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FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
TIME VALUE OF MONEY
Growing Annuity
when the cash flow grows at a constant rate
for a specified period
e.g. office rent @ 20000 per year and increase
per year 3% and rate of discount is 10%
The PV for one year will be will be
(20000 x 1.03)/1.10PV for next five years will be PV of a growing
annuity=An(1+g){ [1-(1+g)t/(1+r)t] /r-g}
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FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
TIME VALUE OF MONEY
Growing Annuity
PV of growing An= 20000(1.03)
{ [1-(1.03)5
/(1.10)5
] / 0.10-0.03 } =20600{[1-(1.159/1.610)] / 0.07
= 20600 (1-0.72)/0.07 = 20600(0.28 /
0.07)= 20600x4 = 82400
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FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
TIME VALUE OF MONEY
PERPETUITY
A Perpetuity is an annuity of infinite period
– PV of Perpetuity= An/r
– e.g. you will make an income of 60 per year inperpetuity with an interest rate of 9%
– PV of Perpetuity will be 60/0.09 = 667
– Growing Perpetuity PV will be=An/(r-g) assume
growth rate is 3%
– 60/(0.09-0.03)=60/(0.06)
– 60/0.06 = 1000
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FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
THE COST OF CAPITAL
A PRESENTATION
BYCA. R.C.AGARWAL
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THE COST OF CAPITAL -
SIGNIFICANCE Provides very basis for financial appraisal of new
capital Exp. Proposals. It serves as acceptance
criterion for the new project
Helps in determining the optimal capital structureHelps in evaluating the financial performance of top
management
Helps in formulating Dividend policy and Working
capital policy
It is the firm’s required rate of return which will just
satisfy all capital providers
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THE COST OF CAPITAL
Important business decisions require capital
Rate of return should exceed the cost of capital
Compensations plans of companies use the concept of
Economic Value Added (EVA). EVA is the differencebetween operating profits after taxes and charge of
capital.Charge of capital is multiplying the capital amount by
cost of capital. Therefore, cost of capital is an importantcomponent of compensation schemes also.
Cost of capital is an important factor in choosing the
mixture of debt and equity
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FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
THE COST OF CAPITAL
Basic conditions
– New investment has similar risk as
the typical or average investmentundertaken by the firm
– Proposed investment does not
change financing policy of the firm
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FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
THE COST OF CAPITAL
Characteristics
– It is really a rate of return and not the cost
– Rate of return calculated on the basis of actual
cost of different components of capital – Usually related to long-term capital funds
– It is used as discount rate to arrive at PV
– It has two components
Return at Zero risk level
Risk premium
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FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Classification of cost of capital
Explicit and Implicit cost
– Explicit cost relates to raising of
funds i.e. rate of return of the cashflows of financing opportunity
– Implicit cost relates to usage of
funds i.e. rate of return associatedto best investment opportunity
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FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Classification of cost of capital
Average cost and Marginal cost
– Average cost is weighted average
cost of each component of funds – Marginal cost is weighted average
cost of new funds raised by the
firm
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FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Classification of cost of capital
Future cost of capital
– Historical cost means the cost of
capital incurred in procuring fundsin past
– Future cost refers to expected
cost to be incurred in raising newfunds
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FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Classification of cost of capital
Specific cost and Combined cost
– Specific cost means cost of
individual components – Combined cost means average
cost of capital of all sources of
capital
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FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
THE COST OF CAPITAL
Discount rate / opportunity cost is called costof capital
Major capital components are equity,preference and debt
Cost of capital = weighted average cost ofvarious capital components used (WACC) or
Average rate of return required by investorswho provide capital
Cost of capital (WACC) is used for – evaluating investment projects
– determining capital structure etc
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FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
THE COST OF CAPITAL
Company cost of capital V/s
Project cost of capital
– Company Cost of capital=returnexpected by existing investors
– Project cost of capital = return
expected by investors in newproject
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FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
THE COST OF CAPITAL
Rational – If rate of return on investment is more than cost of capital
shareholders benefit
– ABC used equity and debt in equal proportion and cost is 14%
and 6% respectively. Cost of capital = 0.5x14+0.5x6= 10% – Firm invests total 100 and rate of return is 12% the benefit willbe = (total return on project – intt. on debt) / equity funds =[(100x0.12) – (50x0.06)] / 50 = 18%
– Therefore return on equity comes to 18% which is more than14% cost of equity, equity shareholders benefit
Return an investor expects to receive is cost tocompany
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Concept of WACC
ABC uses equity 50%, preference 10%
and debt 40% and the respective cost is
16%, 12% and 8% respectively
WACC= (Proportion of equity)(cost of
equity) + (proportion of preference) (cost
of preference) + (proportion of debt)(cost
of debt)
WACC will be?
