Finance- Basic

Concepts
R Srinivasan FCA, FAFD, RV & RP
 Definition and Components
Financial management is a managerial activity concerned with planning and
controlling of the firm’s financial resources.
Components of financial management
•Procurement of Funds - Funds from different sources have different
characteristics in terms of risk, cost and control. The cost of funds should be
kept at the minimum by balancing risk, cost and control. The key consideration
in choosing the source of new business finance is to strike a balance between
equity and debt.
•Effective Utilization of Funds- The finance manager has to ensure that
funds are utilized to generate an income higher than the cost of procuring
them. Else, there is no point in running the business.
•Utilization of Fixed Assets- The funds are to be invested in fixed assets in
a manner that said assets produce a rate of return consistent with cost of
capital.
•Utilization for Working Capital-The finance manager must ensure that
working capital is adequate, without too much funds blocked in inventories,
book debts, cash etc.
Equity Vs Debt
Parameters Equity Debt
Nature Owners’ own funds Borrowed funds
Risk None. No repayment except in liquidation. Need to be repaid as per terms and
conditions exactly on due dates.

Interest None. Dividend payment not mandatory. Interest needs to be paid as per terms and
conditions exactly on due dates.

Cost Expensive. Shareholders take maximum Relatively cheaper than equity because of
risk and therefore expect high returns. lower risk.

Tax implications Not tax deductible. It is an appropriation Tax deductible. It is a deduction from
of post -tax profit profit.
Objectives of Financial Management

• Profit Maximization- There is a direct relationship

between risk and profit. Risk has to be balanced with
the profit objective. Profit maximization also needs
to take into account the social considerations and
also the interests of workers, consumers, society, and
ethical trade practices.
• Wealth / Value Maximization- Primary goal of the
firm is to maximize its market value. Business
decisions should seek to increase the net present
value of the economic profits of the firm.
Sources of Funds
Each source of funds has a cost and risk attached to it. It is a matter of CFO’s judgment as
to what is the appropriate capital structure, based on cost and degree of risk.
• Cost Principle: An ideal capital structure minimizes cost of capital and maximizes
earnings per share. For e.g. debt is cheaper than equity capital from the point of
its cost (interest being deductible for income tax purpose, whereas no such
deduction is allowed for dividends).
• Risk Principle: Higher debt means higher commitment in form of loan repayment
and interest payout. The gearing ratio measures the proportion of a company's
borrowed funds to its equity. The ratio indicates the financial risk to which a
business is subjected, since excessive debt can lead to financial difficulties.
Generally speaking, a firm should not have too high or too low degree of financial
risk.
• Control Principle: As far as possible, existing management control and ownership
need to remain undisturbed. Issue of new equity will dilute existing control
pattern and also involves higher cost. Issue of more debt causes no dilution in
control, but causes a higher degree of financial risk.
• Flexibility Principle: It is necessary adjust swiftly to changes in cost and the need
of funds in future. E.g. if company had borrowed @ 18% and funds are now
available at 15%, it should have the flexibility to return old debt and raise new
debt, at a lesser interest rate.
Determination of Cost of Funds
1. Non-redeemable debenture
• If not traded: Cost of debt = Coupon rate x Effective rate/ Net proceeds%
• If traded : Cost of debt = Coupon rate x Effective rate/ Market Price
2. Redeemable (at the end of period) debentures
• Approximation method
• If not traded: Cost of debt = (Effective rate + Amortized cost)/ Avg
Proceeds
• If traded : Cost of debt = (Effective rate + Amortized cost) / Market
Price
• Net Present Value Method- This is determined by calculation the IRR (Internal
Rate of Return) of the cash flows to maturity. IRR can be calculated by simply
using the MS Excel function “IRR” or by summing up the discounted cash flows
using an approximate rate for discounting (not explained here in detail).
• Redeemable in instalments- Where the principal is also repaid in (yearly)
instalments, the cost shall be ascertained by calculating the IRR.
• Convertible debentures - The calculation methodology is same as redeemable
debentures if the debentures are not converted to equity shares. In the event
they are converted to equity (at a predetermined rate), then the IRR can be
calculated in the same way as explained earlier, by making assumptions of the
market value of the equity share at the date of conversion.
Determination of Cost of Funds- Pref Capital

