Finacial managment www.it-workss.com

Q. Define Financial Management and explain its nature.
Ans. Introduction :– Financial management is that part of managerial process
which is concerned with the planning and controlling of firm’s financial
resources. It is concerned with the procurement of funds from most suitable
sources and making the most efficient use of such funds. In the earlier stages,
financial management was a branch of economics and as a separate subject it
is of recent origin. The subject is of immense importance to the managers
because among the most crucial decisions of the firm are those which relate to
finance.
Meaning of Financial Management :– Financial management is a vital and an
integral part of business management. It refers to that part of managerial
activity which is concerned with planning and controlling of financial resources
of the enterprise. It deals with raising finance for the enterprise and the efficient
utilization of such finance. It includes:
Ø
Investment Decisions
Ø
Financing Decisions
Ø
Dividend Decisions
Ø
Liquidity Decisions
Ø
Capital budgeting
Ø
Budgetary Control
Definition of Financial Management :–
According to Joseph L. Massie
“Financial management is the operational activity of a business that is
responsible for obtaining and effectively utilizing the funds necessary for
efficient operations.”
According to Wheeler
“Financial Management is the activity which is concerned with the
acquisition and administration of capital funds in meeting the financial needs
and overall objectives of business enterprise.”
Nature of Financial Management :–
(1) Financial Management is an essential part of Top Management :– In
the modern business management the financial manager is one of the
active members of top management team and day-by-day his role is
becoming more significant in solving the complex management problems.
This is because almost all kinds of business activities such as production,
marketing etc. directly or indirectly involve the acquisition and use of
finance.
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Institute of IT & Management
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(2) Less Descriptive and More Analytical :– Financial management is less
descriptive and more analytical. Due to the development of new statistical
and accounting techniques of financial analysis, the financial
management chooses the best alternative out of the many possible
alternatives.
(3) Continuous Function :– Financing is a continuous function. In addition
to the raising of finance, there is a continuous need for planning and
controlling the finances of an enterprise. A firm performs finance
functions continuously in the normal course of the business.
(4) Different from Accounting Function :– There are key difference between
the accounting and finance function. Accounting generates information or
data whereas in the finance function the data re analysed and used for the
purpose of decision making.
(5) Wide Scope :– There is wide scope of financial management. It is
concerned not only with the raising of finance but also with the allocation
and efficient use of such finance.
(6) Centralised Nature :– Financial management is centralized in nature. It
is neither possible nor desirable to decentralize the financial
responsibilities.
(7) Measurement of Performance :– Financial management is concerned
with the wise use of finance. It fixes certain norms and standards against
which the benefits of an investment decisions are matched.
(8) Inseparable Relationship between Finance and other Activities :–
There exists an inseparable relationship between finance on the one hand
and production, marketing and other activities on the other. All other
activities are related to finance.
(9) Applicable to All Types of Organisations :– It is applicable to all forms of
organization whether corporate or non-corporate such as sole
proprietorship and partnership firms etc.
Q. Define Financial Management. Explain the Scope of Financial
Management.
OR
Q. Define Finance Function and discuss its nature and scope
Ans. Meaning of Finance :– Finance is defined as the provision of money at the
time when it is required. The role of finance in business enterprise needs no
emphasis. Every enterprise, whether big or small, needs finance to carry on
and expand its operations. Finance holds the key to all the business activities
and a firm’s success and, in fact, its survival is dependent upon how efficiently
it is able to acquire and utilize the funds.
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Meaning of Financial Management :– Financial management is a vital and an
integral part of business management. It refers to that part of managerial
activity which is concerned with planning and controlling of financial resources
of the enterprise. It deals with raising finance for the enterprise and the efficient
utilization of such finance.
Scope of Financial Management :– Financial management as an academic
discipline has undergone notable changes over the years, with regard to its
scope of functions. At the same time, the financial manager’s role also has
undergone fundamental changes over the years. Study of the changes that
have taken place over the years is known as “Scope of Financial Management”.
In order to have an easy understanding and better exposition to the changes, it
is necessary to divide the scope into two approaches:
(A) Traditional Approach
(B) Modern Approach
(A) Traditional Approach :– Under this approach the role of financial
management was limited to the procurement of funds on suitable terms.
The utilization of funds was considered out of the scope of financial
management. Under this approach, a study of the following three things
was made for the procurement of funds:
(1) Arrangement of funds from Financial Institutions.
(2) Arrangement of funds through financial Instruments like share, bonds
etc.
(3) Legal and accounting relationship between a business and its source
of funds.
The notable feature of the traditional approach was the assumption that
the duty of the finance manager was only to raise funds from external parties
and that he was not concerned with taking the internal financial decisions. He
was not responsible for the efficient use of funds.
Limitations of Traditional Approach :– The traditional approach continued
till mid 1950’s. It has now been discarded as it suffers from the following
limitations:
(i) More Emphasis on Raising of Funds :– This approach places more
emphasis on procurement of funds from external sources and neglects
the issues relating to the efficient utilization of funds. Since it is
concerned with the raising of funds, it attaches more importance to the
FINANCIAL MANAGEMENT
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viewpoint of external parties who provide funds to the business and
completely ignores the internal persons who make financial decisions.
(ii) Ignores the Financial Problems of Non-Corporate Enterprises :– It
places more emphasis on the problems faced by corporate enterprises
in procuring the funds. The non-corporate enterprise like sole
proprietorship and partnership firms are considered outside its scope.
(iii Ignored Routine Problems :– This approach concentrates on the
financial problems on the occurrence of special events such as merger,
incorporation etc, and fails to consider the day-to-day financial
problems of a normal firm.
(iv) Ignored Working Capital Financing :– This approach gives more
emphasis on the problems relating to long term financing and the
problems relating to working capital financing are considered outside
the purview of this approach.
(B) Modern Approach :– The modern approach considers the term financial
management in a broad sense. According to this approach the finance
function covers both acquisition of funds as well as their efficient
utilization. According to this approach the financial management is
concerned with the solution of three major problems relating finance:
(1) What is the total volume of funds an enterprise should commit?
(2) How should the funds required be raised?
(3) In what specific assets the enterprise should invest its funds?
Thus, in the modern approach, the financial management is responsible
for taking three decisions:
(1) The Investment Decision :– Investment decision also known as ‘Capital
Budgeting’ is related to the selection of long-term assets or projects in
which investments will be made by the business. Long term assets are
the assets which would yield benefits over a period of time in future.
(2) The Financing Decision :– This function is related to raising of finance
from different sources. For this purpose the financial manager is to
determine the proportion of debt and equity. In other words there are
two sources of finance:
(i) Debt:– Debt means long term loans and includes:
Ø
Debentures
Ø
Loan from Bank
Ø
Loan from Financial Institutions
Ø
Mortgage Loans
(ii) Equity: Equity refers to shareholder’s funds and includes:
Ø
Equity Share Capital
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Ø
Preference Share Capital
Ø
Reserve
Ø
Accumulated Profits
(3) The Dividend Policy Decision:– The financial management has to
decide as to which portion of the profits is to be distributed as dividend
among shareholders and which portion is to be retained in the
business. For this purpose the financial management should take into
consideration the factors of dividend stability, bonus shares and cash
dividends in practice.
Q: Discuss the Chief Functions of Finance OR Financial Management.
Ans: Meaning of Financial Management :– Financial management is a vital
and an integral part of business management. It refers to that part of
managerial activity which is concerned with planning and controlling of
financial resources of the enterprise. It deals with raising finance for the
enterprise and the efficient utilization of such finance.
Functions of Finance OR Financial Management :– The functions of finance
are:
(1) Determining the Financial Needs
(2) Financing Decision
(3) Investment Decision
(4) Working Capital Decision
(5) Dividend Policy Decision
(6) Financial Control
(7) Routine Functions.
1. Determining the Financial Needs :– The first task of the financial
management is to estimate and determine the financial requirements of
the business. For this purpose, the short term and long term needs of the
business are estimated separately. While determining the financial needs
the financial management should take into consideration the:
Ø
Nature of the Business
Ø
Possibilities for future expansion
Ø
Attitude of the management towards risk
Ø
General economic circumstances etc.
2. Financing Decision :– This function is related to raising of finance from
different sources. For this purpose the financial manager is to determine
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the proportion of debt and equity. In other words there are two sources of
finance:
(i) Debt:– Debt means long term loans and includes:
Ø
Debentures
Ø
Loan from Bank
Ø
Loan from Financial Institutions
Ø
Mortgage Loans
(ii) Equity:– Equity refers to shareholder’s funds and includes:
Ø
Equity Share Capital
Ø
Preference Share Capital
Ø
Reserve & Accumulated Profits
3. Investment Decision :– Investment decision also known as ‘Capital
Budgeting’ is related to the selection of long-term assets or projects in
which investments will be made by the business. Long term assets are the
assets which would yield benefits over a period of time in future.
4. Working Capital Decision :– It is concerned with the management of
current assets. It is an important function of financial management.
Current assets should be managed in such a way that the investment in
current assets is neither inadequate nor unnecessary funds are locked up
in current assets.
Ø
If a firm does not have adequate working capital, that is its investment
in current assets is inadequate, it may become illiquid and as a result
may not be able to meet its current obligations.
Ø
On the other hand, if the investment in current assets is too large, the
profitability of the firm will be adversely affected because idle current
assets will not earn anything.
5. Dividend Policy Decision :– The financial management has to decide as
to which portion of the profits is to be distributed as dividend among
shareholders and which portion is to be retained in the business. For this
purpose the financial management should take into consideration the
factors of dividend stability, bonus shares and cash dividends in practice.
6. Financial Control :– The establishment and use of financial control
devices is an important function of financial management. These devices
include:
Ø
Budgetary Control
Ø
Cost Control
Ø
Ratio Analysis etc.
Process of Financial Control :–
(i) Setting the standards
(ii) Measurement of Actual Performance
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(iii)Comparison of Actual Performance with standards
(iv)Finding deviations and taking remedial actions.
7. Routine Functions :– The routine functions are :
Ø
Supervision of cash receipts and payments.
