
structure as well.
 many managers use the estimated relationship between capital structure and
the WACC to guide their capital structure decisions.
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II. EBIT/EPS analysis/approach to Capital Structure
 EBIT/EPS
 an approach for selecting the capital structure that maximizes earnings per
share (EPS) over the expected range of earnings before interest and taxes
(EBIT).
 is one important tool in the hands of the financial manager to get an insight
into the firm's capital structure planning. He can analyse the possible
fluctuations in EBIT and their impact on EPS under different financing plans.
 the firm should employ debt to such an extent that financial risk does not
spoil the leverage effect since under favourable conditions, financial leverage
increases EPS, however it can also increase financial risk to shareholders.
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 EBIT/EPS…
 the goal of the financial manager is to maximize owner wealth, that is, the
firm’s stock price. One of the widely followed variables affecting the firm’s stock
price is its earnings, which represents the returns earned on behalf of owners.
 even though focusing on earnings ignores risk (the other key variable affecting
the firm’s stock price), earnings per share (EPS) can be conveniently used to
analyze alternative capital structures.
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Example
ABC Company’s current capital structure is as follows:
Current capital structure
Long-term debt $0
Common stock equity (25,000 shares at $20) 500,000
Total capital (assets) $ 500,000
Let us assume that the firm is considering three alternative capital structures. If we measure
these structures using the debt ratio, they are associated with ratios of 0%, 30%, and 60%.
Assuming that (1) the firm has no current liabilities, (2) its capital structure currently contains
all equity as shown, and (3) the total amount of capital remains constant at $500,000.
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Example…
Calculation of EPS for Selected Debt Ratios
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Example…
Calculation of EPS for Selected Debt Ratios
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• An algebraic technique can be used to find the indifference points between
the capital structure alternatives.
Comparing ABC Company’s 0% and 30% capital structures, we get
 The calculated value of

the indifference point
between the 0% and
30% capital structures
is therefore $50,000.
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• Interpretation/Analysis
 ABC Co.’s capital structure alternatives were plotted on the EBIT–EPS axes. This
figure shows that each capital structure is superior to the others in terms of
maximizing EPS over certain ranges of EBIT.
 Having no debt at all (debt ratio = 0%) is best for levels of EBIT between $0 and
$50,000. That conclusion makes sense because when business conditions are
relatively weak, ABC would have difficulty meeting its financial obligations if it had
any debt.
 Between $50,000 and $95,500 of EBIT, the capital structure associated with a debt
ratio of 30% produces higher EPS than either of the other two capital structures.
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• Interpretation/Analysis…
 When EBIT exceeds $95,500, the 60% debt ratio capital structure provides the
highest earnings per share. Again, the intuition behind this result is fairly
straightforward. When business is booming, the best thing for shareholders is for
the firm to use a great deal of debt. The firm pays lenders a relatively low rate of
return, and the shareholders keep the rest.
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• Considering risk in EBIT–EPS analysis
 Graphically, the risk of each capital structure can be viewed in light of two
measures:
1. the financial breakeven point (EBIT-axis intercept) and
2. the degree of financial leverage reflected in the slope of the capital structure
line: the higher the financial breakeven point and the steeper the slope of
the capital structure line, the greater the financial risk.
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• Further assessment of risk can be performed by using ratios. As financial
leverage (measured by the debt ratio) increases, we expect a corresponding
decline in the firm’s ability to make scheduled interest payments (measured
by the times interest earned ratio).
• Reviewing the three capital structures plotted for ABC Co. we can see that as
the debt ratio increases, so does the financial risk of each alternative. Both
the financial breakeven point and the slope of the capital structure lines
increase with increasing debt ratios.
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• If we use the $100,000 EBIT value, for example, the times interest earned
ratio (EBIT ÷ interest) for the zero-leverage capital structure is infinity
($100,000 4 $0); for the 30% debt case, it is 6.67 ($100,000 ÷ $15,000); and
for the 60% debt case, it is 2.02 ($100,000 ÷ $49,500). Because lower times
interest earned ratios reflect higher risk, these ratios support the conclusion
that the risk of the capital structures increases with increasing financial
leverage. The capital structure for a debt ratio of 60% is riskier than that for a
debt ratio of 30%, which in turn is riskier than the capital structure for a debt
ratio of 0%.
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III. The effect of capital structure on stock price and
the cost of capital
• Capital structure and Stock price
Difficult to predict the effect of changes in capital structure on stock price.
Capital structure that maximizes the stock price also minimizes the WACC.
• Capital structure and Cost of Capital
Increases in the Debt/Capital ratio increases the costs of both debt and
equity. Hence,
WACC = wd*(rd)*(1-T) + wc(rs); where wd and wc represent the percentage
of debt and equity in the firm’s capital structure that sum to 1.
Bondholders recognize that if a firm has a higher Debt/Capital ratio, this
increases the risk of financial distress which leads to higher interest rates.
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Introduction to Capital Structure Theories
&
Using debt financing to constrain managers
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I. Introduction - Capital Structure Theories
• Capital structure theories explain the relationship between cost of capital,
capital structure and value of the firm.
• The existence of an optimum capital structure is not accepted by all. There are
two extreme views or schools of thought regarding the existence of an optimum
capital structure.
1. Capital structure relevance theory: capital structure influences the value of
the firm and cost of capital and hence there exists an optimum capital
structure.
2. Capital structure irrelevance theory: advocates that capital structure has no
relevance and it does not influence the value of the firm and cost of capital.
• Reflecting these views, different theories of capital structure have been
developed.
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 Assumptions Underlying the Theories:
 In order to have a clear understanding of these theories and the relationship
between capital structure and value of the firm or cost of capital, the following
assumptions are made :
a. Firms employ only debt and equity.
b.The total assets of the firm are given.
c. The firm's total financing remains constant. The degree of leverage can be
changed by selling debt to repurchase shares or selling shares to retire debt.
d.The firm has 100% payout ratio, i.e., it pays 100% of its earnings as dividends.
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 Assumptions Underlying the Theories…
e. The firm has perpetual life.
f. The operating earnings (EBIT) of the firm are not expected to grow.
g. The business risk is assumed to be constant and independent of capital
structure and financial risk.
h. Investors have the same subjective probability distribution of expected
future operating earnings for a given firm.
i. There are no corporate and personal taxes. This assumption is relaxed later.
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1. Modigliani and Miller Approach/Propositions
• Modern capital structure theory began in 1958 with Professors Franco
Modigliani and Merton Miller (hereafter, MM).
• MM approach provides behavioural justification for constant overall cost of
capital and, therefore, total value of the firm.
MM Approach – 1958: without tax
• MM Approach
MM Approach – 1963: with tax
73
a) MM Approach – 1958: without tax
 Assumptions of the MM Approach:
 There is a perfect capital market. Capital markets are perfect when i) investors are
free to buy and sell securities, ii) they can borrow funds without restriction at the
same terms as the firms do, iii) they behave rationally, iv) they are well informed (all
investors have the same/complete information as management), and v) there are no
transaction/brokerage costs
 There are no bankruptcy costs/No default risk.
 There are no corporate taxes. This assumption has been removed/relaxed later.
 Perpetual cash flow
74
 MM Proposition I: VL = VU (the value of the levered firm equals/is the same as the
value of the unlevered firm)
 Intuition: Through homemade leverage, individuals can either duplicate or undo
the effects of corporate leverage.
 for the firms in the same risk class, the total market value is independent of capital
structure and is determined by capitalising net operating income by the rate
appropriate to that risk class.
 MV of Firm (V) = MV of Equity (S) + MV of Debt (D) = Net Operating Income (NOI)/K0
 the average cost of capital is not affected (i.e. constant) by degree of leverage and is
determined as follows: K0 = Cost of capital = NOI/V
75
 MM Proposition I…
 Arbitrage process - if levered firms are priced too high, rational investors will
arbitrage by borrowing on their personal accounts to buy shares in unlevered firms.
This substitution is often called homemade leverage; or investors replicate the firm’s
proposed capital structure or debt-equity ratio (i.e. at company level) at the personal
level.
 Because of this arbitrage process, the market price of securities in higher valued
market will come down and the market price of securities in the lower valued market
will go up, and this switching process is continued until the equilibrium is established
in the market values.
76
 MM Proposition I…
 view the capital structure (RHS) question in terms of a “pie” model, i.e. given for two
firms with identical on the left side of the balance sheet (i.e. their assets and
operations are exactly the same); the right sides are different because the two firms
finance their operations differently; the size of the pie is the same for both firms
because the value of the assets is the same; thus the size of the pie doesn’t depend
on how it is sliced.
77
MM Proposition II: rS = r0 + B/S (r0 - rB)
 Intuition: The cost of equity rises with leverage, because the risk to
equity rises with leverage. (required return/risk to equity holders rises with
leverage).
 Although changing the capital structure of the firm does not change the firm’s
total value, it does cause important changes in the firm’s debt and equity.
 Proposes that a firm’s cost of equity capital is a positive linear function of the
firm’s capital structure.
78
MM Proposition II: rS = r0 + B/S (r0 - rB)...
 defines the cost of equity, for any firm in a given risk class, is equal to the
constant average cost of capital (r0) plus a premium for the financial risk, which
is equal to debt - equity ratio, times the spread between average cost and cost
of debt. Thus, cost of equity is: rS = r0 + B/S (r0 - rB) where r0 can be substituted
for rA (required return on the firm’s overall assets) producing: rS = rA + B/S (r0 -
rB). Thus the cost of equity depends on three things: 1)The required rate of
return on the firm’s assets, rA; 2)the firm’s cost of debt, rB; and 3)the firm’s
debt-equity ratio, B/S.
79
 MM Proposition II: rS = r0 + B/S (r0 - rB)...
 The firm’s overall cost of capital, K, will not increase
with the increase in the leverage, because the low –
cost advantage of debt capital will be exactly offset
by the increase in the cost of equity as caused by
increased risk to equity shareholders due to
borrowing. In other words, the change in the capital
structure weights (E/V and D/V) is exactly offset by
the change in the cost of equity (rS), so the WACC
stays the same.
80
MM Proposition II: rS = r0 + B/S (r0 - rB)...
Example:
 A Co. has a weighted average cost of capital (ignoring taxes) of 12%. It can
borrow at 8%. Assuming that the Co. has a target capital structure of 80%
equity and 20% debt, what is its cost of equity? What is the cost of equity if the
target capital structure is 50% equity? Calculate the WACC using your answers
to verify that it is the same.
 According to MM II, the cost of equity, RE, is: RE = RA + (RA − RD ) × (D / E )
 In the first case, the debt-equity ratio is .2/.8 = .25, so the cost of the equity is:
RE = .12 + (.12 − .08) × .25 = .13, or 13%.
81
 MM Proposition II: rS = r0 + B/S (r0 - rB)...
 In the second case, verify that the debt-equity ratio is 1.0, so the cost of equity is
16%. RE = .12 + (.12 − .08) × 1.0 = .16, or 16%.
 Now calculate the WACC assuming that the percentage of equity financing is 80%,
the cost of equity is 13%, and the tax rate is zero: WACC = (E / V) × RE + (D / V) × RD
= .80 × .13 + .20 × .08 = .12, or 12%
 In the second case, the percentage of equity financing is 50% and the cost of
equity is 16%. The WACC is: WACC = (E / V) × RE + (D / V) × RD = .50 × .16 + .50 × .08
= .12, or 12%
 As calculated, the WACC is 12% in both cases.
82
b) MM Approach – 1958: with tax
 MM later recognised ,the importance of the existence of corporate taxes.
 the value of the firm will increase or the cost of capital will decrease with the
use of debt due to tax deductibility of interest charges.
 the optimum capital structure can be achieved by maximising debt component
in the capital structure.
 MM Proposition I (with taxes)
 The value of the firm levered (VL) is equal to the value of the firm unlevered
(VU) plus the present value of the interest tax shield: VL = VU + TC × D
 where TC is the corporate tax rate and D is the amount of debt.
83
 MM Proposition I (with taxes)…
 Implications of Proposition I: (1) Debt financing is highly advantageous, and, in
the extreme, a firm’s optimal capital structure is 100 percent debt. (2) A firm’s
weighted average cost of capital (WACC) decreases as the firm relies more
heavily on debt financing.
 Given/Assume:
 EBIT is expected to be Br1,000 every year forever for both firms (L & U).
 Firm L has issued Br1,000 worth of perpetual bonds with 8% interest each
year (i.e. pays Br80 interest every year forever). The tax rate is 21%.
84
 the net income for firms U & L is:
 The cash flow from assets is equal to EBIT –
Taxes assuming that depreciation is zero;
capital spending is zero and that there are
no changes in NWC for firms U and L:  the cash flow to stockholders and
bondholders is:
 Firm L has Br16.80 more total cash flow due