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Concept of WACC
WACC will be
WACC=(0.5)(16)+(o.10)(12)+
(0.40)(8) = 12.4%
Assumed non-convertible, non-
callable preference; and non-convertible, non-callable debt
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Concept of WACC
Cost of short term debt like Commercial
paper has to be taken in consideration as
the investors of short term debt also have
claim on the operating earning of thecompany
Non intt. bearing liabilities e.g. trade
creditors are not taken in A/c as the cost ofsuch debt is already taken in account in
purchase price
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Basic conditions for using WACC for
evaluating new investments
Risk of new investment is same as that of
average risk of existing investments
Capital structure of the firm will not be effected
due to new investmentWACC is the discount rate of the project which is
a carbon copy of the existing business
WACC can be used as the base hurdle rate tobe adjusted for variations in risk and financing
pattern
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Cost of Debt and Preference
Debt and preference require fixed payments hence
estimating cost is almost similar
Debt is raised through debentures, bank loans,
commercial paper etc. Cost of debt is weighted average
rate of different type of debt used
Weighted average rate of debt is calculated using market
values and yield to maturity (YTM) or current rate at
which the firm can raise new debt
As the interest on debt is tax deductible exp. pre-tax cost
of debt to be adjusted for tax factor to arrive at post tax
cost of debt
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FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Cost of Debt and Preference-
cont…
Cost of debenture= Po=sum of (I)/(1+r d)t +
(F)/(1+r d )n
Po= current market price of deb.
I = annual intt. payment
F = maturity value of deb.
r d = cost of deb.
n = no. of years left to maturity
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FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Cost of Debt and Preference-
cont…
As computation of rd requires trial and error
method following formula can be used
r d = {I + [(F-Po)/n]}/0.6xPo+0.4xF
e.g. Face value 1000coupon rate 12%
remaining period of maturity
4 years current market price 1040rd i.e. YTM = {120+[(1000-1040)/4]} /
0.6x1040+0.4x1000=10.7%
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FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Cost of Debt and Preference-
cont…
Cost of bank loan= current market rate
of intt. as Bank loan is not traded in
secondary market.
If the company has taken loan earlier @
13% but now the loan can be obtained @
12%
If rate on which fresh loan can be raised
is 12%, that will be treated as cost
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FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Cost of Debt and Preference-
cont…
Cost of commercial paper i.e. short termdebt instrument issued on a discount andredeemed at par. The cost is implicit intt. rate
e.g. ABC ltd. commercial paper face value is10,00,000, remaining period to maturity is 6months and traded in market at 9,65,000
The cost = (10,00,000/9,65,000) – 1
= or (10,00,000-9,65,0000)/9,65,000 =0.0363 Annualized rate will be (1.0363)2 -1= .0739 or7.39%
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FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Cost of Debt and Preference-
cont…
Weighted average cost of debt
Debt Face market coupon curr.rate
Value Value Rate
NCD 100 104 12% 10.7%
Bank loan 200 200 13% 12%
Com.Paper 50 48.25 NA 7.39%total 352.25
Tax rate is 35% Calculate WACC
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FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Cost of Debt and Preference-
cont…
Weighted average cost of debt
Average cost of debt
=10.7%(104/352.25)+12%(200/352.25)+7.39%(48.25/352.25)=10.98
Current rate = rate at which new debt canbe raised
Post-tax cost of debt= pre-tax cost(1-taxrate)=10.98(1-0.35)=7.14%
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Cost of Long term Debt
Debt at premium or discount
r d = (I/Np)(1-tc)
I = Annual interest payment
Np = Net proceeds of loansXYZ issues 10% irredeemable Deb. Of Rs. 1,00,000
and tax rate is 60%
At par = (10,000/1,00,000)(1-0.60)= 4%
At 10% discount = (10,000/90,000)(1-0.60) = 4.44%
At 10% premium =(10,000/1,10,000)(1-0.60)=3.63%
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FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Cost of Debt and Preference-
cont…
Cost of preference
– Preference capital carries fixed Div. and is
redeemable.
– Due to preference Div., principal repaymentcommitment and absence of tax. The cost =
its yield = r p = YTM
– Dividend is not tax deductible exp.