Ø
Opening Bank Accounts and managing them
Ø
Safeguarding of securities, insurance policies and other valuable
documents
Ø
Maintaining records and preparation of reports
Q. What do you mean by Organisation of Finance Function? Explain the
functions of Financial Manager.
Ans. Organisation of Finance Function :– organization of finance function
means the division of functions relating to finance and to set up a sound and
efficient organization for performing the finance functions. Since the financial
decisions are very crucial for the survival as well as growth and development of
the firm. The ultimate responsibility of carrying out the finance function lies
with the top management. Hence, a department to organize and carry out the
financial activities is created under the direct control of the board of directors.
This department is headed by a financial manager.
However, the exact nature of the organization of the finance functions differs
from firm to firm depending upon many factors such as:
(i) Size of the Firm
(ii) Nature of its Business
(iii)Type of financing operations
(iv)Capabilities of firm’s financial officers etc.
Graphic Presentation of Organisation of Finance Function : – The following
chart depicts the organization of the finance function of a large business firm:
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Board of Directors
Managing Director
Production
Manager
Personnel
Manager
Financial
Manager
Marketing
Manager
Treasurer Controller
Cash
Management
Banking
Management
Credit
Management
Assets
Management
Securities
Management
Internal
Audit
Data
Processing
Cost
Accounting
Financial
Accounting
Planning &
Annual
Budgeting Reports
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Functions of Financial Manager :– The financial manager is a member of top
management. He is closely associated with the formulation of financial policies
as well as financial decision making. He is expected to perform the following
functions:
(1) Financial Planning :– The financial manager estimates the financial
needs of the business, determines the capital structure and prepares
financial plan.
(2) Procurement of Funds :– He arranges to acquire the funds from
various sources such as shares, debentures etc.
(3) Coordination :– He maintains a proper coordination among the
financial needs of different departments.
(4) Control :– He establishes the standards of financial performance and
examines whether the actual performance is according to pre-
determined standards. He is responsible for:
Ø
Controlling the Costs
Ø
Analysing the Profits
Ø
Preparation of Reports
(5) Business Forecasting :– He keeps a close watch on the various events
affecting the organization such as:
Ø
Technological Changes
Ø
Competition
Ø
Change in Govt. Policy
Ø
Change in social and business environment and studies their effect
on the firm.
(6) Other Functions: Other functions we includes:
Ø
Cash Management
Ø
Banking Relations
Ø
Credit Management
Ø
Assets Management
Ø
Securities Management
Ø
Accounting
Ø
Internal Auditing.
Functions of Treasurer :–
(1) Cash Management :– It includes the managing of cash receipts and cash
payments of the business.
(2) Banking Relations :– It includes banking relations, operating bank
accounts, and managing deposits and withdrawals etc.
(3) Credit Management :– It includes determining the credit worthiness of
the customers and arrangement for collection of credit sales.
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(4) Assets Management :– It includes arrangement for the acquisition,
disposal and insurance of various assets.
(5) Securities Management :– It includes the investment of surplus funds of
the business.
(6) Protecting Funds and Securities :– It includes custody of funds and
securities.
Functions of Controller :–
(1) Planning & Budgeting :– It includes profit planning, capital
expenditure planning, budgeting, inventory control, sales forecasting
etc.
(2) Financial Accounting :– He establishes a proper system of
accounting, controls it and prepares financial statements such as
profit & Loss Account and Balance Sheet etc.
(3) Cost Accounting :– He establishes a cost accounting system suitable
to the business and controls it.
(4) Data Processing :– It includes the collection and analysis of business
data.
(5) Internal Auditing :– He manages internal audit and internal control.
(6) Annual Reports :– He prepares annual reports and various other
reports needed by the top management.
(7) Information to Government :– He prepares annual reports to be
submitted to the Government under various laws.
Q. What are the goals Or Objectives of Financial Management?
Ans. Meaning of Financial Management :– Financial management is a vital
and an integral part of business management. It refers to that part of
managerial activity which is concerned with planning and controlling of
financial resources of the enterprise. It deals with raising finance for the
enterprise and the efficient utilization of such finance.
Objectives of Financial Management :– It is the duty of the top management
to lay down the objectives or goals which are to be achieved by the business.
The main objectives are:
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1. Profit Maximization :– According to this approach, all activities which
increase profits should be undertaken and which decrease profits should
be avoided. Profit maximization implies that the financial decision
making should be guided by only one test, which is, select those assets,
projects and decisions which are profitable and reject those which are not.
Arguments are in favour of Profit Maximization Approach :–
(i) Best Criterion on Decision-Making :– The goal of profit maximization
is regarded as the best criterion of decision-making as it provides a
yardstick to judge the economic performance of the enterprises.
(ii) Efficient Allocation of Resources :– It leads to efficient allocation of
scare resources as they tend to be diverted to those uses which, in
terms of profitability, are the most desirable.
(iii)Optimum Utilization :– Optimum utilization of available resources is
possible.
(iv)Maximum Social Welfare :– It ensures maximum social welfare in the
form of maximum dividend to shareholder, timely payment to
creditors, higher wages, better quality and lower prices, more
employment opportunities to the society and maximization of capital to
the owners.
Criticism of Profit Maximization Approach:
(i) Ambiguous :– One practical difficulty with this approach is that the
term profit is ambiguous. Different people take different meaning of
term profit. For example:
Ø
Profit may be short-term or long-term.
Ø
Profit may be before tax or after tax.
Ø
Profit may be total profit or rate of profit.
Ø
Profit may be return on total capital employed or total assets or
shareholders funds.
(ii) Ignores the Time Value of Money :– This approach ignores the time
value of money. It does not make a distinction between profits earned
over the different years. It ignores the fact that the value of one rupee at
present is greater than the value of same rupee received after one year.
(iii)Ignores Risk Factor :– This approach ignores the risk associated with
the earnings. If the two firms have the total expected earnings, but if
earnings of one firm fluctuate considerably as compared to the other, it
will be more risky. It is, thus, clear that profit maximization criterion is
inappropriate and unsuitable. It is not only ambiguous but fails to
solve the problems of time value of money and the risk. An alternative
to profit maximization, which solves these problems, is the criterion of
wealth maximization.
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2. Wealth Maximization :– It is also termed as value maximization or Net
Present worth maximization. This approach is now universally accepted
as an appropriate criterion for making financial decision as it removes all
the limitations of profit maximization approach. It is also known as net
present value (NPV) maximization approach. According to this approach
the worth of an asset is measured in terms of benefits received from its
use less the cost of its acquisition. Benefits are measured in terms of cash
flows received from its use rather than accounting profit which was the
basis of measurement of benefits in profit maximization approach.
Another important feature of this approach is that it also incorporates
the time value of money. While measuring the value of future cash flows
an allowance is made for time and risk factors by discounting or reducing
the cash flows by a certain percentage. This percentage is known as
discount rate.
The difference between the present value of future cash inflows generated
by an asset and its cost is known as net present value.
Ø
A financial asset or a project which has a positive NPV creates wealth
for shareholders and, therefore is undertaken.
Ø
On the other hand, a financial asset or a project resulting in negative
NPV should be rejected since it would reduce shareholder’s wealth.
Ø
If one out of various projects is to be choosen, the one with the highest
NPV is adopted.
The NPV can be calculated with the help of the following formula:
A1 A2 An
W =—————— + —————— + ——————— +——————— - C
(1+K)1 (1+K)2 (1+K)n
W = Net Present Worth
A1, A2,——An = Stream of Cash Flows
K = Appropriate discount rate to measure risk and time factors
C = Initial outlay to acquire an asset or pursue a course of action.
Merits of Wealth Maximization Approach :–
The wealth maximization approach is superior to the profit maximization
approach because:
1. Wealth maximization approach uses cash flows instead of accounting
profits which avoids the ambiguity regarding the exact meaning of the
term profit.
2. Wealth maximization approach gives due importance to the time
value of money by reducing the future cash flows by an appropriate
discount or interest rate.
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Compounding or
Future Value
Discounting or
Present Value
Time Value
of Money
Q. Explain the Concept of Time value of Money.
Ans. Introduction :– “Time value of money” means that the value of a unit of
money is different in different time periods. The value of a sum of money
received today is more than its value received after some time. Conversely, the
sum of money received in future is less valuable than it is today. In other words,
the present worth of a rupee received after some time will be less than a rupee
received today. The time value of money can also be referred to as time
preference for money.
Three reasons may be attributed to the individual’s time preference for money.
Ø
Risk
Ø
Preference for consumption
Ø
Investment opportunities.
We live under risk or uncertainty. As an individual is not certain about future
cash receipts, he or she prefers receiving cash now. Most people have
subjective preference consumption over future consumption of goods and
service either because of the urgency of their present wants or because of the
risk is not being in a position to enjoy future consumption that may be caused
by illness or death, Or because of inflation.
(A) Compounding or Future Value Concept :– Under this method of
compounding, the future values of all cash inflows at the end of the time
horizon at a particular rate of interest are found. Interest is compounded when
the amount earned on an initial deposit becomes part of the principal at the end
of the first compounding period.
Example :– If Mr. A invests Rs. 1,000 in a bank which offers him 10%
interest
compounded annually, he as Rs. 1,100 in his account at the end of the first
year. The total of the interest and principal Rs. 1,100 constitutes the principal
for the next year. He thus earns Rs, 1,210 for the second year. This becomes the
principal for the third year and so on.
(1) Compound Value of a Single Flow (Lump Sum):- The process of
calculating future value becomes very cumbersome if they have to be
calculated over long maturity periods 10 to 20 years. A generalized
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procedure for calculating the future value of a single cash flow
compounded annually is as follows:
n
FV = PV (1+i)
Where, FV = Future value of the initial flow in n years
PV= Initial Cash flow
i= Annual rate of interest
n = No. of years for which compounding is done.
Example :– Mr. x invests Rs. 1,000 at 10% is compounded annually for
three years. Calculate value after three years.
n
FV = PV (1+i)
3
FV = 1000 (1+.10)
FV = Rs. 1,331
(2) Multi-period Compounding or Future Value :– If the company will
compounding interest half-yearly (semi-annually) instead of annually
then investors will gain as he will get interest on half-yearly interest. Since
interest will be compounded half-yearly, for finding out the compound
value.
n x m
FV = PV (1+i/m)
m= No. of times compounding is done during a year.