 to the tax savings/ the interest tax shield = Br80 × .21 = Br16.80.
85
 the present value (PV) of the tax shield is: PV = Br16.80/.08 = (.21 × Br1,000 ×
.08)/.08 = .21 × Br1,000 = Br210.
 because the tax shield is generated by paying interest, it has the same risk as
the debt, and 8% (the cost of debt) is the appropriate discount rate.
 Present value of the interest tax shield = (TC × D × RD) / RD = TC × D
 VL = VU + TC × D. if the cost of capital for Firm U is 10%, then
 VU = (EBIT × (1 − TC))/RU = Br790/.10 = Br7,900
 VL = VU + TC × D = Br7,900 + .21 × 1,000 = Br8,110
86
 MM Proposition II (with taxes)
 The cost of equity, RE, is: RE = RU + (RU − RD) × (D/E ) × (1 − TC)
 where RU is the unlevered cost of capital—that is, the cost of capital for the
firm if it has no debt. Unlike the case with Proposition I, the general
implications of Proposition II are the same whether or not there are taxes.
 Given the following information for the Format Co.:
 EBIT = Br126.58; TC = .21; D = Br500; RU = .20; The cost of debt capital is
10%. What is the value of Format’s equity? What is the cost of equity capital
for Format? What is the WACC?
87
 MM Proposition II (with taxes)
 The V of the firm if it has no debt is: VU = (EBIT − Taxes)/RU = (EBIT × (1 − TC))/RU
 = Br100/.20= Br500
 From MM Proposition I with taxes, the value of the firm with debt is: VL = VU + TC ×
D= Br500 + .21 × Br500= Br605.
 Because the firm is worth Br605 total and the debt is worth Br500, the equity is
worth Br105:E = VL − D= Br605 − 500= Br105.
 Based on MM Proposition II with taxes, the cost of equity is:
 RE = RU + ( RU − RD) × (D / E) × (1 − TC)= .20 + (.20 − .10) × (500 / 105) × (1 − .21)=
.5762, or 57.62%
 Finally, the WACC is: WACC = (105 /605) × .5762 + (500 /605) × .10 × (1 − .21)
 = .1653, or 16.53%; hence this is lower than the cost of capital for the firm with no
debt (RU = 20%), so debt financing is advantageous
88
I. Introduction to the theory of capital structure
2. Trade-off theory (also called “the trade-off theory of leverage.” )
 The capital structure theory that states that firms trade off the tax benefits of
debt financing against problems caused by potential bankruptcy.
89
2. Trade-off theory (also called “the trade-off theory of leverage.” )…
 There is some threshold level of debt, labeled D1 below which the probability of
bankruptcy is so low as to be immaterial. Beyond D1, however, bankruptcy-related costs
become increasingly important, and they begin to offset the tax benefits of debt. In the
range from D1 to D2, bankruptcy-related costs reduce but do not completely offset the tax
benefits of debt, so the firm’s stock price continues to rise (but at a decreasing rate) as its
debt ratio increases. However, beyond D2, bankruptcy-related costs exceed the tax
benefits, so from this point on, increasing the debt ratio lowers the stock price. Therefore,
D2 is the optimal capital structure, the one where the stock price is maximized.
 Another disturbing aspect of capital structure theory expressed in the foregoing figure is
the fact that many large, successful firms such as Intel and Microsoft use far less debt than
the theory suggests. This point led to the development of signaling theory.
90
3. Signaling theory
 Information asymmetry - The situation where managers have different (better)
information about firms’ prospects than do investors. contrary to MM
assumption of information symmetry.
 Signal - An action taken by a firm’s management that provides clues to
investors about how management views the firm’s prospects.
 a firm with very favorable prospects would be expected to avoid selling stock
and instead raise any required new capital by using new debt, even if this
moved its debt ratio beyond the target level.
 a firm with unfavorable prospects would want to finance with stock, which
would mean bringing in new investors to share the losses.
 the announcement of a stock offering is generally taken as a signal that the
firm’s prospects as seen by its management are not bright.
91
3. Signaling theory
 What are the implications of all this for capital structure decisions? Issuing
stock emits a negative signal and thus tends to depress the stock price; even if
the company’s prospects are bright, a firm should, in normal times, maintain a
reserve borrowing capacity that can be used in the event that some especially
good investment opportunity comes along. This means that firms should, in
normal times, use more equity and less debt than is suggested by the tax
benefit/bankruptcy cost trade-off model.
 Firms often use less debt than specified by the MM optimal capital structure in
“normal” times to ensure that they can obtain debt capital later if necessary.
92
II. Using debt financing to constrain managers
• Conflicts of interest between managers and shareholders are particularly likely when the
firm has more cash than is needed to support its core operations.
Managers often use excess cash to finance their pet projects or for perquisites such as plush
offices, corporate jets,… all of which may do little to benefit stock prices.
By contrast, managers with more limited free cash flow are less able to make wasteful
expenditures.
• Firms can reduce excess cash flow in a variety of ways.
to funnel some of it back to shareholders through higher dividends or stock repurchases.
to tilt the target capital structure toward more debt in the hope that higher debt service
requirements will force managers to become more disciplined (i.e. if debt is not serviced
as required, the firm will be forced into bankruptcy, in which case its managers would
lose their jobs. Therefore, a manager is less likely to buy an expensive corporate jet if the
firm has large debt service requirements).
93
II. Using debt financing to constrain managers
a leveraged buyout (LBO) is a good way to reduce excess cash flow. High debt
payments after the LBO force managers to conserve cash by eliminating unnecessary
expenditures.
• Of course, increasing debt and reducing free cash flow has its downside: It increases
the risk of bankruptcy. Higher debt forces managers to be more careful with
shareholders’ money, but even well-run firms can face bankruptcy (get stabbed) if
some event beyond their control, such as a war, an earthquake, a strike, or a
recession, occurs.
• The capital structure decision comes down to deciding how big a dagger (i.e. the
analogy - adding debt to a firm’s capital structure is like putting a dagger into the
steering wheel of a car) stockholders should use to keep managers in line.
94
End of Chapter 1 – Part 1
95
CHAPTER. 02
DIVIDEND/PAYOUT POLICY
14-1
Chapter Outline
I. Dividend theories
II. Factors influencing dividend policy
III. Establishing the dividend policy in practice
02-2
The Basics/Elements of Payout Policy
The term payout policy refers to the decisions that a firm

makes regarding:
whether to distribute cash to shareholders,
how much cash to distribute, and
the means by which cash should be distributed.
The decision to pay out earnings versus retaining and
reinvesting them. The options range from nothing to
everything.
02-3
 Dividend Decision
is a choice made by management on behalf of those stockholders
about what to do with their earnings.
theoretically, there are only two alternatives:
a) Earnings can be paid out as dividends (gives stockholders
current income) or
b) retained for reinvestment/growth in the business (retaining
earnings produces deferred income). Both options benefit
stockholders, but in different ways.
is the choice between paying more or less in near-term dividends,
i.e. implying trading off between the two stockholder benefits.
it is not a question of whether the stockholder gets a dividend or
gets nothing.
02-4
Background - Dividends as a Basis for Value

The relationship between dividends and value can be
viewed from the perspective of an individual investor or
from that of the market as a whole.
02-5
• The optimal dividend policy should maximize the price of

the firm’s stock holding the number of shares outstanding
constant. D1
P0 
ke  g
• A decision to increase dividends will raise D1 putting upward

pressure on P0. Increasing dividends, however, means
reinvesting fewer dollars, lowering g, and putting downward
pressure on P0.
• Problem: What is the correct balance between dividends
and retained earnings?
02-6
Dividend Controversy/Conflicting Theories
• The dividend controversy is whether paying or not paying

dividends affects stock price.
• The financial literature has reported numerous theories and
empirical findings concerning payout policy. None of them are
entirely right or wrong.
• The most important question about payout policy is this: Does
payout policy have a significant effect on the value of a firm?
i.e. the central issue about dividends is whether paying them
or paying larger rather than smaller dividends has a positive,
negative, or neutral effect on a firm’s stock price.
02-7
Dividend Controversy/Conflicting Theories
• The question can also be stated in terms of stockholder

preferences.
Do shareholders prefer current or deferred income?
Presumably, doing what they prefer will make a stock more
desirable, and its price will be bid up to some extent.
In other words, we’d like to know whether it’s generally
possible for management to partially accomplish the goal of
maximizing shareholder wealth by manipulating the firm’s
dividend-paying policy.
02-8
Relevance of Payout Policy
I. Dividend Irrelevance
a) The Residual Theory of Dividends
is a school of thought that suggests that the dividend paid by a
firm should be viewed as a residual—the amount left over after
all acceptable/viable investment opportunities have been
undertaken.
using this theory, the firm would treat the dividend decision in
three steps, as follows:
1. Determine its optimal level of capital expenditures, which
would be the level that exploits all of a firm’s positive NPV
projects.
2. Using the optimal capital structure proportions, estimate the
total amount of equity financing needed to support the
expenditures generated in Step 1.
02-9
I. Dividend Irrelevance…
a) The Residual Theory…
3. Because the cost of RE, rr, is less than the cost of new
common stock, rn, use REs to meet the equity requirement
determined in Step 2. If REs are inadequate to meet this
need, sell new common stock. If the available REs are in
excess of this need, distribute the surplus amount—the
residual—as dividends.
 This view of dividends suggests that the required return of
investors, rs, is not influenced by the firm’s dividend policy, a
premise that in turn implies that dividend policy is irrelevant in
the sense that it does not affect firm value.
02-10
b) The Miller and Modigliani Theory
 in a perfect world (certainty, no taxes, no transactions costs, and
no other market imperfections), the firm’s value is determined
solely by the earning power and risk of its assets (investments)
and that the manner in which it splits its earnings stream
between dividends and internally retained (and reinvested)
funds does not affect the value of the firm.
under dividend irrelevance the value of eliminated dividends is
offset by growth created value in the future.
based on the homemade dividend argument, dividend policy is
irrelevant

02-11
Homemade dividends
• Suppose individual Investor X prefers dividends per share of $100 at
both Dates 1 and 2. Would she be disappointed if informed that the
firm’s management was adopting the alternative dividend policy
(dividends of $110 and $89 on the two dates, respectively)?
• Not necessarily; she could easily reinvest the $10 of unneeded funds
received on Date 1 by buying more Wharton stock
• At 10%, this investment would grow to $11 by Date 2; investor X would
receive her desired net cash flow of $110 − 10 = $100 at Date 1 and $89
+ 11 = $100 at Date 2
• Imagine Investor Z, preferring $110 of cash flow at Date 1 and $89 of
cash flow at Date 2, finds that management will pay dividends of $100
at both Dates 1 and 2
• This investor can sell $10 worth of stock to boost his total cash at Date 1
to $110; because this investment returns 10%, Investor Z gives up $11
at Date 2 (= $10 × 1.1), leaving $100 − 11 = $89
• Our two investors can transform the corporation’s dividend policy into a
different policy by buying or selling on their own, resulting in a
homemade dividend policy
02-12
Modigliani-Miller
• Modigliani-Miller support irrelevance.