• Preference share is considered “quasi debt” for many purposes but from a
tax and risk perspective, it is at par with equity rather than debt.
• Payment of dividend to the preference shareholders is not mandatory in a
strict sense but gets priority over the equity shares.
• The preference dividend is not charged as expenses but treated as
appropriation of after tax profit.
• Hence, dividend paid to preference shareholders does not reduce the tax
liability on the company.
• The cost of preference capital is determined in the same way as redeemable
debentures, except that the adjustment of coupon rate for effect of taxation,
not being applicable, is ignored.
Determination of Cost of Funds- Equity Capital
At first blush it may seem that equity capital is free of cost. Actually, this is the
most sensitive and expensive source of funding. Equity shareholders take the
highest risk and hence expect the highest return.
The key elements of the risk premium comprise:
• The uncertainty as to the amount and timing of dividend distributions and
gains realized from public company stock appreciation.
• The company size. Generally, smaller company size is associated with higher
investment risk. Hence small company investors demand higher returns.
• Specific to the industry in which the business operates. High risk industries
would result in higher industry risk premium.
• Company specific risk premium which accounts for the unique attributes of
the business itself. Business risk factors that lead to higher premium values
include unstable earning, high leverage, customer or product concentration.
Determination of Cost of Funds- Equity Capital
• Dividend valuation model- This model can be applied regardless of whether
dividends are constant or growing year-on-year. The formula is:
Cost of Equity= [(Current Dividend(in Rs) )* (1+ Growth rate)/ Market Price)] +
Growth Rate(In decimals)

Example  
Face value 10
Existing dividend 5%
Market Price 20
Expected growth rate of dividend 10%

Solution  
  ={0.50 (1+10%)/ 20}+ 10%
  =0.1275 or 12.75%
Determination of Cost of Funds- Equity Capital
• Gordon’s Growth Model- This model (also known as the
Dividend Discount Model) postulates that, if growth in
dividends is constant, the intrinsic value at the end of the
period can be predicted by the formula:
Value= End period Dividend(in Rs) (D)/ ((Expected Growth Rate or
RFR)- (Actual growth rate)).
Example – If Dividend =Rs10, the Co expects to grow @10%, RFR is
8%, 10/(0.10-0.08)= 10/0.02=Share Price=Rs500
Modigliani and Miller maintain that dividend policy has no effect on the
share price of the firm and is, therefore, of no consequence. What matters,
according to them, is the investment policy through which the firm can
increase its earnings and thereby the value of the firm. ‘Under conditions of
perfect capital markets, rational investors, absence of tax discrimination
between dividend income and capital appreciation, given the firm’s
investment policy, its dividend policy may have no influence on the market
price of shares’.
Determination of Cost of Funds- Equity Capital
• Price to Earnings Ratio - Value of equity share is a multiple of profits per share
available to equity shareholders. This multiple (called PE) is a complex
macroeconomic variable and will vary from industry to industry, company to
company, country to country etc.
• Formula Price = Earning * PE Multiple.

Example  
Face Value 10
Benchmark Earnings Per share 1
Therefore Benchmark PE 10
Actual earnings per share 2.5
Price (before adjusting for growth) 25
Cost of Equity 10%

The above formula is rather simplistic because it assumes constant rate of earning
and does not take into account growth(actually the growth is impliedly considered by
taking a higher PE multiple for growth companies).
A variation of PE Ratio is the PEG ratio. PEG ratio is arrived at by dividing the PE ratio with
the expected growth rate. If the ratio is over 1, then the stock is considered overprice and if
it is less than 1 then the stock is considered undervalued.
Determination of Cost of Funds- Equity Capital
CAPM- Capital Asset Pricing model -This method is used when the project at hand is
substantially different from other projects of the company in terms of risk and cost and it
is therefore decided to know the cost of capital on standalone basis. Under the CAPM
method, the expected return equals the Risk free rate (RFR) + Risk premium. The risk
premium here is a function of beta (β, volatility) and portfolio returns (PFR) for that class
of assets (equity shares in this case). Therefore the formula is given as:
CAPM rate = RFR+ β (PFR- RFR).
Example: Let us say a company is considering a new project.
Existing (without new project): RFR is 10%, PFR is 15%, β is 1.25. Debt-Equity is 3:2,
cost of debt 12% and tax rate is 40% . Then New Project: β is 2, and takes up 25% of
total funds (debt+ equity).
Then, existing CAPM=0.10+ 1.25(0.15-0.10) =0.1625 = 16.25%. Post tax debt cost
=12-(12x40%)=7.2%. WACC= Equity CAPM 16.25% (as above) x 2/5 + Debt Cost 7.2%
x 3/5=10.82%. Then β of Co as a whole= 75% x 1.25 (existing β) + 25% x 2 (project β)
=1.44. Cost of equity of Company as a whole =10%+[1.44(15-10)]=17.20
WACC of Company as a whole = 75% x 17.20 + 25% 10.82 =15.605
Beta -
β is the non diversifiable market risk measured as Covariance of the asset with Market
portfolio/ variance of market portfolio.