Example :– Mr. X invests Rs. 10,000 at 10% p.a. compounded semi-
annually. Calculate value after three years.
n x m
FV = PV (1+i/m)
3 x 2
FV= 10,000 (1+.10/2)
FV = Rs. 11,025
(3) Compounded Value of a Series of Cash Flows :– We have considered
only single payment made once and its accumulation effect. An investor
may be interested in investing money in installments and wish to know the
value of its savings after n years.
2 1
n
FV = A (1+i) ——————————— + A (1+i) + A (1+i) + A
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A = Amount deposit or invested.
Example :– Mr. X invests Rs.500, Rs.1000, Rs.1500, Rs. 2000 and Rs.
2500 at the end of each year for 5 years. Calculate the value at the end of 5 years
compounded annually
if the rate of interest is 5% p.a.
3 2 1
4 +
FV = 500 (1+0.05) 1000 (1+0.05) + 1500 (1+0.05) + 2000 (1+0.05) +2500
FV = Rs. 8020
(4) Compound Value of an Annuity :– Annuity refers to the periodic flows of
equal amounts.
n
FV = A {(1+i) – 1}/i
Example :– Mr. X invests Rs. 2,000 at the end of each year for 5 years into
his account, interest being 5% compounded annually. Determine the amount
of money he will have
th
at the end of the 5 year.
5
FV = 2000 {(1+.05) – 1}/.05
FV = Rs. 11054
(B) Discounting or Present Value Concept :– As per this concept, rupee one
of today is more valuable than rupee one a year later. The reason for more
value of rupee today than a rupee of future is interest. Discounting is the
process of determining present values of a series of future cash flows.
Example :– If Mr. X, depositor expects to get Rs. 100 after one year at the
rate of 10%, the amount he will have to forgo at present is Rs. 90.90 at present.
Thus, it is present value of Rs. 100.
(1) Discounting or Present Value of a Single Flow (Lump Sum):– We can
determine the PV of a future cash flow using the formula:
n
PV = FV (1+i)
PV= Present Value
n = No. of years
Example :– Mr. X expects to have an amount of Rs. 1000 after one year
what should be the amount he has to invest today if the bank if offering 10%
interest rate?
1
PV = 1000 (1+.10)
PV = Rs. 909.09
(2) Present Value of a Series of Cash Flows :– In a business situation, it is
very natural that returns received by a firm are spread over a number of
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years. To estimate the present value of future series of returns, the present
value of each expected inflow will be calculated.
1 2 n
C C C
PV = ———— + —————— + ———— + ———————
1 2 n
(1+i) (1+i) (1+i)
Where PV = Sum of individual present values of each cash flow
C1, C2, Cn= Cash flows after periods 1,2——————n
i= Discounting Rate
Example :– Given the time value of money as 10% (i.e. the discounting
factor). You are required to find out the present value of future cash inflows that
will be received over next four years.
Year Cash Flows
1 1000
2 2000
3 3000
4 4000
1000 2000 3000 4000
PV = ———— + —————— + ————— + ———————
1 2 3 4
(1+.10) (1+.10) (1+.10) (1+.10)
= 909 + 1652 + 2253 + 2732
= Rs. 7546
(3) Present Value of an Annuity :– An investor may have an opportunity to
receive a constant periodic amount for a certain number of years. The
present value of an annuity can be found out by using the following
formula:
A1 A2 An
PVAn = ———— + —————— + ---------- + —————
1 2 n
(1+i) (1+i) (1+i)
PVAn = Present value of an annuity having a duration or ‘n’ periods
A = Value of single installment
I = Rate of interest
Example :– Calculate the present value of annuity of Rs. 500 received
annually for four years, when discounting factor is 10%.
500 500 500 500
PVAn = ———— + —————— + ————— + ——————
1 2 3 4
(1+.10) (1+.10) (1+.10) (1+.10)
PVAn = 454.50 + 413.50 + 375.50 + 341.50
PVAn = Rs. 1585
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UNIT – II
Q. What do you mean by Investment Decisions? What are the
importance and difficulties of Investment Decision?
Ans. Investment Decision :– The most important function of financial
management is not only the procurement of external funds for the business but
also to make efficient and wise allocation of these funds. The allocation of funds
means the investment of funds in various assets and other activities. It is also
known as ‘Investment Decision”, because a choice is to be made regarding the
assets in which funds will be invested. The assets which can be acquired fall
into two broad categories:
(i) Short-term or Current Assets.
(ii) Long-term or Fixed Assets.
Accordingly, we have to take two types of investment decisions:
(1) Short-term investment decisions :– This type of investment decisions
related to the short-term assets. These decisions are also called current
assets management or Working Capital Management.
(2) Long-term Investment Decisions Or Capital Budgeting Decisions :–
This type of investment decisions related to long-term assets. These are
widely known as capital budgeting or capital expenditure decisions.
Capital Budgeting is the technique of making decisions for investment in long-
term assets. It is a process of deciding whether or not to invest the funds in a
particular asset, the benefit of which will be available over a period of time
longer than one year.
Definition of Capital Budgeting :–
According to Milton H. Spencer
“Capital Budgeting involves the planning of expenditures for assets, the
returns from which will be realized in future time periods.”
Features of Capital Budgeting Decisions :–
1. Funds are invested in long-term assets.
2. Funds are invested in present times in anticipation of future profits.
3. The future profits will occur to the firm over a series of years.
4. Capital Budgeting decisions involve a high degree of risk because
future benefits are not certain.
Importance of Capital Budgeting Decision :–
1. Such Decision affect the profitability of the Firm :– Capital Budgeting
decision affect the long-term profitability of a firm. They enable a firm to
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produce finished goods which is ultimately sold for profit. Hence, a correct
investment decision can yield large profits, whereas an incorrect decision
can endanger the very survival of the firm.
2. Long-Term Effects :– The consequence of capital expenditure decisions
extend far into the future. To illustrate, if a company purchases a new
plant to manufacture a new product, the company will have to incur a
sizable amount of fixed costs, in terms of labour, supervisor’s salary,
insurance, rent of building etc, If, in future, the product turns out to be
unsuccessful, the company will have to bear the burden of heavy fixed
costs.
3. Irreversible Decision :– Capital Budgeting decisions, once taken, are not
easily reversible without heavy financial loss to the firm.
4. Involvement of Large Amount of Funds :– Capital Budgeting decisions
require large amount of funds and most of the firm have limited financial
resources. Hence, it is absolutely necessary to take thoughtful and correct
investment decisions.
5. Risk :– Capital investment proposals have different degrees of risk.
6. Most difficult to make :– These decisions are among the most difficult
decisions to be taken by a firm. This is, because they require an
assessment of future events which are uncertain and difficult to predict.
Difficulties :–
1. Measurement Problems :– Identifying and measuring the costs and
benefits of a capital expenditure proposals tend to be difficult. This is more
so when a capital expenditure has a bearing on some other activities of the
firm.
2. Uncertainty :– A capital expenditure decision involves costs and benefits
that extend fall into the future. It is impossible to predict exactly what will
happen in the future. Hence, there is usually a great deal of uncertainty
characterizing the cost and benefits of a capital expenditure decision.
3. Temporal Spread :– The costs and benefits associated with a capital
expenditure decision are spread out over a long period of time, usually 10-
20 years for industrial projects and 20-50 years for infrastructural
projects.
Q. Explain the methods OR Techniques of Capital Budgeting?
Ans. Capital Budgeting :– Capital Budgeting is the technique of making
decisions for investment in long-term assets. It is a process of deciding whether
or not to invest the funds in a particular asset, the benefit of which will be
available over a period of time longer than one year.
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Methods of Capital Budgeting :– There are two criterias for capital
expenditure decisions:
(A) Accounting Profit Criteria
(B) Cash Flow Criteria
(A) Accounting Profit Criteria :– Under accounting profit criteria, there is
only one method for making capital expenditure decisions. This method is
known as Average Rate of Return Method.
(1) Average Rate of return Method (ARR): This method is also known as
Accounting Rate of Return Method. It is based on accounting
information rather than cash flows. It is calculated as follows:
Average Annual Profits after Taxes
ARR = —————————————————————— X 100
Average Investment
Total of after tax profits of all years
Average Annual Profits after Taxes = ——————————————
Number of years
Original investment + Salvage value
Average Investment = ———————————————————————
2
Accept-Reject Criteria :–
Ø
If actual ARR is higher than the predetermined rate of return
.......................Project would be accepted.
Ø
If actual ARR is lower than the predetermined rate of return
.......................Project would be rejected.
Techniques of Capital Budgeting
Accounting
Profit Criteria
Cash Flow Criteria
1.Average Rate of
Return Method
1. Non-Discounting
Methods
2. Discounting
Methods
(i)Pay Back Method
(i)Net Present Value Method
(ii)Profitability Index Method
(iii)Internal Rate of Return Method
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Merits of ARR :–
(i) Simple :– ARR method is very simple to understand and use.
(ii) Entire life time of the project is considered :– ARR method uses the
entire profits earned during the life time of the project in calculating the
project’s profitability.
Demerits of ARR :–
(i) It uses accounting income rather than cash flows :– The principal
shortcoming of ARR approach is that it uses accounting income
instead of cash flows received from a project. Cash profits are superior
than accounting income because cash profits can be reinvested during
the life of the project itself.
(ii) Time Value of money not considered :– The second principal
shortcoming of ARR approach is that it does not take into account the
time value of money. Earning of all the years during the life time of the
project is given equal weightage under this method.
(iii)Difficult to Fix a Pre-Determined Rate :– It is very difficult to fix a
pre-determined rate of return with which the actual ARR is compared.
(B) Cash Flow Criteria :– Cash flow criteria is based on cash flows rather
than accounting profit. Cash flow methods are divided into two sections:
(1) Non-Discounting Methods :– Under non-discounting methods only
method is included:
(i) Pay Back Method (PB) :– The payback method is the simplest method.