• Investors are indifferent between dividends and retention-
generated capital gains.
• If the firm’s cash dividend is too big, you can just take the
excess cash received and use it to buy more of the firm’s
stock. If the cash dividend is too small, you can just sell a
little bit of your stock in the firm to get the cash flow you
want.
• Theory is based on unrealistic assumptions (no taxes or
brokerage costs), hence may not be true. Need empirical
test.
02-13
c) The Clientele Effect
The clientele effect is the argument that different payout
policies attract different types of investors but still do not
change the value of the firm.
• Each company develops a clientele of investors whose needs
match its dividend paying characteristics, hence, the term
clientele effect.
• Tax-exempt investors may invest more heavily in firms that
pay dividends because they are not affected by the typically
higher tax rates on dividends.
02-14
c) The Clientele Effect…
• Investors who would have to pay higher taxes on dividends
may prefer to invest in firms that retain more earnings
rather than paying dividends.
• If a firm changes its payout policy, the value of the firm will
not change—what will change is the type of investor who
holds the firm’s shares.
• The clientele effect maintains that investors choose stocks
for dividend policy, so any change in payments is disruptive.
02-15
c) The Clientele Effect…
Companies with high payouts will attract one group, and
low-payout companies will attract another
• Some groups (e.g., wealthy individuals) have an incentive
to pursue low-payout (or zero-payout) stocks
• Other groups (e.g., corporations) have an incentive to
pursue high-payout stocks
Clientele effect argument states that stocks attract
particular groups based on dividend yield and the resulting
tax effects
02-16
II. Dividend Relevance Arguments
Dividend relevance theory is the theory, advanced by Gordon
and Lintner, that there is a direct relationship between a firm’s
dividend policy and its market value.
a) Dividend preference/Bird-in-the-hand argument/theory
is the belief, in support of dividend relevance theory which
maintains that generally stockholders prefer receiving
dividends to not receiving them.
the argument is based on the uncertainty of the future (is not
a time value of money argument).
02-17
II. Dividend Relevance Arguments…
a) Dividend preference/Bird-in-the-hand theory…
it asserts that stockholders prefer current dividends to future
capital gains, because something paid today is more certain to
be received than something expected in the future.
investors see current dividends as less risky than future
dividends or capital gains.
dividends are less risky, thus, high dividend payout ratios will
lower ke (reducing the cost of capital), and increase stock price.
Because of the desire for current income and related factors
(e.g. Resolution of uncertainty), a high-dividend policy is best.
02-18

b) The Signaling Effect/Information Content of Dividends
 Information content effect is the market’s reaction to a
change in corporate dividend payout
 Informational content is the information provided by the
dividends of a firm with respect to future earnings, which
causes owners to bid up or down the price of the firm’s stock.
 The agency cost theory says that a firm that commits to
paying dividends is reassuring shareholders that managers
will not waste their money.
 Studies have shown that large changes in dividends do affect
share price.
02-19

b) The Signaling Effect/Information Content…
Managers hate to cut dividends, so they won’t raise
dividends unless they think raise is sustainable. So, investors
view dividend increases as signals of management’s view of
the future.
Generally, stock prices rise when the current dividend is
unexpectedly increased, and they fall when the dividend
is unexpectedly decreased
The fact that dividend changes convey information about
the firm to the market makes it difficult to interpret the
effect of the dividend policy of the firm
02-20
c) Tax Preference Theory
• Retained earnings lead to long-term capital gains, which are

taxed at lower rates than dividends: 20% vs. up to 39.6%.
Capital gains taxes are also deferred.
• This could cause investors to prefer firms with low payouts,

i.e., a high payout results in a low P0.
02-21
Possible Stock Price Effects
Stock Price ($)
Bird-in-Hand
40
30 Irrelevance
20
Tax preference
10
0 50% 100% Payout
14-22
Possible Cost of Equity Effects
Cost of equity (%)

Tax Preference
20
15 Irrelevance
10 Bird-in-Hand
0 50% 100% Payout
14-23
Implications of 3 Theories for Managers
Theory Implication
Irrelevance Any payout OK
Bird in the hand Set high payout
Tax preference Set low payout
But which, if any, is correct???

24
Which theory is most correct?
• empirical studies/testing have not provided evidence that

conclusively settles the debate about whether and how payout
policy affects firm value or determine which theory, if any, is
correct.
• thus, managers use judgment when setting policy.
• analysis is used, but it must be applied with judgment.
02-25
Factors Affecting Dividend Policy
• Real-world Factors Favoring a High/Low Dividend Payout

• Dividend policy represents the firm’s plan of action to be
followed whenever it makes a dividend decision.
• First consider five factors in establishing a dividend policy:
1. legal constraints
2. contractual constraints
3. the firm’s growth prospects
4. owner considerations
5. market considerations
02-26
Legal Constraints
Most states prohibit corporations from paying out as cash
dividends any portion of the firm’s “legal capital,” which is
typically measured by the par value of common stock.
These capital impairment restrictions are generally established
to provide a sufficient equity base to protect creditors’ claims.
If a firm has overdue liabilities or is legally insolvent or
bankrupt, most states prohibit its payment of cash dividends.
02-27
Contractual Constraints
Often the firm’s ability to pay cash dividends is constrained by
restrictive provisions in a loan agreement.
Generally, these constraints prohibit the payment of cash
dividends until the firm achieves a certain level of earnings, or
they may limit dividends to a certain dollar amount or
percentage of earnings.
Constraints on dividends help to protect creditors from losses
due to the firm’s insolvency.
02-28
Growth Prospects
A growth firm is likely to have to depend heavily on internal
financing through retained earnings, so it is likely to pay out
only a very small percentage of its earnings as dividends.
A more established firm is in a better position to pay out a
large proportion of its earnings, particularly if it has ready
sources of financing.
02-29
Owner Considerations
Tax status of a firm’s owners: If a firm has a large percentage of
wealthy stockholders who have sizable incomes, it may decide
to pay out a lower percentage of its earnings to allow the
owners to delay the payment of taxes until they sell the stock.
Owners’ investment opportunities: If it appears that the
owners have better opportunities externally, the firm should
pay out a higher percentage of its earnings.
Potential dilution of ownership: If a firm pays out a high
percentage of earnings, new equity capital will have to be
raised with common stock. The result of a new stock issue may
be dilution of both control and earnings for the existing
owners.
02-30
Market Considerations
Catering theory is a theory that says firms cater to the
preferences of investors, initiating or increasing dividend
payments during periods in which high-dividend stocks are
particularly appealing to investors.
02-31
Types of Dividend Policies
Constant-Payout-Ratio Dividend Policy
A firm’s dividend payout ratio indicates the percentage of

each dollar earned that a firm distributes to the owners in
the form of cash. It is calculated by dividing the firm’s cash
dividend per share by its earnings per share.
A constant-payout-ratio dividend policy is a dividend policy

based on the payment of a certain percentage of earnings to
owners in each dividend period.
02-32
 Regular Dividend Policy

Regular dividend policy is a dividend policy based on the
payment of a fixed-dollar dividend in each period.
A regular dividend policy is often build around a target dividend-
payout ratio, which is a dividend policy under which the firm
attempts to pay out a certain percentage of earnings as a stated
dollar dividend and adjusts that dividend toward a target payout
as proven earnings increases occur.
02-33
Low-Regular-and-Extra Dividend Policy

A low-regular-and-extra dividend policy is a dividend policy
based on paying a low regular dividend, supplemented by an
additional (“extra”) dividend when earnings are higher than
normal in a given period.
An extra dividend is an additional dividend optionally paid
by the firm when earnings are higher than normal in a given
period.
02-34
A test
1. True or false: Dividends are irrelevant

• False
• Investors prefer higher dividends to lower dividends at any
single date if the dividend level is held constant at every other
date
2. True or false: Dividend policy is irrelevant

• True, at least in the simple case
• Dividend policy by itself cannot raise the dividend at one date
while keeping it the same at all other dates; rather, dividend
policy merely establishes the trade-off between dividends at
one date and dividends at another date
02-35
CHAPTER 3
Financial Forecasting & Planning
14-1
Chapter Outline
I. Financial forecasting Vs Financial Planning
II. Importance of sales forecasting
III. The financial planning process
IV. Methods of forecasting financial statements

• Percentage of sales method
• Pro-forma financial statement method
V. The EFR (External Fund Required( Formula

02-2
Financial planning
Definition - Financial planning is a process consisting of:

1. Analyzing the investment and financing choices open to
the firm.
2. Projecting the future consequences of current decisions.
3. Deciding which alternatives to undertake.
4. Measuring subsequent performance against the goals set
forth in the financial plan.
02-3
Financial planning
 Components of a Financial Planning Model

Inputs. The inputs to the financial plan consist of the firm’s
current financial statements and its forecasts about the future.
The Planning Model. The financial planning model calculates
the implications of the manager’s forecasts for profits, new
investment, and financing. The model consists of equations
relating output variables to forecasts. For example, the
equations can show how a change in sales is likely to affect
costs, working capital, fixed assets, and financing
requirements.
02-4
Financial planning
Components of a Financial Planning Model

 Outputs. The output of the financial model consists of
financial statements such as income statements, balance
sheets, and statements describing sources and uses of cash.
These statements are called pro formas, which means that
they are forecasts based on the inputs and the assumptions
built into the plan.
02-5
Financial planning
Components of a Financial Planning Model

 Outputs. The output of the financial model consists of
financial statements such as income statements, balance
sheets, and statements describing sources and uses of cash.
These statements are called pro formas, which means that
they are forecasts based on the inputs and the assumptions
built into the plan.
02-6
Financial planning
The Purpose of Planning and Plan Information

 The Planning Process: The planning process can pull a management
team into a cohesive unit with common goals.
 A Road Map for Running the Business: A business plan functions as
a road map for getting an organization to its goal.
 A Statement of Goals: A business plan is a projection of the future
that generally reflects what management would like to see happen.
 Predicting Financing Needs: Financial planning is extremely
important for companies that rely on outside financing.
 Communicating Information to Investors: A business plan is
management’s statement about what the company is going to be in
the future, and can be used to communicate those ideas to
investors.
02-7
Financial planning
Financial Planning vs Financial Forecasting
 Financial forecasting is the process of identifying the
opportunities in the future in terms of market size,
customer base, or business strategies. Forecasting involves
making projections about what will happen in the future. As
a process, financial forecasting involves estimating future
business performance. It provides information of the
organization’s future revenues and costs that is needed by
management to project financing requirements. The
“future” is the planning period that could be short-term
(one or less), medium term (3-5 years), or long-term (over
five years).
02-8
Financial planning
Financial Planning vs Financial Forecasting

 Some argue that financial planning and financial forecasting
are one and the same. However, financial forecasting is the
basis for financial planning. Financial planning is done
effectively through financial forecasting.
 Financial planning is not just forecasting. Forecasting
concentrates on the most likely future outcome. But
financial planners are not concerned solely with forecasting.
They need to worry about unlikely events as well as likely
ones.
02-9
Financial planning
Financial Forecasting Procedures

The following procedures may be used in predicting the future
(financial forecasting).
1. Projection of Organization’s sales revenues -Financial
forecasting begins with sales forecast.
2. Estimation of the level of investments in current assets and
fixed assets
3. Determination of the organization’s financing needs &
sources of funds
4. Preparing pro forma or forecasted financial statements,
namely, pro forma income statement, pro forma balance
sheet, and cash budget.
02-10
The Percentage-of-Sales Model
02-11
02-12
02-13
Example
Top Company has prepared the following Balance Sheet and Income
Statement for the year ended December 31, 2005.
Assets Liabilities and Stockholders’ Equity
Cash 175,000 A/P 140,000
A/R 150,000 Accrued liabilities 150,000
Inventory 800,000 Mortgage N/P 1,410,000
Plant Assets, Net 1,500,000 Common Stock 800,000
Retained earnings 125,000
Total 2,625,000 Total 2,625,000
Sales 2500000
Costs and Expenses except depreciation 1,400,000
Depreciation 200,000
Total costs and expenses 1,600,000
Income before taxes 900,000
Taxes (40%) 360,000
Net Income 540,000
02-14
• Additional Information
 The company plans to have dividend payout ratio of 45%
 Sales are expected to increase by 25% during next year (2006).
 All assets are affected by sales proportionately. Accounts Payable
and accrued liabilities are also affected by sales.
 All expenses are directly proportional to sales
 The firm has been operating at full capacity.
 The company has no preferred stock.
 Assume that additional funds needed would be financed from
bond issue and common stock in 40% and 60% respectively.
02-15
02-16
02-17
02-18
02-19
02-20
 Determinants of External Capital (Fund) Requirements
1. Sales growth rate
• The higher the sales growth rate, the greater the need for external capital
and vice versa
• The financial feasibility of the expansion plans should be reconsidered if
the company expects difficulties in raising the required capital.
2. Dividend payout ratio
• The higher the payout ratio, the greater the need for external capital
requirement
• Management should balance between internally generated funds (by
reducing payout ratio) and the need for increasing stock price because
divided policy affects stock price.
3. Capital intensity
• Capital intensity refers to the amount of asset required per Birr of sales
• Capital intensity Ratio = Assets/ Sales
• The lower capital intensity ratio, the lower the need for external capital
02-21
 Excess capacity Adjustments
The assumption of constant ratio between assets and sales may
not always hold true. In that case, the percentage of sales model
or Additional Funds Needed model is not appropriate.
What are the conditions under which constant ratios are not
maintained between asset, and sales?
1. Economies of scale
Economies of scale imply that as a plant gets larger and volume
increases, the average cost per unit of output drops. This is
particularly due to lower operating and capital cost. A piece of
equipment with twice that capacity of another piece typically
does not cost twice as much to purchase or operate. Plants also
gain efficiencies when they become large enough to fully utilize
dedicated resources for tasks such as materials handling,
computer equipment, and administrative support personnel.
02-22
 Excess capacity Adjustments …
2. Lumpy asset increments
Lumpy assets are assets that cannot be acquired in small