Beta Value Interpretation

(-) Ve Inverse correlation – If market moves one way, the asset moves
opposite direction. Very rare.
Zero No correlation at all. The asset does not react to market.
Less than 1 Asset is less volatile than market
One Almost perfectly correlated. Moves in tandem with market.
More than 1 Asset is more volatile than market.

For example, if a stock's beta is 1.2, it's theoretically 20% more volatile than the
market. Conversely, if an ETF's beta is 0.65, it is theoretically 35% less volatile
than the market.
Beta -
• Levered and Unlevered β- Levered and Unlevered β is given
by the Formula:
• βL= βU * (1+[(1-Tax rate) * DE Ratio])
• βU= βL / (1+[(1-Tax rate) * DE Ratio])
Example – If levered β = 2.23, DE is 0.67, Tax rate=36% then,
βU= 2.23/ (1+ [(1-.36)*.67])=2.23/1.4288=1.56.
Value of a Levered Company= Value of Levered Co + Tax benefit
• Adjusted Beta and Raw Beta. The adjusted beta is an
estimate of a security's future beta. It uses the historical data
of the stock, but assumes that security's beta moves toward
the market average over time. The formula is as
follows: Adjusted beta = (.67) * Raw beta + (.33) * 1.0.
Terminal Value
The terminal value of a series of stable cash flows (constant growth) to
perpetuity is given by the formula:
TV= CF (of terminal year) (1+g)/ (WACC-g).
• If cash flow is not constant, we have to break down the cash flows to
2 stages. In the two-stage model, it is assumed that the first stage
goes through an extraordinary growth phase while the second stage
goes through a constant growth phase. The first stage is calculated by
applying conventional PV formula to each year cash flow and added
to the constant growth rate phase estimated as above.
• Another variation of the two stage growth (or de-growth) is the H
model, wherein growth reduces gradually to approach the constant
growth rate in the second stage. The key point to note here is that
the growth rate is assumed to reduce in a linear way in the initial
phase till it reaches stable growth rate in the second stage.
Other Terms
• Economic Valued Added - In macroeconomics this is the return achieved by the firm
minus a charge for capital. In finance, this is calculated as Return on Net-worth (-)
(Capital employed * WACC).
• Profitability index is an index that attempts to identify the relationship between the
costs and benefits of a proposed project through the use of a ratio calculated as: PV of
future cash flows / Initial investment.
• A profitability index of 1.0 is logically the lowest acceptable measure on the index, as
any value lower than 1.0 would indicate that the project's present value (PV) is less
than the initial investment. As the value of the profitability index increases, so does the
financial attractiveness of the proposed project.
• Adjusted Present Value- Adjusted present value refers to the net present value (NPV)
or investment adjusted for the interest and tax advantages of leveraging debt provided
that equity is the only source of financing. The method is to calculate the NPV of the
project as if it is all-equity financed (so called base case). The main benefit is a tax
shield resulted from tax deductibility of interest payments. Another benefit can be a
subsidized borrowing at sub-market rates.
• APV = Unlevered NPV of Free Cash Flows and assumed Terminal Value + NPV of Interest
Tax Shield and assumed Terminal Value. The discount rate used in the first part is the
return on assets or return on equity if unlevered. The discount rate used in the second
part is the cost of debt financing by period.
Leverages
• Operating Leverage- It is defined as the extent to which
contribution needs to happen to cover fixed costs (other than
interest). It is calculated as Contribution/ EBIT. Higher the leverage,
higher is the risk.
• Financial Leverage- It is defined as the extent to which EBIT needs
to happen to cover interest costs. It is calculated as EBIT/ EBT.
Higher the financial leverage, higher the risk but is also to be noted
that higher is the Earning per share. Financial leverage is therefore
known as the “double edged sword”.
• Combined Leverage – It is Operating Leverage x Financial leverage.
It is calculated as Contribution / EBT.
• Indifference Point – It is that level of EBIT at which two capital
structures, with different levels of debt and Equity, give the same
EPS. It is calculated as : [(EBIT- Interest 1)/ Equity 1]= [(EBIT-
Interest 2)/ Equity 2]