This method calculates the number of years required to payback the
original investment in a project. There are two methods of calculating
the Payback Period:
Ø
First Method :– This method is adopted when the project generates
equal cash inflow each year. In such a case payback period is
calculated as follows:
Investment
Payback Period (PB)= ————————————————
Constant Annual Cash Flow
Ø
Second Method :– This method is adopted when the project
generates unequal cash inflow each year. Under this method,
payback period is calculated by adding up the cash inflows till the
time they become equal to the original investment.
Formula :–
Amount required to equalise the investment
PB = Completed Year + ——————————————————————
Amount received during the period
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Ø
If the actual payback period is less than the predetermined payback
period ...................... Project would be accepted.
Ø
If the actual payback period is more than the predetermined
payback period ...................... Project would be rejected.
Merits of Pay Back Method :–
(i) Simple :– The most significant merit of this method is that it is simple
to understand and easy to calculate.
(ii) Appropriate for Firms Suffering from Liquidity :– This method is
very appropriate for firms suffering from shortage of cash because
emphasis in this method is on quick recovery of the original
investment.
(iii)Appropriate in case of Uncertain Conditions :– This method is very
suitable where the long term outlook is extremely uncertain and risky.
(iv)Importance to Short-Term Earnings :– This method is beneficial for
firms which lay more emphasis on short-term earnings rather than the
long-term growth.
(v) Superior to ARR Method :– It is superior to ARR method because it is
based on cash flow analysis.
Demerits of Pay Back Method :–
(i) It ignores the Cash Flows After the Pay Back Period :– The major
shortcoming of this method is that it completely ignores all cash
inflows after the pay back period.
(ii) It ignores the Time Value of Money :– Another deficiency of the
payback method is that it ignores the time value of money. This method
treats a rupee received in the second or third year as valuable as a
rupee received in the first year.
(iii)It does not give the Accept-Reject Decision in case of single
project :– If suppose the payback period is 4 years, the method does
not provide an answer as to whether the project will be accepted or
rejected.
(iv)It ignores cost of Capital :– Cost of capital is not taken into
consideration under this method.
(v) It ignores the Profitability of a Project.
(2) Discounting Methods :– Under discounting methods we include:
(I) Net Present Value (NPV) Method :– This method measures the Present
value of returns per rupee invested. Under this method, present value of
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cash outflows and cash inflows is calculated and the present value of cash
outflow is subtracted from the present value of cash inflows. The
difference is called NPV.
NPV= PV of Inflow – PV of Outflow
OR
st 1 nd 2
NPV = [(Cash inflow in 1 year x PVF ) + (Cash inflow in 2 year x PVF ) +(Cash
3
inflow in 3rdyear x PVF ) +———————————(Cash inflow in nth year X
0
PVFn)] - [Initial cash outflow X PVF ]
1 st
PVF = Present Value Factor in 1 year
2 nd
PVF = Present value factor in 2 year and so on.
If PVF is not given, we may calculate NPV as follows:
OR
st 1 nd 2
NPV = [Cash inflow in 1 year X 1/(1+r) ] + [Cash inflow in 2 year X 1/(1+r) ] +
3
[Cash inflow in 3rd year X 1/(1+r) ] +————————[Cash inflow in nth year
n 0
X 1/(1+r) ] - [Initial Cash outflow X 1/(1+r) ]
Ø
If NPV is positive, the project may be accepted
Ø
If NPV is negative, the project may not be accepted.
Ø
If NPV is zero, the project may be accepted only if non-financial benefits
are there.
Merits of NPV method :–
(i) Time value of money is taken into consideration :– Because this
method takes into account the time value of money, it is the best
method to use for long range decisions.
(ii) Full Life of the project is taken into consideration :– This method
takes into account the fall life of the project and not only the payback
period.
(iii)Wealth Maximisation :– Wealth maximization object of the business
is achieved by this method. By accepting the project with highest NPV,
the wealth of the business is maximized.
Demerits of NPV :–
(i) Difficult to Understand and Implement :– This method is difficult to
understand as well as implement in comparison to the payback and
the ARR method.
(ii) Difficulty in fixing the required rate of return :– Required rate or
discount rate is the most important in calculating the NPV because
different discount rates will give different present values.
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(iii)In case of two projects with unequal initial investment, this method
may not give satisfactory result.
(iv)In case of two projects with different lives, this method may not give
satisfactory result.
(II) Profitability Index OR (PI) :– Second method of evaluating a project
through discounted cash flows is profitability index method. This method
is also called Benefit-Cost Ratio.
This method is similar to NPV approach. A major drawback of the NPV
method was that it does not give satisfactory results while evaluating the
projects requiring different initial investments. PI method provides a
solution to this problem.
Present Value of Cash Inflows
PI = —————————————————————
Present Value of Cash Outflows
Ø
If PI is more than one, the project will be accepted
Ø
If PI is less than one, the project will be rejected.
Ø
If PI is one, project may be accepted only on the basis of non-financial
considerations.
Merits of PI method :–
(i) Like the other DCF techniques, the PI method also takes into account
the time value of money.
(ii) It considers all cash flows during the life-time of the project
(iii)PI method is a reliable method in comparison to the NPV method when
the initial investment in various projects are different.
Demerits of PI method :–
(i) This method is difficult to understand and implement
(ii) Calculations under this method are complex.
(III) Internal Rate of return Method (IRR) :– IRR method is also known as
time adjusted rate of return, marginal efficiency of capital, marginal
productivity of capital and yield on investment.
Like the NPV method the IRR method also takes into consideration the
time value of money by discounting the cash flows. IRR is the discount rate
at which present value of cash inflows is equal to the present value of cash
outflows.
Procedure to Find Out IRR :–
Ø
Step I : Calculate the fake payback period
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Initial Cash Outflows
Fake Payback Period = ——————————————————
Average Cash Inflows
Total Cash Inflows during the life of the project
Average Cash Inflows = —————————————————————
Number of year of life
Ø
Step II : Locate the closest figure to fake payback period in the annuity
table A-2 against the row of number of years of the project. The rate of that
column will be the first discount rate.
Ø
Step III : Find the NPV of the project at the first discount rate located
above. If NPV is positive, determine one more discount rate which should
be higher than the first discount rate so that the second NPV may be
negative. Similarly, If NPV from first discount rate located above is
negative, determine second rate lower than the first rate so that second
NPV may be positive. Now there are two NPVs at two different rates, one is
positive and other is negative.
Ø
Step IV: Now, apply the following formula to find IRR:
NPV at lower discount rate
IRR = Lower discount rate +—————— X Difference in discount rate
NPV at lower discount rate – NPV at higher discount rate
Merits of IRR Method :–
(i) Like the other DCF methods, IRR methods also take into consideration the
time value of money.
(ii) It takes into account all cash inflows and outflows occurring over the
entire life time of the project.
(iii) Although the calculation of IRR involves tedious calculation, its meaning
is easier to understand in comparison to the concept of NPV.
Demerits of IRR Method :–
(i) Calculation of IRR involves tedious calculations.
(ii) Sometimes, this method produces more than one IRR. In such a case, it
becomes difficult to accept or reject the proposal.
(iii) It is assumed under the IRR method that all cash inflows of the project are
reinvested at IRR rate. This assumption is not valid.
Q. What do you mean by Risk Analysis in Capital Budgeting? Explain the
Risk Adjusted Discount Rate Method.
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Ans. Risk Analysis :– Risk in an investment refers to the variability that is
likely to observed between the estimated returns and the actual returns form
the proposal. The greater is the variability between the two returns, the more is
the risk involved in the project, and vice versa.
Incorporation of the Risk in Investment Proposal :– As stated earlier, risk is
involved in every capital budgeting decision. As risk is involved in every capital
budgeting proposal, the management of a firm must take the risk factor into
account, while determining the returns or cash inflows and the profitability of a
project for the purpose of capital budgeting.
Risk Adjusted Discount Rate Method :–
Meaning :– Under the risk adjusted discount rate method, the future cash flow
from capital projects are discount at the risk adjusted discount rate and
decision regarding the selection of a project is made on the basis of the net
present value of the project computed at the risk adjusted discount rate.
The risk adjusted discount rate is based on the assumption that investors
expect a higher rate of return on more risky projects and a lower rate of return
on less risky projects, and so, a higher discount rate is used for discounting the
cash flows of more risky project and a lower discount rate is used for
discounting the cash flows of less risky project.
The risk adjusted discount rate comprises two rates, viz.,
(i) Risk-free rate :– Risk free rate is the normal rate or the usual discount
rate that takes care of time element and
(ii) Risk Premium Rate :– Risk Premium Rate is the surplus rate or extra
rate that takes care of the risk factor.
So, the risk adjusted discount rate is the usual or normal discount rate for the
time factor plus the extra or additional discount rate.
Merits :–
(1) It is easy to understand and simple to calculate.
Techniques used for Incorporation of Risk Factor in
Capital Budgeting Decision
General Techniques Quantitative Techniques
Risk Adjusted
Discount Rate
Methods
Certainly
Equivalent
Coefficient
Method
Sensitivity
Analysis
Standard
Deviation
Decisio
Tree
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(2) The risk premium rate included in the risk adjusted rate takes care of the
risk element in the future cash flows of the project.
(3) It takes into account the risk averse attitude of investors.
Demerits :–
(1) The risk premium rates, determined under this method, are arbitrary. SO
this method may not give objective results.
(2) Under this method, the risk is compounded over time, since the risk
premium is added to the discount rate. Which means, this method
presumes that risk necessarily increases with the passage of time. But
this may not happen in all situations or cases.
(3) This method presumes that investors are averse to risk I i.e., investors
avoid facing risk). This may not be true in all cases. There are many
investors who would like to take risk and are prepared to pay premium for
taking risk.
Example :– From the following date, state which project is preferable:
Year Project A Project B
1 60000 80000
2 50000 60000
3 40000 50000
Initial Cost of 120000 120000
the Project1
Riskless discount rate is 5%. Project A is less risky as compared to project B
and so, the management considers risk premium rates at 5% and 10%
respectively as appropriate for discounting the cash inflow.