increments, but must be obtained (added) in large, discrete units.
Suppose, if we obtained that Br. 25,000 is needed for additional
investment in fixed assets, it may be difficult to get fixed assets
that exactly cost Br. 25,000. The minimum prices for the lowest
capacity fixed asset may be Br. 45,000. Thus, if you decided to
make additional investment in fixed assets, you need to purchase
fixed assets of Br. 45,000 instead of Br. 25,000.
02-23
 Excess capacity Adjustments …
3. Excess assets due to forecasting errors.
Actual assets to sales ratio may be different from planed ratio
because actual sales may be different from planed sales. Actual
assets may be different from planned assets. Excess capacity may
occur plant assets and inventories.
When excess capacity exists, sales can grow to the full capacity
sales with no increase whatever in fixed assets. However, beyond
full capacity sales, increase in sales requires increase in assets.
The following steps may be used in determining additional
investments in fixed assets in excess capacity situation.
02-24
02-25
02-26
• Increase in sales without increase in Fixed Assets (FA)
= Full capacity sales – current sales = 1,250,000 – 1,000,000 = 250,000
• Required level of FA = (TFA to sales ratio) x (projected sales)
= 0.48 x 1,400,000 = 672,000
• Additional Investment in FA = (1,400,000 – 1,250,000) x 0.48 = 72,000
• Increase in Current assets = 0.15 x 400,000 = 60,000
• Spontaneously generated funds= 0.09 x 400,000 = 36,000
• Internally generated funds = M (S1) (1-d) = 0.10(1,400,000) (1 –0.60)
= 56,000
• AFN = (72,000 + 60,000) – (36,000 + 56,000)
= 132,000 – 92,000 = 40,000
02-27
The Pro-forma Financial Statement Method
• Refer Cost and Management Accounting – Master Budget
02-28
CHAPTER. 4 & 5
MANAGING & FINANCING

CURRENT ASSETS (WORKING
CAPITAL MANAGEMENT)
Chapter Outline
I. Managing Current Assets

Working capital terminologies
Alternative current asset investment policies
Cash management
Inventory management
Receivables management
II.Financing Current Assets
Alternative current asset financing policies
Advantages and disadvantages of short-term
financing
Sources of short-term financing
Tracing capital and net working capital
• Current assets are cash and other assets that are expected to convert to
cash within the year
• Four of the most important items found in the current assets section of
a balance sheet are cash and cash equivalents, marketable securities,
accounts receivable, and inventories
• Current liabilities are obligations expected to require cash payment
within one year (or within operating period if longer than one year)
• Three major items current liabilities are accounts payable, expenses
payable (including accrued wages and taxes), and notes payable
• Basic balance sheet identity can be written as:
• Net working capital is:
• Therefore,
Tracing capital and net working capital
(continued)
Activities that Increase Cash, Activities that Decrease Cash,
or Sources of Cash or Uses of Cash
• Increasing long-term debt • Decreasing long-term debt
(borrowing over the long term) (paying off a long-term debt)
• Increasing equity (selling some • Decreasing equity (repurchasing
stock) some stock)
• Increasing current liabilities • Decreasing current liabilities
(getting a 90-day loan) (paying off a 90-day loan)
• Decreasing current assets other • Increasing current assets other
than cash (selling some than cash (buying some
inventory for cash) inventory for cash)
• Decreasing fixed assets (selling • Increasing fixed assets (buying
some property) some property)
The operating cycle and The cash cycle
• Primary concern in short-term finance is the firm’s short-run operating
and financing activities
• For a typical manufacturing firm, these short-run activities might
consist of the following sequence of events and decisions:
• These cash flows are both unsynchronized and uncertain:

• They are unsynchronized because, for example, the payment of cash for
raw materials does not happen at the same time as the receipt of cash
from selling the product
• They are uncertain because future sales and costs cannot be precisely
predicted
DEFINING THE OPERATING CYCLE
• One day, call it Day 0, we purchase $1,000 worth of inventory on credit.
We pay the bill 30 days later; and after 30 more days, someone buys
the $1,000 in inventory for $1,400. Our buyer does not actually pay for
another 45 days. We summarize these events below:
• Operating cycle is the period between the acquisition of inventory and the
collection of cash from receivables (i.e., 105 days in our example)
• Inventory period is the time it takes to acquire and sell the inventory
(i.e., a 60-day span in our example)
• Accounts receivable period is the time between sale of inventory and
collection of the receivable (i.e., 45 days in our example)
Defining the Cash Cycle
• Notice the cash flows and other events that occur are not synchronized
• Accounts payable period is the time between receipt of inventory and

the payment for it (i.e., 30 days in our example)
• Cash cycle is the time between cash disbursement and cash collection
(i.e., 75 days in our example)
figure - cash flow time line and the short-term operating
activities of a typical manufacturing firm
The operating cycle and the firm’s
organizational chart
• Short-term financial management in a large corporation involves
several different financial and nonfinancial managers
Calculating the operating and
cash cycles
• In our earlier example, the lengths of time that made up the
different periods were obvious
• Using only financial statement information requires more work
• Balance sheet information is shown below:
• Most recent income statement provides the following figures:
• Next step is to calculate some financial ratios

Calculating the operating cycle
• We turned our inventory over 3.28 times during the year:
• On average, we held our inventory for 111 days:

Calculating the operating cycle (continued)
• Receivables were turned over 6.39 times during the year:
• Receivables period is 57 days:
Operating cycle = Inventory period + Accounts receivable period

= 111 days + 57 days = 168 days
Calculating the cash cycle
• Our payables turnover is:
• Our payables period is:
Cash cycle = Operating cycle − Accounts payable period

= 168 days − 39 days = 129 days
The operating and cash cycles
Interpreting the cash cycle
• Our examples show that the cash cycle depends on the inventory,
receivables, and payables periods
• Cash cycle increases as inventory and receivables periods get longer
• It decreases if the company can defer payment of payables and thereby
lengthen the payables period
• Most firms have a positive cash cycle, and they require financing for
inventories and receivables
• The longer the cash cycle, the more financing is required
• Changes in the firm’s cash cycle are often monitored as an early-
warning measure
• Lengthening cycle can indicate that the firm is having trouble moving
inventory or collecting on its receivables
• All other things being the same, the shorter the cash cycle, the lower is
the firm’s investment in inventories and receivables
• As a result, the firm’s total assets are lower and total asset turnover is
higher
Some aspects of short-term financial policy
• The short-term financial policy adopted by a firm will be reflected in at
least two ways:
1. The size of the firm’s investment in current assets: This is usually
measured relative to the firm’s level of total operating revenues
• A flexible, or accommodative, short-term financial policy would
maintain a relatively high ratio of current assets to sales
• A restrictive short-term financial policy would entail a low ratio of
current assets to sales
2. The financing of current assets: This is measured as the proportion
of short-term debt (that is, current liabilities) and long-term debt
used to finance current assets
• A restrictive short-term financial policy means a high proportion of
short-term debt relative to long-term financing
• A flexible policy means less short-term debt and more long-term debt
• With a flexible policy, firms maintain higher overall level of liquidity
The size of the firm’s investment in current
assets
• Short-term financial policies that are flexible with regard to current
assets include such actions as:
1. Keeping large balances of cash and marketable securities
2. Making large investments in inventory
3. Granting liberal credit terms, which results in a high level of accounts
receivable
• Restrictive short-term financial policies would be just the opposite:

1. Keeping low cash balances and making little investment in
marketable securities
2. Making small investments in inventory
3. Allowing few or no credit sales, thereby minimizing accounts
receivable
The size of the firm’s investment in current
assets (continued)
• Managing current assets can be thought of as involving a trade-off
between costs that rise and costs that fall with the level of investment
• Carrying costs are costs that rise with increases in the level of
investment in current assets
• Shortage costs are costs that fall with increases in the level of
investment in current assets, and there are two types:
1. Trading, or order, costs: Order costs are the costs of placing an order
for more cash (e.g., brokerage costs) or more inventory (e.g.,
production setup costs)
2. Costs related to lack of safety reserves: These are costs of lost sales,
lost customer goodwill, and disruption of production schedules
• Optimal current asset holdings are highest under a flexible policy, one
in which the carrying costs are perceived to be low relative to shortage
costs
Alternative financing policies for current
assets: an ideal case
• In an ideal economy, short-term
assets can always be financed with
short-term debt, and long-term
assets can be financed with long-term
debt and equity
• Net working capital is always zero
• Consider a simplified case for a grain
elevator operator.
• Grain elevator operators buy crops
after harvest, store them, and sell
them during the year.
• They have high inventories of grain
after the harvest and end up with
low inventories just before the next
harvest.
• Figure - displays a “sawtooth” pattern
different policies for financing current assets
• In the real world, it is unlikely that
current assets will ever drop to
zero
• A growing firm can be thought of
as having a total asset
requirement consisting of the
current assets and long-term
assets needed to run the business
efficiently
• Total asset requirement may
exhibit change over time for many
reasons, including
• General growth trend
• Seasonal variation around trend
• Unpredictable day-to-day and
month-to-month fluctuations
different policies for financing current assets
(continued)
• For a lawn and garden supply firm, the peaks might represent inventory
buildups prior to the spring selling season, while the valleys would
come about because of lower off-season inventories
• Such a firm might consider two strategies to meet its cyclical needs:
1. Policy F (flexible) involves the firm keeping a relatively large pool of
2. Policy R (restrictive) is characterized by the firm keeping relatively
little in marketable securities
Which financing policy is best?
• What is the most appropriate amount of short-term borrowing?
• No definitive answer, but several considerations must be included in a
proper analysis:
1. Cash reserves: The flexible financing policy implies surplus cash and
little short-term borrowing. This policy reduces the probability that a
firm will experience financial distress.
2. Maturity hedging: Most firms attempt to match the maturities of
assets and liabilities. They finance inventories with short-term bank
loans and fixed assets with long-term financing. Firms tend to avoid
financing long-lived assets with short-term borrowing. This type of
maturity mismatching would necessitate frequent refinancing and is
inherently risky because short-term interest rates are more volatile
than longer-term rates.
3. Relative interest rates: Short-term interest rates are usually lower
than long-term rates. This implies that it is, on average, more costly
to rely on long-term borrowing as compared to short-term
borrowing.
Which financing policy is best?
(continued)
• With the compromise approach, the firm borrows in the short term
to cover peak financing needs, but it maintains a cash reserve in the
form of marketable securities during slow periods
Current assets and liabilities in practice
• Short-term assets represent significant portion of typical firm’s overall
assets
• Operating and cash cycles are industry and company specific
• Operating and cash cycles can also be different for companies within
the same industry
The cash budget
• Cash budget is a forecast of cash receipts and disbursements for the
next planning period
• Assume all Fun Toys’ cash inflows come from the sale of toys
• Sales forecast for the coming year, by quarter:
• Note that these are predicted sales, so forecasting risk exists

• Fun Toys started the year with accounts receivable equal to $120
• Fun Toys has a 45-day receivables, or average collection, period
• We now need to estimate Fun Toys’ projected cash collections:
The cash budget: cash outflows
• Cash disbursements, or payments, are one of four categories:
1. Payments of accounts payable are payments for goods or services
rendered by suppliers, such as raw materials
2. Wages, taxes, and other expenses includes all other regular costs of
doing business that require actual expenditures
3. Capital expenditures are payments of cash for long-lived assets
4. Long-term financing expenses includes, for example, interest
payments on long-term debt outstanding and dividend payments to
shareholders
• Fun Toys’ purchases from suppliers in a quarter are equal to 60% of the
next quarter’s predicted sales
• Payments to suppliers are equal to the previous quarter’s purchases, so
the accounts payable period is 90 days
• Wages, taxes, and other expenses are routinely 20% of sales; interest and
dividends are currently $20 per quarter
• Fun Toys plans a major plant expansion (a capital expenditure) costing
$100 in the second quarter
cash disbursements for fun toys
(in millions)
The cash budget: the cash balance
• Predicted net cash inflow is the difference between cash collections and
cash disbursements
• There is a cash surplus in the first and third quarters and a cash deficit
in the second and fourth quarters
• Comments about Fun Toys’ cash needs:

1. Fun Toys’ large outflow in the second quarter is not necessarily a sign
of trouble. It results from delayed collections on sales and a planned
capital expenditure (presumably a worthwhile one)
2. The figures in our example are based on a forecast; sales could be
much worse (or better) than the forecast figures
cash balance for fun toys
(in millions)
unsecured loans
• Most common way to finance a temporary cash deficit is to arrange a
short-term unsecured bank loan
• Line of credit is a formal (committed) or informal (noncommitted)

prearranged, short-term bank loan
• Committed lines of credit are more formal legal arrangements that
usually involve a commitment fee paid by the firm to the bank
• Noncommitted lines of credit are informal arrangements that allow
firms to borrow up to a previously specified limit without going through
the normal paperwork
• Revolving credit arrangement (or revolver) is similar to a line of credit,

but it is usually open for two or more years, whereas a line of credit
would usually be evaluated on an annual basis
unsecured loans (continued)
• Compensating balance is money kept by the firm with a bank in low-
interest or non-interest-bearing accounts as part of loan agreement
• Suppose that we have a $100,000 line of credit with a 10%
compensating balance requirement, meaning 10% of the amount used
must be left on deposit in a non-interest-bearing account. The quoted
interest rate on the credit line is 16%. Suppose we need $54,000 to
purchase some inventory. How much do we have to borrow? What
interest rate are we effectively paying?
• If we need $54,000, we must borrow enough so that $54,000 is left
over after we take out the 10% compensating balance:
$54,000 = ( 1 − .10 ) × Amount borrowed
Amount borrowed = $54,000 / .90 = $60,000
• Interest on the $60,000 for one year at 16% is $60,000 × .16 = $9,600.
We’re getting only $54,000 to use, so effective interest rate is:
Effective interest rate = Interest paid / Amount available
= $9,600 / $54,000 = .1778, or 17.78%
unsecured loans (concluded)
• Several points bear mentioning regarding compensating balances:
1. Compensating balances are usually computed as a monthly
average of the daily balances
• Effective interest rate may be lower than our example (on the previous
slide) illustrates
2. It has become common for compensating balances to be based on
the unused amount of the credit line
• Requirement of such a balance amounts to implicit commitment fee
3. Most importantly, details of any short-term business lending
arrangements are highly negotiable
• Banks will work with firms to design package of fees and interest
• With a letter of credit, the bank issuing the letter promises to make a
loan if certain conditions are met
• Typically, the letter guarantees payment on a shipment of goods
provided that the goods arrive as promised
• May be revocable (subject to cancellation) or irrevocable
Secured loans:
accounts receivable financing
• Accounts receivable financing is a secured short-term loan that
involves either the assignment or the factoring of receivables
• Under assignment, the lender has the receivables as security, but the
borrower is still responsible if a receivable can’t be collected
• With conventional factoring, the receivable is discounted and sold to
the lender (the factor); once it is sold, collection is the factor’s
problem, and factor assumes the full risk of default on bad accounts
• With maturity factoring, the factor forwards the money on an agreed-
upon future date
• Credit card receivable funding or business cash advances
• Company goes to a factor and receives cash up front, after which a
portion of each credit card sale (perhaps 6 to 8%) is routed directly to
the factor by the credit card processor until the loan is paid off
• Purchase order financing (or PO financing)
• With PO financing, the factor pays the supplier who manufactures the
product; when the sale is completed and the seller is paid, the factor is
repaid
Secured loans: inventory loans
• Inventory loan is a secured short-term loan to purchase inventory
and comes in one of three forms:
1. Blanket inventory lien gives the lender a lien against all the
borrower’s inventories (the blanket “covers” everything)
2. Trust receipt is a device by which the borrower holds specific
inventory in “trust” for the lender.
3. Field warehouse financing involves a public warehouse company
(an independent company that specializes in inventory
management) acting as a control agent to supervise the
inventory for the lender
Other sources of short-term funds
• Variety of other sources of short-term funds are employed by
corporations:
1. Commercial paper consists of short-term notes issued by large,
highly rated firms
• Usually of short maturity, ranging up to 270 days (beyond that limit, the
firm must file a registration statement with the SEC)
• Firm usually issues these directly and backs the issue with a special
bank line of credit; interest rate the firm obtains is often significantly
below the rate a bank would charge for a direct loan
2. Trade credit involves a firm increasing the accounts payable period
(i.e., the firm may take longer to pay its bills)
• Extremely important form of financing for smaller businesses
• Firm using trade credit may end up paying a much higher price for what
it purchases, so it can be a very expensive source of financing
A short-term financial plan
• To illustrate a completed short-term financial plan, assume that Fun
Toys arranges to borrow needed funds on a short-term basis
• Interest rate is 20% APR, and it is calculated on a quarterly basis
• Assume that Fun Toys starts the year with no short-term debt
• Recall from Table 18.7 that Fun Toys has a second-quarter deficit of $60
million, so the firm will have to borrow this amount
• Net cash inflow in the following quarter is $55 million
• Firm will now have to pay $60 million × .05 = $3 million in interest out
of that, leaving $52 million to reduce the borrowing
• Fun Toys still owes $60 million − 52 million = $8 million at the end of
the third quarter
• Interest in the last quarter will be $8 million × .05 = $.4 million
• Net inflows in the last quarter are −$15 million
• Company will have to borrow a total of $15.4 million, bringing total
borrowing up to $15.4 million + 8 million = $23.4 million
Short-term financial plan for fun toys (in millions)
A short-term financial plan
(continued)
• Our plan is very simple:
• Ignored the fact that the interest paid on the short-term debt is tax
deductible
• Ignored the fact that the cash surplus in the first quarter would earn
some interest (which would be taxable)
• Even so, our plan highlights the fact that in about 90 days, Fun Toys will
need to borrow $60 million or so on a short-term basis
• Plan also illustrates that financing the firm’s short-term needs will cost
about $3.4 million in interest (before taxes) for the year
• If Fun Toys’ sales are expected to keep growing, then the deficit of $20
million-plus will probably also keep growing, and the need for
additional financing will be permanent
Reasons for Holding Cash
• John Maynard Keynes identified three motives for liquidity:
1. Speculative motive is the need to hold cash to take advantage of
additional investment opportunities, such as bargain purchases
2. Precautionary motive is the need to hold cash as a safety margin to
act as a financial reserve
3. Transaction motive is the need to hold cash to satisfy normal
disbursement and collection activities associated with a firm’s
ongoing operations
• Compensating balances are another reason to hold cash

• Recall from the last chapter, cash balances are kept at commercial banks
to compensate for banking services the firm receives
Costs of Holding Cash
• Opportunity cost of excess cash (held in currency or bank deposits) is
the interest income that could be earned in the next best use, such as
an investment in marketable securities
• Why would a firm hold cash in excess of its compensating balance
requirements?
• Cash balance must be maintained to provide the liquidity necessary for
transaction needs—paying bills
• If the firm maintains too small a cash balance, it may run out of cash, at
which point the firm may have to raise cash on a short-term basis
• Cash management versus liquidity management
• Cash management is much more closely related to optimizing
mechanisms for collecting and disbursing cash
• Liquidity management concerns the optimal quantity of liquid assets a
firm should have on hand
Understanding float
• Float is the difference between book cash and bank cash, representing
the net effect of checks in the process of clearing
• Checks written by a firm generate disbursement float, causing a
decrease in the firm’s book balance but no change in its available
balance
• Checks received by the firm create collection float, increasing book
balances but not immediately changing available balances
• In general, a firm’s payment (disbursement) activities generate
disbursement float, and its collection activities generate collection float
• Net float at a point in time is the overall difference between the firm’s
available balance and its book balance
• A firm should be concerned with its net float and available balance
more than with its book balance
Float management
• Float management involves controlling the collection and disbursement
of cash
• Objective in cash collection is to speed up collections and reduce the
lag between the time customers pay their bills and the time the cash
becomes available
• Objective in cash disbursement is to control payments and minimize
the firm’s costs associated with making payments
• Total collection or disbursement times can be broken down into three
parts:
1. Mailing time is the part of the collection and disbursement process
during which checks are trapped in the postal system
2. Processing delay is the time it takes the receiver of a check to process
the payment and deposit it in a bank for collection
3. Availability delay refers to the time required to clear a check through
the banking system
Measuring float
• Size of float depends on both the dollars and the time delay involved
• Suppose you mail a check for $500 to another state each month. It
takes five days in the mail for the check to reach its destination (the
mailing time) and one day for the recipient to get over to the bank (the
processing delay). The recipient’s bank holds out-of-state checks for
three days (availability delay). The total delay is 5 + 1 + 3 = 9 days. In
this case, what is your average daily disbursement float?
1. First, you have a $500 float for nine days, so we say that the total
float is 9 × $500 = $4,500. Assuming 30 days in the month, the
average daily float is $4,500/30 = $150
2. Alternatively, your disbursement float is $500 for 9 days out of the
month and zero the other 21 days (again assuming 30 days in a
month). Your average daily float is:
Average daily float = ( 9 × $500 + 21 × 0 ) / 30
= $4,500 / 30 = $150
Measuring float:
multiple disbursements or receipts
• Suppose Concepts, Inc., receives two items each month as follows:
• Average daily float is equal to:

Measuring float: multiple disbursements or
receipts (continued)
• Another way to see this is to calculate the average daily receipts and
multiply by the weighted average delay
• Average daily receipts are:
• Of the $8 million total receipts, $5 million, or 5/8 of the total, is

delayed for nine days. The other 3/8 is delayed for five days. The
weighted average delay is thus:
Weighted average delay = (5 / 8) × 9 days + (3 / 8) × 5 days
= 5.625 days + 1.875 days = 7.50 days
• Average daily float is:
Some details
• In measuring float, there is an important difference to note between
collection and disbursement float
• With a disbursement, firm’s book balance decreases when check is
mailed, so mailing time is an important component in disbursement
float
• With a collection, firm’s book balance isn’t increased until check is
received, so mailing time is not a component of collection float
• When we talk about availability delay, how long it actually takes a check
to clear isn’t really crucial; rather, what matters is how long we must
wait before the bank grants availability—that is, use of the funds
Cost of the float
• Suppose the Lambo Corporation has average daily receipts of $1,000
and a weighted average delay of three days. The average daily float is 3
× $1,000 = $3,000. This means that, on a typical day, there is $3,000
that is not earning interest. Suppose Lambo could eliminate the float
entirely. What would be the benefit? If it costs $2,000 to eliminate the
float, what is the NPV of doing so?
Cost of the float
(continued)
• Figure - illustrates what happens if the float is eliminated entirely on
some Day t in the future
• Only change occurs the first day; on that day, as usual, Lambo collects
$1,000 from the sale made three days before. Because the float is gone,
it also collects on the sales made two days before, one day before, and
that same day, for an additional $3,000
• Total collections on Day t are $4,000 instead of $1,000
• PV of eliminating the float is equal to the total float
• If it costs $2,000 to eliminate the float, then the NPV is $3,000 − 2,000 =
$1,000; so Lambo should do it
Ethical and legal questions
• Cash manager must work with collected bank cash balances and not the
firm’s book balance (which reflects checks that have been deposited
but not collected)
• If this is not done, a cash manager could be drawing on uncollected
cash as a source of funds for short-term investing
• Most banks charge a penalty rate for the use of uncollected funds
• However, banks may not have good enough accounting and control
procedures to be fully aware of the use of uncollected funds
• Systematic overdrafting of accounts (or check kiting) is neither legal nor
ethical, but despite stiff penalties for check kiting, the practice
continues
• In May 2019, a Kansas couple was indicted for a check kiting scheme
involving more than $2 billion in checks
• Fraud involved 409 wire transfers and 7,584 checks
Electronic data interchange and check 21:
the end of float?
• Electronic data interchange (EDI) refers to the growing practice of
direct, electronic information exchange between all types of businesses
• One important use of EDI, often called financial EDI or FEDI, is to
electronically transfer financial information and funds between parties,
thereby eliminating paper invoices, paper checks, mailing, and handling
• As the use of FEDI increases, float management will evolve to focus
much more on issues surrounding computerized information exchange
and funds transfers
• One of the drawbacks of EDI (and FEDI) is that it is expensive and
complex to set up
• On October 29, 2004, the Check Clearing Act for the 21st Century, also
known as Check 21, took effect
• Now, a bank can transmit an electronic image of the check to the
customer’s bank and receive payment immediately
Cash collection and concentration
• Basic parts of cash collection process can be depicted as follows:
• Cash collection approaches