The discount factors at 10% and 15% are:
Year 10% 15%
1 0.909 0.876
2 0.826 0.756
3 0.751 0.650
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Solution :–
First Step :– Calculation of Risk-Adjusted Discount Rate
For Project A:
Riskless Discount Rate 5%
And Risk-Premium Rate 5%
Risk Adjusted Discount Rate 10%
For Project B:
Riskless Discount Rate 5%
And Risk-Premium Rate 10%
Risk Adjusted Discount Rate 15%
Second Step :– Calculation of Discounted Cash Inflows ( i.e, Present Value
and Net Present Value of the Projects)
Year Project A Project B
Discounted Cash Inflows at 10%
Cash Discount Present Value Cash Discount Present Value
Inflows Factor (Rs.) Inflows Factor (Rs.)
(Rs) 10% (Cash Inflow x (Rs.) 15% (Cash Inflow x
Discount Factor) DiscountFactor)
1 60000 .909 54540 80000 .876 70080
2 50000 .826 41300 60000 .756 45360
3 40000 .751 30040 50000 .650 32500
PV of Cash Inflow 125880 147940
Less: PV of Cash Outflow 120000 120000
Net Present Value 5880 27940
Comments :– The Net Present Value of Project B is higher than that of Project
A. So Project B is Preferable.
Q. Explain the Certainty Equivalent Coefficient Method.
Ans. Introduction :– Certainty equivalent coefficient method which makes
adjustment against risk in the estimates of future cash inflows for a risky
capital investment project.
Under this method, adjustment against risk is made in the estimates of future
cash inflows of a risky capital project by adjusting to a conservative level of the
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estimated cash flows of a capital investment proposal by applying a correlation
factor termed as certainty equivalent coefficient.
Formula for Calculating Certainty Equivalent Coefficient :– The certainty
equivalent coefficient is the ratio of riskless cash flow to risky cash flow. The
certainty equivalent coefficient can be calculated with the help of the following
formula:
Riskless Cash Flow
Certainty Equivalent Coefficient = ————————————
Risky Cash Flow
(1) Riskless Cash Flow :– Riskless cash flow means the cash flow which the
management expects, when there is no risk in investment proposal.
(2) Risky Cash Flow :– Risky cash flow means the cash flow which the
management expects when there is risk in investment proposal.
Example :– Suppose the risky cash flow is Rs. 200000 and the riskless
cash flow is Rs. 140000.
140000
The Certainty Equivalent Coefficient = —————— = 0.7
200000
Steps Involved in Certainty Equivalent Coefficient Method :– The various
steps involved in the certainty equivalent coefficient method are:
(1) First Step :– Firstly, the certainty equivalent coefficient has to be
calculated for each year of a project.
(2) Second Step :– Secondly, the risk-adjusted cash flow of a project for each
year has to be calculated. The risk-adjusted cash flow of a year can be
Risk-Adjusted Cash Flow = Estimated Cash flow for the year X Certainty
Equivalent Coefficient
(3) Third Step :– Thirdly, we have to find out the present value of the capital
project. The present value of the Capital Project can be found by adopting
the following procedure. First, the risk-adjusted cash flow for each year
should be multiplied by the present value factor or discount factor
applicable to that year to get the present value of the risk-adjusted cash
flow of each year.
(4) Fourth Step :– Fourthly, we have to ascertain the net present value of the
project. The net present value of the project will be:
Present Value of the Project ——————————-
Less: Initial Investment on the Project ———————————
Net Present Value of the Project ———————————
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(5) Fifth Step :– After the NPV of a project is computed, decision is taken as
to the selection of the project. The selection of a project, is , usually made
on the following line:
(i) Generally, a project becomes acceptable, if it has a positive NPV
(ii) If there are two or more mutually exclusive projects, generally, the
project whose NPV is higher or highest is selected.
Example :– Two mutually exclusive investment proposals, X and Y under
consideration before the management of a company. The initial outlay of each
project is Rs. 30000. Both the projects are estimated to have a useful economic
life span of 5 years. The estimates of cash inflows and their certainty equivalent
coefficients are as follows:
Year Project X Project Y
Estimated Cash Flows C.E.C Estimated Cash Flows C.E.C.
1 25000 0.7 30000 0.6
2 30000 0.5 35000 0.5
3 20000 0.4 25000 0.4
4 15000 0.3 12000 0.2
5 10000 0.2 10000 0.1
The cost of capital for the company is 15%.
Compare the NPV of the two projects and suggest which project should be
accepted by the management.
The present value factor at 15% is:
Year Present Value Factor at 15%
Or Discount Factor
1 0.870
2 0.750
3 0.658
4 0.572
5 0.497
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Solution :–
Computation of the NPV of the Project X :
Year Estimated cash Certainty Risk Adjusted Discount Present
Flows Equivalent Cash Flows Factor Velue
Coefficient 10%
1 25000 0.7 17500 0.870 15225
2 30000 0.5 15000 0.756 11340
3 20000 0.4 8000 0.658 5264
4 15000 0.3 4500 0.572 2574
5 10000 0.2 2000 0.497 994
Present Value of Cash Inflows 35397
Less: PV of Cash Outflow 30000
NPV of Project X 5397
Computation of the NPV of Project Y:
Year Estimated cash Certainty Risk Adjusted Discount Present
Flows Equivalent Cash Flows Factor Velue
Coefficient 10%
1 30000 0.6 18000 0.870 15660
2 35000 0.5 17500 0.756 13230
3 25000 0.4 10000 0.658 6580
4 12000 0.2 2400 0.572 1373
5 10000 0.1 1000 0.497 497
Present Value of Cash Inflows 37340
Less: PV of Cash Outflow 30000
NPV of Project Y 7340
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Comments :– Both the projects have positive net present value. So, both are
acceptable.
However, the Net Present Value (NPV) of project Y is more than that of Project X.
That means, Project Y is preferable.
Q. What do you mean by ‘Cost of Capital’? What is its significance and
what are the problems in determination of cost of capital?
Ans. Meaning of Cost of Capital :– Cost of capital of a firm is the minimum rate
of return expected by its investors. The capital used by a firm may be in the
form of equity shares, preference shares, debts and retained earnings. The cost
of capital is the weighted average cost of these sources of finance used by the
firms. The concept of cost of capital occupies a very important role in financial
management because the investment decisions are based on it.
Definition :–
According to Milton H. Spencer
“The cost of capital is the minimum rate of return which a firm requires as
a condition for undertaking an investment.”
According to M.J. Gordon
“The cost of capital is the rate of return a company must earn on an
investment to maintain the value of the company.”
Significance of the Cost of Capital :–
(1) Helpful in Designing the Capital Structure :– The concept of cost of
capital plays a vital role in designing the capital structure of a company.
Capital structure of a company is the ratio of debt and equity. These
sources differ from each other in terms of their respective costs. As such a
company will have to design such a capital structure which minimizes
cost of capital.
(2) Helpful in taking capital Budgeting Decisions :– Capital budgeting is
the process of decision making regarding the investment of funds in long
term projects of the company. The concept of cost of capital is very useful
in making capital budgeting decisions because cost of capital is the
minimum required rate of return on an investment project.
(3) Helpful in evaluation of financial efficiency of top management
:–Concept of cost of capital can be used to evaluate the financial efficiency
of top management. Such an evaluation will involve a comparison of
projected overall cost of capital with the actual cost of capital incurred by
the management. Lower the actual cost of capital is the better financial
performance of the management of the firm.
(4) Helpful in comparative analysis of various sources of finance :– Cost of
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capital to be raised from various sources goes on changing from time to
time. Calculation of cost of capital is helpful in analysis of usefulness of
various sources of finance.
(5) Helpful in taking other financial decisions :– The cost of capital concept
is also useful in making other financial decisions such as:
Ø
Dividend Policy
Ø
Right Issue
Ø
Working Capital Decisions
Ø
Capitalisation of profits.
Problems in Determination of Cost of Capital :–
1. Historic Cost and Future Cost :– One major problem in the
determination of cost of capital arises due to difference of opinion
regarding the concept of cost itself. It is argued that book costs are historic
costs and the calculation of cost of capital on the basis of such costs is
irrelevant for decision making.
2. Problems in Computation of Cost of Equity :– The computation of cost
of equity capital depends upon the rate of return expected by equity
shareholders. But it is very difficult to assess the expectation of equity
shareholders because there are many factors which influence their
expectations.
3. Problems in computation of cost of retained earnings :– Sometimes it
may appear that retained earning are free of cost because they have not
been raised from outside.
4. Problems in Assigning Weights :– Weights have to be assigned to various
sources of finance to compute the weighted average cost of capital. The
choice of using the book value weights or market value weights places
another problem in the computation of cost of capital.
Q. How will you determine the cost of capital from different sources?
Ans. Meaning of Cost of Capital :– Cost of capital of a firm is the minimum rate
of return expected by its investors. The capital used by a firm may be in the
form of equity shares, preference shares, debts and retained earnings. The cost
of capital is the weighted average cost of these sources of finance used by the
firms. The concept of cost of capital occupies a very important role in financial
management because the investment decisions are based on it.
Computation of Cost of Capital :– Computation of cost of capital includes:
(A) Computation of cost of specific sources of finance
(B) Computation of weighted average cost of capital
Computation of Cost of Specific Sources of Finance :– It includes:
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(1) Cost of Debt :– A company may raise the debt in a number of ways. It may
borrow funds from the financial institutions or public either in the form of
public deposits or debentures for a specified period of time at a specified
rate of interest. A debenture or bond may be issued at par, at a discount or
at a premium.
Debt may either be irredeemable or redeemable after a certain period.