• Over-the-counter collection is characterized by most customers paying
with cash, check, or credit card at the point of sale
• If some or all payments a firm receives are checks that arrive via mail,
all three components of collection time become relevant
• With preauthorized payment arrangement, the payment amounts and
payment dates are fixed in advance
• When agreed-upon date arrives, amount is automatically transferred
from customer’s bank account to firm’s bank account, which sharply
reduces or even eliminates collection delays
lockboxes
• Lockboxes are special post
office boxes set up to intercept
and speed up accounts
receivable payments
• Figure 19.3 illustrates a lockbox

system
• Bank lockbox system should

enable a firm to get its receipts
processed, deposited, and
cleared faster than if it were to
receive checks at its
headquarters and deliver them
itself to the bank for deposit
and clearing
Cash concentration
• Cash concentration is the practice
of, and procedures for, moving
cash from multiple banks into the
firm’s main accounts
• Figure 19.4 illustrates how
integrated cash collection and
concentration system might look
• Key part of process is transfer of
funds to the concentration bank,
and there are various options for
accomplishing this transfer:
• Depository transfer check (DTC)
• Automated clearinghouse (ACH)
• Wire transfers
Increasing disbursement float
• Slowing down payments comes from the time involved in mail delivery,
check processing, and collection of funds
• Disbursement float can be increased by writing a check on a
geographically distant bank
• Mailing checks from remote post offices is another way firms slow
down disbursement
• Tactics for maximizing disbursement float are debatable on both ethical
and economic grounds
• Payment terms frequently offer a substantial discount for early
payment
• Suppliers are not likely to be fooled by attempts to slow down
disbursements; negative consequences of poor relations with suppliers
can be costly
• Intentionally delaying payments by taking advantage of mailing times or
unsophisticated suppliers may amount to avoiding paying bills when
they are due—an unethical business procedure
Controlling disbursements
• Zero-balance accounts are disbursement accounts in which the firm
maintains a zero balance, transferring funds in from a master
account only as needed to cover checks presented for payment
• Controlled disbursement account is a disbursement account to

which the firm transfers an amount that is sufficient to cover
demands for payment
Investing idle cash
• Firms have temporary cash surpluses for various reasons, but two of
the most important are the following:
1. Seasonal or cyclical activities
• Some firms have a predictable cash flow pattern, with surplus cash
flows during part of the year and deficits the rest of the year
• Firm may buy marketable securities when surplus cash flows occur and
sell marketable securities when deficits occur
• Bank loans are another short-term financing device
2. Planned or possible expenditures
• Firms often accumulate temporary investments in marketable securities
to provide the cash for a plant construction program, dividend payment,
or other large expenditure
• Firms may issue bonds and stocks before the cash is needed, investing
the proceeds in short-term marketable securities and then selling the
securities to finance the expenditures
• Firms may build up cash surpluses to cover the possibility of having to
make a large cash outlay (e.g., losing a large lawsuit)
Characteristics of short-term securities
• Given that a firm has some temporarily idle cash, a variety of short-
term securities are available for investing
• Most important characteristics of these short-term marketable
securities are the following:
• Maturity: For a given change in the level of interest rates, the prices of
longer-maturity securities will change more than those of shorter-
maturity securities (i.e., interest rate risk)
• Default risk refers to the probability that interest and principal will not
be paid in the promised amounts on the due dates (or will not be paid
at all)
• Marketability refers to how easy it is to convert an asset to cash; so
marketability and liquidity mean much the same thing
• Taxability: Interest earned on money market securities that are not
some kind of government obligation (either federal or state) is taxable
at the local, state, and federal levels
Some different types of money market
securities
• Money market securities are generally highly marketable and short
term, usually have low default risk, and are issued by U.S. government
(e.g., U.S. Treasury bills), domestic and foreign banks (e.g., certificates of
deposit), and business corporations (e.g., commercial paper)
• A few types of money market securities are defined below:
• U.S. Treasury bills are obligations of the U.S. government that mature in
30, 90, or 180 days; bills are sold by auction every week
• Short-term tax-exempts are short-term securities issued by states,
municipalities, local housing agencies, and urban renewal agencies
Commercial paper consists of short-term securities issued by finance
companies, banks, and corporations; usually unsecured
• Certificates of deposit (CDs) are short-term loans to commercial banks
• Repurchase agreements (repos) are sales of government securities by a
bank or securities dealer with an agreement to repurchase
• Money market preferred stock (i.e., auction rate preferred) features a
floating dividend
DETERMINING THE TARGET CASH BALANCE
• Target cash balance is a firm’s desired cash level as determined by the
trade-off between carrying costs and shortage costs
• Adjustment costs are the costs associated with holding too little cash
(i.e., shortage costs)
• If the firm has a flexible working capital policy, it will probably maintain
a marketable securities portfolio
• In this case, adjustment, or shortage, costs will be the trading costs
associated with buying and selling securities
• If the firm has a restrictive working capital policy, it will probably
borrow in the short term to meet cash shortages
• Costs in this case will be the interest and other expenses associated
with arranging a loan
• In our discussion that follows, we will assume the firm has a flexible
policy
The basic idea
• If a firm tries to keep its cash
holdings too low, it will find itself
running out of cash more often
than is desirable and selling
marketable more frequently than
would be the case if the cash
balance were higher
• Trading costs will be high when
the cash balance is small, and
these costs will fall as the cash
balance becomes larger
• Opportunity costs of holding cash
are low if the firm holds little cash
• These costs increase as the cash
holdings rise because the firm is
giving up more interest that could
have been earned
The bat model
• Baumol-Allais-Tobin (BAT) model is a classic means of analyzing our
cash management problem
• Suppose Golden Socks Corporation starts off at Week 0 with a cash

balance of C = $1.2 million.
• Each week, outflows exceed inflows by $600,000. As a result, the cash
balance will drop to zero at the end of Week 2.
• The average cash balance will be the beginning balance ($1.2 million)
plus the ending balance ($0) divided by 2, or ($1.2 million + 0)/2 =
$600,000, over the two-week period.
• At the end of Week 2, Golden Socks replenishes its cash by depositing
another $1.2 million.
• Simple cash management strategy for Golden Socks boils down to

depositing $1.2 million every two weeks
The bat model (continued)
• Notice how the cash balance
declines by $600,000 per week
• Because the firm brings the account
back up to $1.2 million, balance hits
zero every two weeks, resulting in
sawtooth pattern displayed in
Figure 19A.2
• To determine optimal strategy,
Golden Socks needs to know the
following three things:
• F = fixed cost of making a
securities trade to replenish cash
• T = total amount of new cash
needed for transaction purposes
over the relevant planning
period—say, one year
• R = opportunity cost of holding
cash (i.e., interest rate on
marketable securities)
The opportunity costs
• Golden Socks has, on average, C/2 in cash, which could be earning interest
at rate R, so the total dollar opportunity costs of cash balances are equal to
average cash balance multiplied by interest rate:
• Opportunity costs of various alternatives are given here, assuming the

interest rate is 10%:
• In our original case, where the initial cash balance is $1.2 million, the
average balance is $600,000; interest Golden Socks could have earned on
this (at 10%) is $60,000, so this is what the firm gives up with this strategy
• Notice opportunity costs increase as initial (and average) cash balance rises
The trading costs
• Total amount of cash disbursed during the year is $600,000 per
week, so T = $600,000 × 52 weeks = $31.2 million
• If initial cash balance is set at C = $1.2 million, Golden Socks will sell
$1.2 million in marketable securities:
T/C = $31.2 million/$1.2 million = 26 times per year
• It costs F dollars each time, so trading costs are given by:
($31.2million / $1.2million) × F = 26 × F
• In general, the total trading costs will be given by:
Trading costs = (T/C) × F
• If F were $1,000 in this example, trading costs would be $26,000
The total cost
• Now that we have the opportunity costs and the trading costs, we
can calculate the total cost by adding them together:
Total cost = Opportunity costs + Trading costs
= (C/2) × R + (T/C) × F
• Using the numbers generated earlier, we have the following:
• Notice how the total cost starts out at almost $250,000 ($246,500)
and declines to $82,000 before starting to rise again
The solution
The solution
(continued)
The BAT MODEL: AN EXAMPLE
THE MILLER-ORR MODEL:
A MORE GENERAL APPROACH
• Miller-Orr model describes a cash management system designed to
deal with cash inflows and outflows that fluctuate randomly from
day to day
• Unlike the situation with the BAT model, we assume this balance
fluctuates up and down randomly and the average change is zero
Using the model
• Management sets the lower limit (L), essentially defining a safety
stock; where it is set depends on how much risk of a cash shortfall
the firm is willing to tolerate
• As with BAT model, optimal cash balance depends on trading costs
and opportunity costs
• Cost per transaction of buying and selling marketable securities, F, is
assumed to be fixed
• Opportunity cost of holding cash is R, the interest rate per period on
• σ2 is the variance of the net cash flow per period
• Given L, which is set by the firm, Miller and Orr show that the cash
balance target, C*, and the upper limit, U*, that minimize the total
costs of holding cash are:
C* = L + (3/4 × F × σ2/R)(1/3)
U* = 3 × C* − 2 × L
Average cash balance = (4 × C* − L)/3
Using the model
(continued)
• Suppose F = $10, the interest rate is 1% per month, and the standard
deviation of the monthly net cash flows is $200
• The variance of the monthly net cash flows is:
σ2 = $2002 = $40,000
• If L = $100, the cash balance target, C*, is:
C * = L + (3/4 × F × σ2/R)1/3
= $100 + (3/4 × $10 × $4 0,000/.01 )1/3
= $100 + 30,000,0001/3 = $100 + 311 = $411
• The upper limit, U*, is:
U * = 3 × C* − 2 × L
= 3 × $411 − 2 × $100 = $1,032
• Finally, the average cash balance will be:
Average cash balance = (4 × C* − L)/3
= (4 × $411 − $100)/3 = $514
Implications of the bat
and MILLER-ORR models
• In both models, all other things being equal, we see that:
• The greater the interest rate, the lower is the target cash balance
• The greater the order cost, the higher is the target cash balance
• Advantage of Miller-Orr model is that it improves our understanding

of the problem of cash management by considering the effect of
uncertainty as measured by the variation in net cash inflows
• Miller-Orr model shows that the greater the uncertainty (the higher
σ2 is), the greater the difference between the target balance and the
minimum balance will be
• Similarly, the greater the uncertainty, the higher the upper limit and
the average cash balance will be
Other factors influencing the target cash balance
• In our discussion of cash management, we assume cash is invested in
marketable securities (e.g., Treasury bills), and the firm obtains cash by
selling these securities
• Another alternative is to borrow cash, but borrowing introduces
additional considerations to cash management:
1. Borrowing is likely to be more expensive than selling marketable
securities because the interest rate is likely to be higher
2. The need to borrow will depend on management’s desire to hold low
cash balances
• For large firms, the trading costs of buying and selling securities are
small when compared to the opportunity costs of holding cash
• A large firm will buy and sell securities very often before it will opt to
leave substantial amounts of cash idle
Credit and receivables
• When a firm sells goods and services, it can demand cash on or before
the delivery date, or it can extend credit to customers and allow some
delay in payment
• Why do firms grant credit?