(i) Cost of Irredeemable Debt :–
Ø
Cost of Irredeemable Debt, before tax :– Formula for calculating
cost of debt before tax is:
I
Kdb = —— X 100
NP
Kdb = Cost of debt before tax
I = Annual Interest Charges
NP = Net Proceeds from the issue of Debt
Ø
Cost of Irredeemable Debt, after tax :– When a company uses debt
as a source of finance then it saves a considerable amount in payment of tax
because the amount of interest paid on the debts is a deductible expense in
computation of tax. Formula for calculating cost of debt after tax is:
I
Kda = —— X 100 (1-t)
NP
Kda = Cost of debt after tax
t = Rate of Tax
(ii) Cost of redeemable Debt :– Normally a company issues a debt which
is redeemable after a certain period during its life-time. Such a debt is
termed as Redeemable Debt. Cost of redeemable debt may also be
calculated before tax and after tax:
Ø
Cost of Redeemable Debt, before tax :–
1
I + —— (RV –NP)
n
Kdb = —————————————— X 100
1
—— (RV +NP)
2
Kdb = Cost of debt before tax
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n = Number of years in which debt is to be redeemed
RV = Redeemable Value of Debtredeemed.
Ø
Cost of Redeemable Debt, after tax :–
1
I + —— (RV –NP)
n
Kda = —————————————— X 100 (1-t)
1
—— (RV +NP)
2
K = Cost of debt before tax I = Annual Interest Charges
db
NP= Net Proceeds from the issue of Debt
n = Number of years in which debt is to be redeemed
RV = Redeemable Value of Debt t = Rate of Tax
(2) Cost of Preference Share Capital :– A fixed rate of dividend is payable on
preference shares. But, unlike debt, the dividend is payable at the discretion of
the Board of Directors and there is no legal binding to pay the dividend.
Preference Shares may either be irredeemable or redeemable after a certain
period.
(i) Cost of Irredeemable Preference Share Capital :– Formula for
calculating cost of Irredeemable Preference Share Capital is:
D
KP = —— X 100
NP
K = Cost of Irredeemable Preference Share Capital
P
D = Annual Preference Dividend
NP = Net Proceeds of Preference Share Capital
(ii) Cost of Redeemable Preference Share Capital :– Redeemable
preference capital has to be returned to the preference shareholders after
a stipulated period. The cost of redeemable preference share capital is
1
D + —— (RV –NP)
n
Kpr = —————————————— X 100
1
—— (RV +NP)
2
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Kpr = Cost of Redeemable Preference Capital
D = Annual Preference Dividend
NP = Net Proceeds of Preference Share Capital
n = Number of years
RV = Redeemable Value of Preference Share Capital
(3) Cost of Equity Share Capital :– The cost of equity is the ‘maximum rate
of return’ that the company must earn on equity financed position of its
investments in order to leave unchanged the market price of its stock. The cost
of equity capital is a function of the expected return by its investors. The cost of
equity share capital can be computed in the following ways:
(i) Dividend Yield Method :– This method is based on the assumption that
when an investor invests in the equity shares of a company he expects to
get a payment at least equal to the rate of return prevailing in the market.
The equation is:
DPS
Ke = ———— X 100
MP
Ke = Cost of Equity Capital
DPS = Dividend Per Share
MP = Market Price Per Share
(ii) Dividend Yield Plus Growth in Dividend Method :– This method is used
to compute the cost of equity capital when the dividends of a firm are
expected to grow at a constant rate.
DPS
Ke = ———— X 100 + G
MP
DPS = Dividend Per Share
G = Rate of growth in Dividend
(iii) Earning Yield Method :– As per this method, cost of equity capital is
calculated by establishing a relationship between earning per share and
the current market price of the share. The equation is :
EPS
Ke = ———— X 100
MP
EPS = Earning Per Share
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(iv) Earning Yield plus Growth in Earning Method :– If the EPS of a company
is expected to grow at a constant rate of growth, the cost of equity capital
can be computed as follows:
EPS
Ke = ———— X 100 + G
MP
EPS = Earning Per Share
G = Rate of growth in EPS
(4) Cost of Retained Earnings :– It is sometimes argued that retained
earnings carry no cost since a firm is not required to pay dividend on retained
earnings. However, this is not true. Though retained earnings do not have any
explicit cost to the firm but they involve an opportunity cost. The cost of
retained earning can be calculated as follows:
Kr = Ke (1-Percentage Brokerage or Flotation Cost)
Where Kr = Cost of Retained Earnings
Q. What is meant by weighted average cost of capital OR Composite ?
How is it computed? Illustrate with an example.
Ans. Weighted Average Cost of Capital :– Capital structure of a company
consists of different sources of capital. Cost of these different sources of capital
is also calculated by different methods. Hence, after the calculation of cost of
capital of these different sources of capital a practical difficulty arise as to what
is the cost of overall capital structure of the firm. In order to solve this problem
finance managers developed the concept of Weighted Average Cost of capital. It
is also known as Composite Cost or Overall Cost.
Computation of Weighted Average Cost of Capital :– The computation of
weighted cost of capital involves the following steps:
(i) Compute the cost of each source of funds.
(ii) Assign weights to specific costs
(iii)Multiply the cost of each of the sources by the assigned weights
(iv)Divide the total weighted cost by the total weights
Formula :–
S
XW
Kw = ————
S
W
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Kw = Weighted Average Cost of Capital
X = Cost of specific source of finance
W = Weight of specific source of finance.
Assignment of Weights :–
For computing weighted average cost of capital, it is necessary to
determine the proportion of each source of finance in the total capitalization.
For this purpose weights will have to be assigned to various sources of finance.
Weights may be assigned by any of the following methods:
(i) Book Value Weights (ii) Market Value Weights
(i) Book Value Weights :– Book value weights are computed form the values
taken from the balance sheet. The weight to be assigned to each source of
finance is the book value of that source of finance divided by the book
value of total sources of finance.
Advantages of Book Value Weights:
Ø
Book values are readily available from the published records pf the
firm.
Ø
Book value weights are more realistic because the firms set their
capital structure targets in terms of book values rather than market
values.
Ø
Book value weights are not affected by the fluctuations in the capital
market.
Ø
In the case of those companies whose securities are not listed, only
book value weights can be used.
Limitations of Book Value Weights :–
Ø
The costs of various sources of finance are calculated using prevailing
market prices. Hence weights should also be assigned according to
market values.
Ø
The present economic values of various sources of capital may be
totally different from their book values.
(ii) Market Value Weights :– As per market value scheme of weighting, the
weights to different sources of finance are assigned on the basis of their
market values.
Advantages of Market Value Weights :–
Ø
The costs of various sources of finance are calculated using prevailing
market prices. Hence, it is proper to use market value weights
Ø
Weights assigned according to market values of the sources of finance
represent the true economic values of various sources of finance.
Limitations of Market Value Weights :–
Ø
Market value weights may not be available as securities of all the
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companies are not actively traded.
Ø
It is very difficult to use market value weights because the market prices of
securities fluctuate widely and frequently.
Example :–
A company’s after tax specific cost of capital are as follows:
Cost of debt 10%
Cost of Preference Shares 12%
Cost of Equity Shares 15%
The following is the capital structure:
Source Amount
Debt 3,00,000
Preference Share Capital 2,00,000
Equity Share Capital 5,00,000
____________
10,00,000
____________
Calculate the weighted average cost of capital, Kw
Computation of Weighted Average Cost of Capital using Book Value Weights :–
Sources of Book Value Proportion or Cost (%) Weighted
Funds (1) Rs. (2) Weight (3) (4) Cost (5)
=(3x4)
Debt 3,00,000 .3 10 3.0
Preference 2,00,000 .2 12 2.4
Share Capital
Equity 5,00,000 .5 15 7.5
Share Capital
Total 10,00,000 1.00 12.9
The weighted average cost using book value weights is 12.9%
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UNIT – III
Q. Define leverage? Explain its types & Utility.
Ans. Meaning of Leverage :– The dictionary meaning of the term leverage
refers to ‘an increased means of accomplishing some purpose’. For example,
leverage helps us in lifting heavy objects which may not be otherwise possible.
However, in the area of finance it is used to describes the firm’s ability to used
fixed cost assets or funds to magnify the returns to its owners.
Leverage can be define as ‘the employment of an assets or fund for which
the firms pays a fixed cost or fixed return thus according to him, leverage result
as a result of the firm employing an assets or source of funds which has a fixed
cost or return. The former may be termed as ‘fixed operating cost’ while the
latter may be termed as ‘fixed financial cost’. It should be noted that fixed cost
or return is the fulcrum of leverage. If a firm is not required to pay fixed cost or
fixed return, there will be no leverage.
A high degree of leverage implies that there will be a large change in the
profits due to relatively small change in sales and vice- versa. Thus, the higher
is the leverage, the higher is the risk and higher is the expected return.
Types of Leverage :– Leverage are of two types :
(1) Operating Leverage
(2) Financial Leverage
(1) Operating Leverage :– The operating leverage may be defined as the
tendency of the operating profit to vary disproportional with sales. It is
said to exist when a firm has to pay fixed cost regardless of volume of
output or sales. The firm is said to have a high degree of operating leverage
if it employs a greater amount of fixed cost and a smaller amount of
variable cost. On the other hand, a firm will have a low operating leverage
when it employs a greater amount of variable cost and a smaller amount of
fixed cost. Thus, the degree of operating leverage depends upon the
amount of fixed element in the cost structure.
Operating leverage in the firm is a function of three factors :–
(a) The amount of fixed cost
(b) The contribution margin
(c) The volume of sales
Formulae :–
Contribution or C_
Operating leverage = –––––––––––––––––– –––––––
Operating profit OP
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Utility :– The operating leverage indicates the impact of change in sales on
operating income. If a firm has a high degree of operating leverage, small
changes in sales will have large effect on operating income. In other words, the
operating profit (EBIT) of such firm will increase at a faster rate than the
increase in sales.
Similarly, the operating profit of such a firm will suffer a great loss as compared
to reduction in its sales.
(2) Financial Leverage :– The financial leverage may be defined as the
tendency of the residual net profit to vary disproportionately with
operating profit. It indicates the change that take place in the taxable
income as a result of change in the operating income. It signifies the
existence of fixed interest/ fixed dividend bearing securities in the total
capital structure of the company. Thus the use of fixed interest/ dividend
bearing securities such as debt & capital preference along with the
owner’s equity in the total owner capital structure of the company is
described as financial leverage. Where in capital structure of the
company, the fixed interest /dividend bearing securities are greater as
compared to the equity capital, the leverage is said to be larger. In the
reverse case the leverage will be said to be smaller.
Favorable and Unfavorable financial leverage :– Financial leverage may
be favorable or unfavorable upon whether the earning made by the use of
fixed interest or dividend – bearing securities exceed the or not explicit the
fixed cost, the firm has to pay for the employment of such funds. The
leverage will be considered to be favorable so long the firm earns more on
assets purchased with the funds than the fixed cost of there use
unfavorable or negative leverage occurs when the firm does not earns as
much as the fund cost.
Financial leverage is also termed as ‘trading on equity’. The company
resorts to trading on equity with the objective of giving the equity
shareholders higher rate of return than the general rate of earning on
capital employed in the company to compensate them for the risk that
they have to bear. For example – If a company borrows Rs. 100 @ 10% P.a.
and earns a return for 12%, the balance 4% p.a. after payment of interest
belongs to the shareholders and thus they can be paid a higher rate of
return than the general rate of earning of company. But in case company
could earn a return of only 6% on Rs. 100 employed by it, the equity
shareholders loss will be Rs. 2 p.a. Thus, the financial leverage is a double
– edged sword. It has the potentially of increasing the return to equity
shareholders.
Earning before tax and Interest
Formulae :– Financial leverage = ———————————————
Profit before tax but after interest
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Alternative definition of financial leverage :– One of the objectives of
planning an appropriate capital structure is to maximize the return on equity
shareholders fund or maximize the earning per share. Some authorities have
used the term ‘financial leverage’ in the context that it defines the relationship
between EBIT and EPS. According to Gitman “financial leverage” is the ability
of a firm to use fixed financial charges to magnify the effects of change in EBIT
on the firm’s earning per share. The financial leverage, therefore indicate the
percentage change in earning per share in relation to a percentage change in
EBIT. The degree of financial leverage can be written as follows:
Percentage change in EPS
Degree of financial leverage = ———————————————
(DFL) Percentage change in EBIT
Utility :– Financial leverage helps considerably the financial manager while
devising the capital structure of the company. A high financial leverage means
high fixed financial manager must plan the capital structure in a way that the
firm is in a position to meet its fixed financial costs. Increase in fixed financial
costs requires necessary increase in EBIT level. In the event of failure to do so,
the company may be technically forced into liquidation.
Q. Explain Net Income Approach (NI) to Capital Structure.
Ans. Net Income Approach :– According to the Net Income Approach, as
suggested by Durand, the capital structure decision is relevant for the
valuation of the firm. In other words, a change in the financial leverage (the
ratio of debt to equity) will lead to a corresponding change in the value of the
firm as well as the overall cost of capital.
According to this approach:
(i) If the ratio if debt to equity is increase, the cost of capital will decline, while
the value of the firm as well as the market price of equity shares will
increase.
(ii) A decrease in the ratio of debt to equity will cause an increase in the overall
cost of capital and a decline both in the value of the firm as well as the
market price of equity shares.
Hence a firm can minimize the cost of capital and increase the value of the
firm as well as market price of its equity shares by using debt financing to the
maximum possible extent.
Assumptions :– Net Income Approach is based upon the following
assumptions:
(i) The cost of debt is lower than the cost of equity.
(ii) There are no corporate or personal income taxes.
(iii)Use of debt does not change the risk perception of investors.
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Explanation :–
(i) Net Income approach says that an increase in the proportion of debt
financing in capital structure results in an increase in the proportion of a
cheaper source of funds. This, in turn, results in the decrease in overall
cost of capital leading to an increase in the value of the firm. The main
reasons are:
Ø
The assumption of cost of debt to be less than the cost of equity.
Ø
The interest on debt is a deductible expense, when the company gets
the tax benefits on it.
(ii) With a judicious mixture of debt and equity, a firm can evolve an optimum
capital structure which will be the one at which the overall cost of capital is
lowest and market value of the firm is highest. At that structure, the
market price per share would be maximum.
Graphic Presentation of Net Income Approach :– Net Income approach is
explained graphically as follows:
In the above figure, the degree of leverage is plotted along the X-axis, while the
percentage rate of cost of capital is shown on Y-axis. The figure shows that Ke
and Kd remain unchanged. But as the degree of leverage increases, cost of
capital Ko decreases. K however cannot touch K as there cannot be all debt
o d
firm. The optimal capital structure is one at which K is nearest to K . At this
o d
level, the firm’s overall cost of capital would be lowest and the market value of
the firm and market value per share is highest.
Basic Terms :–
EBIT = Earnings before Interest and Tax S = Value of Equity
B = Value of Debt V = Value of firm
NI = Net Income Kd = Cost of Debt
Ko = Overall Cost of Capital K = Cost of Equity
e
Y
X
Ke
Ko
Kd
Degree of Leverage
%
Rate
of
cost
of
capital
43
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Basic Formulas :–
V = S + B NI = EBIT - Interest
EBIT NI
K = ————— S = —————
o
V Ke
Example :–
EBIT = Rs. 50,000
10% Debentures = Rs. 2,00,000
K = 12.5%
e
Solution :–
(a) Calculation of Value of the Firm (V) & Overall Cost of Capital :–
NI = EBIT – Interest
= 50,000 - 20,000 = 30,000
10
Interest = 2,00,000 x ——— = 20,000
100
NI 30,000 30,000
Value of Equity (S) = ——— = ————— = ————— X 100 = 2,40,000
K 12.5 % 12.5
e
Value of Debt = 2,00,000
Value of Equity = 2,40,000
Value of the Firm = S + B = 2,40,000 + 2,00,000 = 4,40,000
Calculation of Overall Cost Of Capital :–
EBIT 50,000
K = ————— X 100 = ——————— X 100 = 11.36%
o
V 4,40,000
Value of the Firm = 4,40,000
Overall Cost of Capital = 11.36%
(b) Calculation of Value of the Firm (V) & Overall Cost of Capital, When
debt is raised to Rs, 3,00,000
When the debt is raised to Rs. 3,00,000, Then Value of Firm :
NI = EBIT – Interest = 50,000 - 30,000 = 20,000
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10
Interest = 3,00,000 x –––––– = 30,000
100
20,000 20,000
Value of Equity (S) = —————— = ————— X 100 = 1,60,000
12.5 % 12.5
Value of Equity (S) = 1,60,000 Value of Debt = 3,00,000
Calculation of Overall Cost Of Capital
EBIT 50,000
Ko = ———— X 100 = ——————— X 100 = 10.87%
V 4,60,000
Value of The Firm = 4,60,000 Overall Cost of Capital = 10.87%
Thus, the use of additional debt has caused the total value of the
firm to increase and the overall cost of capitalto decrease.
(c) Calculation of Value of the Firm (V) & Overall Cost of Capital, When
debt is lowered to Rs, 1,00,000
When the debt is lowered to Rs. 1,00,000 , then Value of Firm:
NI = EBIT – Interest = 50,000 - 10,000 = 40,000
10
Interest = 1,00,000 x ——— = 10,000
100
40,000 40,000
Value of Equity (S) = ————— = ————— X 100 = 3,20,000
12.5 % 12.5
Value of Equity (S) = 3,20,000 Value of Debt = 1,00,000
Calculation of Overall Cost Of Capital :
EBIT 50,000
o
K = ———— X 100 = ————— X 100 = 11.90%
V 4,20,000
Value of the Firm = 4,20,00 Overall Cost of Capital = 11.90%
Thus, we find that the decrease in leverage has increase the
overall cost of capital and has reduced the value of the firm.
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Criticism of Net Income Approach:
(i) Wrong assumption of no corporate taxes.
(ii) Wrong assumption of constant equity capitalization rate.
(iii)Wrong assumption of constant debt capitalization rate.
(iv)Wrong assumption of constant risk perception.
Q. Explain Net Operating Income Approach (NOI) to Capital Structure.
Ans: Net Operating Income Approach (NOI) :– This is another theory of
capital structure which is propounded by ‘Durand’ and is just opposite to Net
Income Approach. The essence of this approach is that the capital structure
decision of a firm is irrelevant. Any change in leverage will not lead to any
change in total value of the firm. It means that the overall cost of capital would
remain same whether the debt-equity mix is 50:50 or 30: 70 or 60:40. Thus,
the total value of the firm, the market price of shares as well as the overall cost
of capital is independent of the degree of leverage.
Assumptions of NOI Approach :–
(i) The cost of debt is lower than the cost of equity
(ii) There are nor corporate or personal income taxes.
(iii)The business risk remains constant at every level of debt & equity.
Explanation :–
(i) The Net Operating Income approach advocates that the cost of equity
increases with the increase in the financial leverage. This is due to
increased risk assumed by the equity shareholders due to the use of more
debt by the firm. To compensate for increased risk, shareholders would
expect a higher rate of return on their investments.
(ii) Therefore, the advantage of using the cheaper source of funds, i.e. the debt
is exactly offset by the increased cost of equity. Consequently, the overall
cost of capital remains constant at all degrees of financial leverage. Since
the value of the firm is measured as a whole on the basis of overall cost of
capital and since the overall cost of capital remains constant, the value of
the firm also remains same at all degrees of financial leverage.
Graphic Presentation of Net Operating Income Approach :– Net Operating
Income approach is explained graphically as follows:
Y
X
Ke
Ko
Kd
Degree of
Leverage
%
Rate
of
cost
of
capital
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K = Cost of Equity
e
K = Cost of debt
d
K = Overall cost of capital
o
In the above figure, the degree of leverage is plotted along the X-axis, while
the percentage rate of cost of capital is shown on Y-axis. The figure shows that
K and K remain unchanged. as the degree of leverage is increased. But with
d o
the increase in the leverage the cost of equity rises in such a manner so as to
offset the advantage of using cheaper debt. As a result, K and the value of firm
o
(V) remain unchanged by the increase in the financial leverage.