• Offering credit is a way of stimulating sales, but there are costs
associated with granting credit:
1. Chance the customer will not pay
2. Costs of carrying the receivables
• When credit is granted, an account receivable is created

• Trade credit is credit granted to other firms
• Consumer credit is credit granted to consumers
Components of credit policy
• If a firm decides to grant credit to its customers, it will have to deal with
the following components of credit policy:
• Terms of sale are the conditions under which a firm sells its goods and
services for cash or credit
• Credit analysis is the process of determining the probability that
customers will not pay
• Collection policy is the procedure followed by a firm in collecting
accounts receivable
• Accounts receivable period involves several events:
The investment in receivables
• Investment in accounts receivable for any firm depends on the amount
of credit sales and the average collection period
• If a firm’s average collection period, ACP, is 30 days, then, at any given

time, there will be 30 days’ worth of sales outstanding. If credit sales
run $1,000 per day, the firm’s accounts receivable will then be equal to
30 days × $1,000 per day = $30,000, on average.
• Firm’s receivables generally will be equal to its average daily sales

multiplied by its average collection period:
Terms of the sale
• Terms of a sale are made up of three distinct elements:
1. Period for which credit is granted (i.e., credit period)
2. Cash discount and the discount period
3. Type of credit instrument
• Terms such as 2/10, net 60 are common
• Customers have 60 days from the invoice date to pay full amount; but,
if payment is made within 10 days, a 2% cash discount applies
• Consider a buyer who places an order for $1,000, and assume that the
terms of the sale are 2/10, net 60
• The buyer has the option of paying $1,000 × (1 − .02) = $980 in 10 days,
or paying the full $1,000 in 60 days
• If terms are stated as net 30, customer has 30 days from invoice date to
pay the entire $1,000; no discount applies for early payment
The credit period
• Credit period is the length of time for which credit is granted
• Varies across industries, but is usually between 30 and 120 days
• If a cash discount is offered, the credit period has two components:
• Net credit period is the length of time the customer must pay
• Cash discount period is time during which the discount is available
• Invoice date is the beginning of the credit period
• Invoice is a bill for goods or services provided by seller to purchaser
• Terms of sale include the following:
• ROG, receipt of goods, means the credit period starts when the customer
receives the order
• With EOM dating, all sales made during a particular month are assumed to
be made at the end of that month
• Terms of 2/10th, EOM tell the buyer to take a 2% discount if payment is
made by the 10th of the month; otherwise the full amount is due by the
end of the month
• Seasonal dating is sometimes used to encourage sales of seasonal products
during the off-season
Length of the credit period
• Buyer’s inventory period and operating cycle influence length of credit
period; the shorter these are, the shorter the credit period
• Several other factors influence the credit period:
1. Perishability and collateral value: Perishable items have relatively rapid
turnover and relatively low collateral value; credit periods are shorter
for such goods
2. Consumer demand: Products that are well established generally have
more rapid turnover, while newer or slow-moving products will often
have longer credit periods to entice buyers
3. Cost, profitability, and standardization: Relatively inexpensive goods
tend to have shorter credit periods
4. Credit risk: The greater the credit risk of the buyer, the shorter the credit
period is likely to be
5. Size of the account: Small accounts may have shorter credit periods
6. Competition: In a highly competitive market, longer credit periods may
be offered as a way of attracting customers
7. Customer type: Wholesale/retail customers may have different terms
Cash discounts
• Cash discounts (i.e., sales discounts) are given to induce prompt
payment
• When a cash discount is offered, the credit is essentially free during the
discount period
• Cash discounts also serve as a way of charging higher prices to
customers that have had credit extended to them
• Suppose an order is for $1,000. The buyer can pay $980 in 10 days or
wait another 20 days and pay $1,000. It’s obvious that the buyer is
effectively borrowing $980 for 20 days and that the buyer pays $20 in
interest on the “loan.” What’s the interest rate?
• With $20 in interest on $980 borrowed, the rate is $20/$980 = .020408,
or 2.0408% per 20-day period
• There are 365/20 = 18.25 such periods in a year; so, by not taking the
discount, the buyer is paying an effective annual rate (EAR) of:
EAR = 1.02040818.25 − 1 = .4459, or 44.59%
trade discounts and
the cash discount and the acp
• Sometimes the discount is not an early payment incentive, but rather a
trade discount, a discount routinely given to some type of buyer
• To the extent that a cash discount encourages customers to pay early, it
will shorten the receivables period and, all other things being equal,
reduce the firm’s investment in receivables
• Suppose a firm currently has terms of net 30 and an ACP of 30 days. If it
offers terms of 2/10, net 30, then perhaps 50% of its customers (in terms
of volume of purchases) will pay in 10 days. The remaining customers will
still take an average of 30 days to pay. What will the new ACP be? If the
firm’s annual sales are $15 million (before discounts), what will happen to
the investment in receivables?
• If half of the customers take 10 days to pay and half take 30, the new
average collection period is: .50 × 10 days + .50 × 30 days = 20 days
• ACP falls from 30 days to 20 days
• Average daily sales are $15 million/365 = $41,096 per day, so receivables
will fall by $41,096 × 10 = $410,959
Credit instruments
• The credit instrument is the basic evidence of indebtedness
• Most trade credit is offered on open account, where the only formal
instrument of credit is the invoice, which is sent with the shipment of
goods and which the customer signs as evidence that the goods have
been received
• Afterward, the firm and its customers record the exchange on their
books of account
• Firm may require the customer sign a promissory note, a basic IOU
• Could be used with large orders, when there is no cash discount
involved, or when the firm anticipates a problem in collections
• Promissory notes are signed after delivery of the goods
• Firm can obtain a credit commitment from a customer before the goods
are delivered by arranging a commercial draft
• When draft is presented and buyer “accepts” it, it is called a trade
acceptance is sent back to the selling firm
• If a bank accepts the draft, meaning that the bank is guaranteeing
payment, then the draft becomes a banker’s acceptance
Analyzing credit policy
• Granting credit makes sense only if NPV from doing so is positive
• In evaluating credit policy, there are five basic factors to consider:
1. Revenue effects: If the firm grants credit, then there will be a delay in
revenue collections as some customers take advantage of the credit
offered and pay later
2. Cost effects: Although the firm may experience delayed revenues if it
grants credit, it will still incur the costs of sales immediately
3. The cost of debt: When the firm grants credit, it must arrange to
finance the resulting receivables
4. The probability of nonpayment: If the firm grants credit, some
percentage of the credit buyers will not pay
5. The cash discount: When the firm offers a cash discount as part of its
credit terms, some customers will choose to pay early to take
advantage of the discount
Evaluating a proposed credit policy
• Locust Software has been in existence for two years, and it is one of
several successful firms that develop computer programs
• Currently, Locust sells for cash only
• Locust is evaluating a request from some major customers to change its
current policy to net one month (30 days)
• To analyze this proposal, we define the following:

• P = Price per unit
• v = Variable cost per unit
• Q = Current quantity sold per month
• Q′ = Quantity sold under new policy
• R = Monthly required return
NPV of switching policies
• Suppose we have the following for Locust:
• P = $49, v = $20, Q = 100, and Q′ = 110
• If required return, R, is 2% per month, should Locust make the switch?
• Currently, Locust has monthly sales of P × Q = $4,900. Variable costs
each month are v × Q = $2,000, so the monthly cash flow from this
activity is:
• If Locust does switch to net 30 days on sales, the quantity sold will rise
to Q′ = 110. Monthly revenues will increase to P × Q′, and costs will be v
× Q′. The monthly cash flow under the new policy will be:
NPV of switching policies…
• Relevant incremental cash flow is the difference between the new and
old cash flows:
Incremental cash inflow = (P − v)(Q′ − Q)
= ($49 − 20) × (110 − 100) = $290
• Present value of the future incremental cash flows is:
• For Locust, this PV works out to be: PV = ($29 × 10)/.02 = $14,500

• Cost of switching involves two components:
1. Locust will have to produce Q′ − Q more units at a cost of v(Q′ −
Q) = $20 × (110 − 100) = $200
2. Sales that would have been collected this month under the current
policy (P × Q = $4,900) will not be collected
• For Locust, this cost would be $4,900 + 200 = $5,100

NPV of switching policies…
• Putting it all together, we see that the NPV of the switch is:
• As we saw earlier, the benefit is $290 per month forever. At 2% per

month, the NPV is:
NPV = −$5,100 + $290/.02
= −$5,100 + 14,500
= $9,400
• Therefore, the switch is profitable

A break-even application
• Key variable for Locust is Q′ − Q, the increase in unit sales
• Projected increase of 10 units is only an estimate, so there is some
forecasting risk
• What increase in unit sales is necessary to break even?
• Earlier, the NPV of the switch was defined as:
NPV = −[PQ + v(Q′ − Q)] + [(P − v)(Q′ − Q)]/R
• Calculate the break-even point explicitly by setting the NPV equal to
zero and solving for (Q′ − Q):
• For Locust, the break-even sales increase is:

Q′ − Q = $4,900/($29/.02 − $20)
= 3.43 units
The total credit cost curve
• Trade-off between granting credit and not granting credit isn’t hard to
identify, but it is difficult to quantify precisely
• Carrying costs associated with granting credit come in three forms
1. Required return on receivables
2. Losses from bad debts
3. Costs of managing credit and credit collections
• If a firm has a very restrictive credit policy, all the associated costs will
be low, the firm will have a “shortage” of credit, and there will be an
opportunity cost
• Opportunity cost is the extra potential profit from credit sales that are
lost because credit is refused, and it comes from two sources:
1. Increase in quantity sold, Q′ minus Q
2. (Potentially) a higher price
• Credit cost curve is a graphical representation of the sum of the
carrying costs and the opportunity costs of a credit policy
Credit cost curve
• There is a point in the credit
cost curve where the total credit
cost is minimized
• This point corresponds to the
optimal amount of credit or,
equivalently, the optimal
investment in receivables
• All other things being equal, it is
likely that firms with the
following characteristics will
extend credit more liberally
than other firms:
• Excess capacity
• Low variable operating costs
• Repeat customers
Organizing the credit function
• Firms that grant credit have the expense of running a credit
department, though many choose to contract out all or part of the
credit function to a factor, an insurer, or a captive finance company
• Firms that manage internal credit operations are self-insured against
default
• Alternative is to buy credit insurance through an insurance company,
where the insurance company offers coverage up to a preset dollar
limit for each account
• Large firms often extend credit through a captive finance company, a
wholly owned subsidiary that handles the credit function for the parent
company
• Why would a firm choose to set up a separate company to handle the
credit function?
• Primarily, to separate the production and financing of the firm’s
products for management, financing, and reporting
Credit analysis: a one-time sale
• Credit analysis refers to the process of deciding whether to extend
credit to a particular customer, and it usually involves two steps:
1. Gathering relevant information
2. Determining creditworthiness
• One-time sale example:
• Assume a new customer wishes to buy one unit on credit at a price of P
per unit
• If credit is refused, the customer will not make the purchase
• If credit is granted, then, in one month, the customer will either pay up
or default
• Probability of default is π and can be interpreted as the percentage of
new customers who will not pay
• Our business does not have repeat customers; this is a one-time sale
• Required return on receivables is R per month, and the variable cost is v
per unit
Credit analysis: a one-time sale (continued)
• If the firm grants credit, it spends v (variable cost) this month and
expects to collect (1 − π)P next month
• NPV of granting credit is: NPV = −v + (1 − π)P/(1 − R)
• For Locust Software, this NPV is: NPV = −$20 + (1 − π) × $49/1.02
• With a 20% rate of default, NPV = −$20 + .80 × $49/1.02 = $18.43
• In granting credit to a new customer, a firm risks its variable cost (v). It
stands to gain the full price (P). For a new customer, then, credit may be
granted even if the default probability is high.
• Beak-even probability can be determined by setting NPV equal to zero
and solving for π:
NPV = 0 = −$20 + (1 − π) × $49/1.02
1 − π = $20/$49 × 1.02
π = .584, or 58.4%
• Locust should extend credit as long as there is a 1 − .584 = .416, or
41.6% chance or better of collecting
Credit analysis: repeat business
• Repeat business example
• Important assumption: A new customer who does not default the first
time around will remain a customer forever and never default
• If the firm grants credit, it spends v this month