Basic Terms :–
EBIT = Earnings before Interest and Tax S = Value of Equity
B = Value of Debt V = Value of firm
NI = Net Income Kd = Cost of Debt
Ko = Overall Cost of Capital K = Cost of Equity
e
Basic Formulas :–
V = S + B NI = EBIT – Interest
EBIT EBIT -I EBIT
V = ——— Ke= ————— X 100 Ko = ——————X 100
K S V
o
Example :–
EBIT = 50,000
10% Debentures = 2,00000
Overall Cost of Capital (K ) = 12.5%
o
Solution :–
(a) Calculation of Value of the Firm :–
EBIT = 50,000 Ko = 12.5%
EBIT 50,000 50,000
V = ———— = ————— = ———— X 100 = 4,00,000
Ko 12.5% 12.5
V = S + B S = V-B S = 4,00,000 – 2,00,000 = 2,00,000
50,000 -20,000
Ke = —————————— X 100 = 15%
2,00,000
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EBIT 50,000
Ko = ————— X 100 K = ————— X 100 = 12.5%
o
V 4,00,000
(b) Calculation of Value of the Firm (V) & Overall Cost of Capital, When
debt is raised to Rs, 3,00,000
EBIT = 50,000 Ko = 12.5%
50,000
V = —————— = 4,00,000 Value of the firm = 4,00,000
12,5%
S = 4,00,000- 3,00,000 = 1,00,000 Value of Equity = 1,00,000
50,000 -30,000
Ke = ———————— X 100 = 20% Cost of Equity = 20%
1,00,000
EBIT 50,000
Ko = ——— X 100 = ————— X 100 = 12.5%
V 4,00,000
Thus, the value of the firm and overall cost of capital remains
unchanged but the cost of equity increases
(c) Calculation of Value of the Firm (V) & Overall Cost of Capital, When
debt is lowered to Rs, 1,00,000
EBIT = 50,000 Ko = 12.5%
50,000
V = —————— = 4,00,000 Value of the firm = 4,00,000
12,5%
S = 4,00,000- 1,00,000 = 3,00,000 Value of Equity = 3,00,000
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50,000 -10,000
Ke = ————————— X 100 = 13.33% Cost of Equity = 3.33%
3,00,000
EBIT 50,000
Ko = ————— X 100 = —————— = 12.5%
V 4,00,000
Thus, the value of the firm and overall cost of capital
remains unchanged but the cost of equity decreased.
Criticism :
(i) Irrelevant assumption of constant NOI.
(ii) Wrong assumption of constant interest rate.
(iii)Wrong assumption of business risk.
Q. What is Traditional Approach of capital Structure? Explain its
various stages.
Ans. Traditional Approach :– The traditional approach establishes a midway
between the Net Income approach and the Net Operating Income Approach. It
resembles Net Income approach in arguing that overall cost of capital and the
value of the firm are both affected by capital structure decision. But it does not
subscribe to the view of NI approach that use of debt in capital structure to any
extent will necessarily decrease the overall cost of capital and increase the
value of the firm. It resembles Net Operating Income approach that beyond a
certain degree of leverage, the cost of equity increases. But it differs from the
NOI approach that overall cost of capital and the value of the firm are constant
for all degrees of leverage.
Stages of Traditional Approach: According to the traditional approach, the
manner in which the overall cost of capital and the value of the firm reacts to
changes in the degree of financial leverage can be divided into three stages:
(1) First Stage :– In the first stage, increase in financial leverage, i.e., the use
of increased debt in the capital structure results in decrease in the overall
cost of capital (k ) and increase in the value of the firm. This is because, a
o
relatively cheaper source of funds debt replaces a relatively costlier source
of funds equity. In this stage, cost of equity(k) and cost of debt (k ) remains
e d
constant.
(2) Second Stage :– Once the firm has reached a certain degree of financial
leverage, increase in leverage does not affect the overall cost of capital and
49
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the value of the firm. This because the increase in the cost of equity due to
added financial risk completely offsets the advantage of using cheaper
debt. With in that range, the overall cost of capital will be minimum and
the value of the firm will be maximum. This range represents optimum
capital structure.
(3) Third Stage :– In the third stage, the further increase in debt will lead to
increase in overall cost of capital and will reduce the value of the firm. This
happens due to two factors:
(i) Owing to increased financial risk, K will rise sharply and
e
(ii) K would also rise because the lenders will also raise the rate of interest
d
as they may require compensation for higher risk.
Figure depicts that cost of equity (k) rises negligibly in the initial stage but
e
starts rising sharply in the later stage. Cost of debt remains constant upto a
certain degree of leverage and thereafter it also starts rising. The overall cost of
capital (k ) curve is saucer-shaper with a horizontal range RR. The optimum
o
capital structure of the firm is represented by range RR because in this stage
the overall cost of capital (k ) is minimum and the value of firm is maximum.
o
Q. Explain the Modigliani and Miller Approach (M-M)of Capital
Structure. What are its limitations?
Ans. Modigliani and Miller Approach :– The Modigliani-Miller approach is
similar to the net operating income approach when taxes are ignored. However,
when corporate taxes are assumed to exist, their hypothesis is similar to the
Net Income approach.
(1) The Modigliani-Miller Approach-When the taxes are ignored :– The
theory propounds that a change in capital structure does not affect the
overall cost of capital and the total value of the firm. The reason behind the
theory is that although the debt is cheaper to equity, with the increased
Degree of Leverage
O
Y
Ke
Ko
Kd
R R X
Stage I Stage II
Stage III
Cost
of
Capital
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use of debt as a source of finance, the cost of equity increases and this
increase in the cost of equity offsets the advantage of the low cost of debt.
Thus, although the change in the debt-equity ratio affects the cost of
equity, the overall cost of capital remains constant. The theory further
propounds that beyond a certain limit of debt, the cost of debt increases
but the cost of equity falls thereby again keeping the overall cost of capital
constant.
Graphic Presentation :–
Assumptions :– MM approach is based on the following assumptions:
(i) Securities are traded in a perfect capital market situation.
(ii) There are no corporate taxes
(iii)All the investors have same expectations about the net operating
income of the firm.
(iv)The cut-off rate of investment in a firm is the capitalization rate.
(v) All the earnings are distributed to the shareholders
(vi)Firms can be grouped into homogeneous risk classes.
Arbitrage Process :– The fundamental theory of the MM approach, if we ignore
the taxes, is that the total value of a firm must be constant irrespective of the
degree of leverage. In other words, the basic preposition of the MM approach is
that the capital structure decision is irrelevant. MM approach provides
behavioural justification for the irrelevance of the capital structure decision
and are not content with merely stating the preposition. The justification lies in
the arbitrage process.
Arbitrage process involves buying and selling of those securities whose
prices are lower (undervalued securities) and selling those securities whose
prices are higher (overvalued securities). Buying the undervalued securities
will increase their demand and will result in raising their prices and the selling
of overvalued securities will increase their supply thereby bringing down their
prices. This will continue till the equilibrium is restored. The arbitrage process
Y
X
V
Ko
Degree of Leverage
51
Cost
of
Capital
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ensures that the securities of two identical firms cannot sell at different prices
for long.
Example :– The following is the data regarding two companies X and Y
belonging to the same risk class:
Company X Company Y
Number of Ordinary Shares 90,000 1,50,000
Market price per share 1.20 1.00
6% Debentures 60,000 ————
EBIT 18,000 18,000
All profits after debentures interest are distributed as dividends.
Explain how under Modigliani and Miller approach an investor holding 10%
shares in company X will be better off in switching his holding to Company Y.
Solution :–
(a) Investor’s current position in company X with 10% equity holdings:
Investments ( 9000 shares X Rs. 1.20) Rs. 10,800
Dividend Income 10% of (18000-6%of 60,000) 1,440
(b) Investor sells his holdings in X for Rs. 10,800
He creates a personal leverage by borrowing Rs. 6,000. Thus,
The total amount available with him is Rs. 16,800
(c) He purchases 10% equity holding of Y for Rs. 15,000
(15,000 shares X re 1) for which he pays as follows:
From Borrowed funds 6,000
From Own funds (15,000-6,000) 9,000
(d) His dividend income is 10% of 18,000 1,800
Less: Interest on personal borrowings 6% on Rs. 6000 360
Net Income 1,440
Thus, he gets the same income of Rs, 1,440 from switching over to Y. But,
in the process he reduces his investment outlay by Rs. 1800(10,800-9,000).
Therefore, he is better off by investing in company Y.
(2) The Modigliani-Miller Approach-When corporate taxes are assumed
to exist :–
Modigliani and Miller agree that the value of the firm will increase and cost
capital will decline with the use of debt if corporate taxes are considered. Since
interest on debt is tax-deductible, the effective cost of borrowing will be less
than the rate of interest. Hence, the value of the levered firm would exceed that
of the unlevered firm by an amount equal to the levered firm’s debts multiplied
by the tax rate. Value of the levered firm can be calculated on the basis of the
following equation:
VL = Vu + Dt
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VL = Value of Levered Firm Vu = Value of Unlevered Firm
D = Amount of Debt t = Tax Rate
Equation implies that the value of the levered firm equals the value of an
unlevered firm plus tax saving resulting from the use of debt.
Example :– Two firm U and L are identical in every respect, except that U is
unlevered and L is levered. L has Rs. 20 Lakh of 8% debt outstanding. The net
operating income of both the firms is identical.i.e., Rs. 6 Lakh. The corporate
tax rate is 35% and equity capitalization rate for U is 10%. Find out the value of
each firm according to the MM Approach.
Solution :–
(i) Value of Unlevered Firm U :–
EBIT 6,00,000
Less : Interest Nil
_________
Earning before tax 6,00,000
Less : Tax @ 35% 2,10,000
_________
Earning After Tax 3,90,000
__________
Cost of Equity(K) 10%
e
__________
EBIT (1-t)
Value of the firm = —————————
Ke
3,90,000
Value of the firm (Vu) = ——————— = 39,00,000
10%
(ii) Value of Levered Firm L
VL = Vu + Dt
V L = 39,00,000 + 20,00,000 (.35)
VL = 39,00,000 + 7,00,000
VL = 46,00,000
Limitations or Criticism of MM Approach :–
(1) Risk Perceptions of personal and corporate leverages are different :–
It is incorrect to assume that ‘personal leverage’ is a perfect substitute for
‘corporate leverage’. Liability of an investor is limited in corporate
53
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