• Next month, it gets nothing if the customer defaults, or it gets P if the
customer pays
• If the customer pays, then the customer will buy another unit on credit
and the firm will spend v again
• The net cash inflow for the month is P − v
• In every subsequent month, this same P − v will occur as the customer
pays for the previous month’s order and places a new one
Credit analysis: repeat business (continued)
• In one month, the firm will receive $0 with probability π
• With probability (1 − π), the firm will have a permanent new customer,
where the value of a new customer is equal to the present value of (P −
v) every month forever:
• PV = (P − v)/R
• NPV of extending credit is: NPV = −v + (1 − π)(P − v)/R
• For Locust, this is:
NPV = −$20 + (1 − π) × ($49 − 20)/.02
= −$20 + (1 − π) × $1,450
• Even if the probability of default is 90%, the NPV is:
NPV = −$20 + .10 × $1,450 = $125
• Locust should extend credit unless default is a virtual certainty
• It costs only $20 to find out who is a good customer and who is not
CREDIT INFORMATION
• Information sources commonly used to assess creditworthiness include
the following:
1. Financial statements: A firm can ask a customer to supply financial
statements such as balance sheets and income statements
2. Credit reports about the customer’s payment history with other
firms: Quite a few organizations sell information about the credit
strength and credit history of business firms
3. Banks: Banks will generally provide some assistance to their
business customers in acquiring information about the
creditworthiness of other firms
4. The customer’s payment history with the firm: The most obvious
way to obtain information about the likelihood of customers not
paying is to examine whether they have settled past obligations
(and how quickly)
CREDIT EVALUATION AND SCORING
• Five Cs of credit are the five basic credit factors to be evaluated in
assessing the probability a customer will not pay:
1. Character: Customer’s willingness to meet credit obligations
2. Capacity: Customer’s ability to meet credit obligations out of
operating cash flows
3. Capital: Customer’s financial reserves
4. Collateral: An asset pledged in the case of default
5. Conditions: General economic conditions in the customer’s line of
business
• Credit scoring is the process of quantifying the probability of default

when granting consumer credit
• Because credit-scoring models and procedures determine who is and
who is not creditworthy, it is not surprising that they have been the
subject of government regulation
Collection policy: Monitoring receivables
• To keep track of payments by customers, most firms will monitor
outstanding accounts
• Firm will normally keep track of its ACP through time
• Aging schedule is a compilation of accounts receivable by the age of
each account
• To prepare, the credit department classifies accounts by age
• Suppose a firm has $100,000 in receivables. Some are only a few days
old, but others have been outstanding for quite some time.
• If firm has a credit period of 60 days, then 25% of accounts are late
Collection effort
• A firm usually goes through the following sequence of procedures for
customers whose payments are overdue:
1. Sends out a delinquency letter informing the customer of the past-
due status of the account
2. Makes a telephone call to the customer
3. Employs a collection agency
4. Takes legal action against the customer
• Firm may refuse to grant additional credit to customers until arrearages

are cleared up
• When the customer files for bankruptcy, the credit-granting firm is just
another unsecured creditor
• The firm can wait, or it can sell its receivable
Inventory management
• Financial manager of a firm will not normally have primary control over
inventory management
• Other functional areas (e.g., purchasing, production, and marketing)
will usually share decision-making authority regarding inventory
• For a manufacturer, inventory is normally classified into one of three
categories:
1. Raw material is whatever the firm uses as a starting point in its
production process.
2. Work-in-progress is unfinished products
3. Finished goods are products ready to ship or sell
• Keep in mind three things concerning inventory types:
• Names for different types of inventory can be misleading because one
company’s raw materials can be another’s finished goods
• Various types of inventory can be different in terms of liquidity
• Derived (or dependent demand) items versus independent items
Inventory costs
• Carrying costs represent all the direct and opportunity costs of keeping
inventory on hand and include:
1. Storage and tracking costs
2. Insurance and taxes
3. Losses due to obsolescence, deterioration, or theft
4. The opportunity cost of capital on the invested amount
• Shortage costs are associated with having inventory on hand and
consist of two components:
1. Restocking or order costs are either the costs of placing an order
with suppliers or the costs of setting up a production run
2. Costs related to safety reserves are opportunity costs such as lost
sales and loss of customer goodwill that result from having
inadequate inventory
• Basic trade-off exists in inventory management because carrying costs
increase with inventory levels, whereas shortage or restocking costs
decline with inventory levels
Inventory management techniques:
ABC approach
• Basic idea is to divide inventory into
three (or more) groups
• Underlying rationale is that a small
portion of inventory in terms of
quantity might represent a large
portion in terms of inventory value
• As Figure 20.2 shows, A Group
comprises only 10% of inventory by
item count, but represents more than
half of the value of inventory
• Items monitored closely; inventory
levels are kept relatively low
• C Group are basic inventory items
(e.g., nuts and bolds); crucial and
inexpensive, so large quantities are
ordered and kept on hand
• B Group consists of in-between items
Inventory management techniques:
economic order quantity (EOQ) model
• Best-known approach for explicitly
establishing an optimal inventory
level
• Basic idea illustrated in Figure
20.3, which plots various costs
associated with holding inventory
against inventory levels
• With the EOQ model, we will
attempt to specifically locate the
minimum total cost point, Q*
• Keep in mind is the cost of the
inventory itself is not included
• This is because the total amount
of inventory the firm needs in a
given year is dictated by sales
EOQ model: inventory depletion
• To develop the EOQ, we will assume that the firm’s inventory is sold at
a steady rate until it hits zero
• At that point, firm restocks its inventory back to some optimal level
• Suppose the Eyssell Corporation starts out today with 3,600 units of a
particular item in inventory. Annual sales of this item are 46,800 units,
which is about 900 per week.
• If Eyssell sells off 900 units of inventory each week, then all the
available inventory will be sold after four weeks, and Eyssell will restock
by ordering (or manufacturing) another 3,600 units and start over
• This selling and restocking process produces a sawtooth pattern for
inventory holdings
• Eyssell always starts with 3,600 units and ends up at zero
• On average, then, inventory is half of 3,600, or 1,800 units
EOQ model: the carrying costs
• Carrying costs are normally assumed to be directly proportional to
inventory levels
• Suppose we let Q be the quantity of inventory that Eyssell orders each

time (3,600 units); we will call this the restocking quantity
• Average inventory would then be Q/2, or 1,800 units
• If we let CC be the carrying cost per unit per year, Eyssell’s total carrying
costs will be:
Total carrying costs = Average inventory × Carrying cost per unit
= (Q/2) × CC
• In Eyssell’s case, if carrying costs were $.75 per unit per year, total
carrying costs would be the average inventory of 1,800 units multiplied
by $.75, or $1,350 per year
EOQ model: the restocking costs
• Restocking costs are normally assumed to be fixed
• Suppose we let T be the firm’s total unit sales per year

• If the firm orders Q units each time, then it will need to place a total of
T/Q orders
• For Eyssell, annual sales are 46,800, and the order size is 3,600
• Eyssell places a total of 46,800/3,600 = 13 orders per year
• If the fixed cost per order is F, the total restocking cost for the year
would be:
Total restocking cost = Fixed cost per order × Number of orders
= F × (T/Q)
• For Eyssell, order costs might be $50 per order, so the total restocking
cost for 13 orders would be $50 × 13 = $650 per year
EOQ model: the total costs
• Total costs associated with holding inventory are the sum of the
carrying costs and the restocking costs:
Total costs = Carrying costs + Restocking costs
= (Q/2) × CC + F × (T/Q)
• Our goal is to find the value of Q, the restocking quantity, that
minimizes this cost
• For Eyssell, carrying costs (CC) were $.75 per unit per year, fixed costs
(F) were $50 per order, and total unit sales (T) were 46,800 units
• With these numbers, here are some possible total costs:
EOQ model: the total costs (continued)
• We can find the minimum point by setting carrying costs equal
restocking costs and solving for Q*:
Carrying costs = Restocking costs
(Q*/2) × CC = F × (T/Q*
• With a little algebra, we get:
Q*2 = (2T×F)/CC
• Economic order quantity (EOQ) is the restocking quantity that
minimizes the total inventory costs
Carrying costs and restocking costs
The EOQ
Extensions to the EOQ model
• We have assumed a company will let its inventory run down to zero and
then reorder, but a company will wish to reorder before its inventory
goes to zero for two reasons:
1. By always having some inventory on hand, firm minimizes risk of a
stockout (and resulting losses of sales and customers)
2. When a firm does reorder, there will be some time lag before the
inventory arrives
• Safety stock is minimum level of inventory a firm keeps on hand

• Inventories are reordered whenever the level of inventory falls to the
safety stock level
• To allow for delivery time, a firm will place orders before inventories
reach a critical level
• Reorder points are the times at which the firm will actually place its
inventory orders
Managing derived-demand inventories
• Materials requirement planning (MRP) is a set of procedures used to
determine inventory levels for demand-dependent inventory types,
such as work-in-progress and raw materials
• Basic idea behind MRP is that, once finished goods inventory levels are
set, it is possible to determine what levels of work-in-progress
inventories must exist to meet the need for finished goods
• Particularly important for complicated products for which a variety of
components are needed to create the finished product
• Just-in-time inventory is a system for managing demand-dependent

inventories that minimizes inventory holdings c
• Goal is to minimize inventories, thereby maximizing turnover
• Began in Japan and is a fundamental part of Japanese manufacturing
philosophy
• Result is that inventories are reordered and restocked frequently

Financial Management II CH 1-5

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Course Title: Financial Management-II

 Capital structure (What?)

 What will be the final impact of the restructuring?

 Sprint should borrow Br500 if it expects Scenario I

• Trading on equity and EBIT - EPS analysis (Financial risk)…

Hence, a finance manager in designing a suitable pattern of capital structure

• Substituting Q = 1,000, P = Birr10,

 the DOL value of 2.0 means that at

Capital Structure Decision

Comparing ABC Company’s 0% and 30% capital structures, we get

 The calculated value of

 Firm L has Br16.80 more total cash flow due

II. Factors influencing dividend policy

III. Establishing the dividend policy in practice

The term payout policy refers to the decisions that a firm

Background - Dividends as a Basis for Value

• The optimal dividend policy should maximize the price of

• A decision to increase dividends will raise D1 putting upward

• The dividend controversy is whether paying or not paying

• The question can also be stated in terms of stockholder

• Modigliani-Miller support irrelevance.

II. Dividend Relevance Arguments…

II. Dividend Relevance Arguments…

II. Dividend Relevance Arguments…

c) Tax Preference Theory

• Retained earnings lead to long-term capital gains, which are

• This could cause investors to prefer firms with low payouts,

Stock Price ($)

0 50% 100% Payout

Cost of equity (%)

0 50% 100% Payout

But which, if any, is correct???

• empirical studies/testing have not provided evidence that

• thus, managers use judgment when setting policy.

• analysis is used, but it must be applied with judgment.

• Real-world Factors Favoring a High/Low Dividend Payout

Constant-Payout-Ratio Dividend Policy

A firm’s dividend payout ratio indicates the percentage of

A constant-payout-ratio dividend policy is a dividend policy

 Regular Dividend Policy

Low-Regular-and-Extra Dividend Policy

1. True or false: Dividends are irrelevant

2. True or false: Dividend policy is irrelevant

I. Financial forecasting Vs Financial Planning

II. Importance of sales forecasting

III. The financial planning process

IV. Methods of forecasting financial statements

V. The EFR (External Fund Required( Formula

Definition - Financial planning is a process consisting of:

 Components of a Financial Planning Model

Components of a Financial Planning Model

Components of a Financial Planning Model

The Purpose of Planning and Plan Information

Financial Planning vs Financial Forecasting

Financial Forecasting Procedures

Lumpy assets are assets that cannot be acquired in small

• Refer Cost and Management Accounting – Master Budget

MANAGING & FINANCING

I. Managing Current Assets

• These cash flows are both unsynchronized and uncertain:

• Accounts payable period is the time between receipt of inventory and

• Most recent income statement provides the following figures:

• Next step is to calculate some financial ratios