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FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Cost of Debt and Preference-
cont…
Cost of preference
– E.g. preference face value 100
Dividend rate 11%
Maturity period 5 years
Market price 95
r p = {I + [(F-Po)/n]}/0.6xPo+0.4xF
r p={11+[(100-95)/5]}/0.6x95+0.4x100 = 12.37
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Cost of Preference
It can also be calculated as:
Dividend / Face value – Issue cost
ABC issues 9% preference shares atRs.85 par value. Cost of issue is Rs.3 per
share
Preference dividend will be 85X9 = 7.65
7.65 / 82 i.e. (85-3) = 9.33%
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FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Cost of equity
Equity finance can be obtained by – Retention of earnings involves cost, as opportunity
cost is lost by shareholders. Only flotation cost is notinvolved
– Issue of additional equity
Cost of equity or the return required by equity holders issame in both cases
Hence in both cases cost of capital is same
Cost of equity means cost of retained earnings and cost
of external equityThere is no definite commitment to dividend
Equity to provide higher expected rate of return than
debt of the company
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FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Cost of equity
The required rate of return=expected rate ofreturn
r e=Rf + Rp= (D1/Po)+g
r e=cost of equityRf =risk free rate
Rp=risk premium
D1=dividend expected to be paid
Po=current price of the stock
g=expected growth rate of dividend
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Cost of equity
E/P (earning price ratio) Ratio method: (Eo/Po)X100
Eo = current earning per share
Po = current market price per share
A has 5 EPS Current market price is Rs. 50
The r e = (5/50)100 = 10%
Limitations:
– Earning do not represent expectations of shareholders
– Earnings are not constant
– There should not be debt capital
– All earnings should be paid to shareholders
– There is no growth in earnings
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Cost of equity
E/P Ratio + Growth rate method:
[Eo (1+b)3]/Po
(1+b)3 = Growth factor i.e. b is growth rate as a
% and estimated for 3 years
A has 5 EPS with 10% growth rate earning for a
period of 3 years. Current market price is Rs. 50
r e = {[5(1+.10)3
]/50}100{[5(1.331)/50}100 = (6.665/50)100 = 13.31%
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FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Cost of equity
Risk premium approach
–Cost of equity=Yield on long term
bonds + Risk premium –Firm having high risk have high cost
of debt will have high cost of equity
–Difficult to determine risk premium
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Cost of equity
D/P (Dividend price ratio) Ratio method:
(Do/ Po)100
Do = Dividend per share
Po = Market price per shareMarket price Rs. 15 and dividend rate is 15% (par value
Rs. 10 per share)
(1.5/15)100 = 10%
Assumptions: – Risk remains unchanged
– Investors desire to have dividend
– Shares are purchased at par
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FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Cost of equity-cont…
Dividend growth approach
If dividend is expected to grow at constant rate
Po=D1/(r e-g) or r e=(D1/Po)+g
Po=current price of stock
D1=dividend expected to be paid at the end of yearr e=required rate of return on equity
ABC ltd. market price of share is Rs. 50.
Expected dividend Rs. 4 at the end of year. Approximate
growth rate 5% p.a. The share price should be:50 = 4/(r e – 0.05) = 4/(0.13-0.05) = 4/0.08
r e = (4/50)+0.05 = 0.08 + 0.05 = 13%
Required return = dividend yield + expected growth rate
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FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Cost of equity-cont…
Dividend growth approach
Expected growth to be determined by averaging
the growth of dividend declared in last few years
Or multiply retention rate(1-dividend payout rate)x expected future return on equity (ROE)
e.g. retention rate is 0.60 and return on equity is
15%Expected growth i.e. g= (0.6)(15%)=9%
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FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Determining proportion
Proportions=target capital structureweights stated in market value terms
Purpose of using target capital structure is
that present capital structure may notreflect capital structure expected to remainin future
For calculating weights use market valueand if not available than use book value.Investors expect return on market value
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FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Weighted average cost of capital
Multiply specific cost of each source of financingby its proportion in capital structure and addweighted values
WACC=wEr E+w
pr p+w
Dr D(1-t
c)
WACC=weighted average cost of capital
wE=proportion of equity
r E=cost of equity
wp=proportion of preference
r p=cost of preferencewD=proportion of debtr D=cost of debt
tc=corporate tax rate
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FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Weighted average cost of
capital-cont…
Source of capital Proportion Cost Weighted cost
(1x2)
Equity 0.60 16% 9.60%
Preference 0.05 14% 0.70%
Debt 0.35 8.4% 2.94%
WACC= 13.24%
Cost of debt= 12x(1-0.30)=12x0.70=8.4%
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FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Weighted marginal cost of
capital
In market suppliers expect more return toprovide more capital
Estimate cost of each source of financing forvarious levels of its use through expectation of
investors and lendersIdentify breaking points i.e. where cost of newcomponent would change
Calculate WACC for various range of total
financing between breaking pointsPrepare weighted marginal cost of capitalschedule which reflects WACC for each level oftotal new financing
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W i ht d i l t f
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FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Weighted marginal cost of
capital-cont… WACC for various range of total finance Range of total source of proportion cost weighted
New finance capital % cost%
Rs.inlakhs
0-75 Equity 0.4 0.18 .072Debt 0.6 0.10 .060
WACC .132
Above75-83.3 Equity 0.4 0.20 .080
Debt 0.6 0.10 .060
WACC .140 Above 83.3 Equity 0.4 0.20 .080
Debt 0.6 0.11 .066
WACC .146
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FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Floatation cost and WACC
The cost incurred for raising funds
It should not affect WACC instead it should be
adjusted in project cost
e.g. project cost is 200 and floatation cost is 8%it means company will receive 184.
Therefore to raise net 200
200=(1-0.08) x amount required to be raisedamount required to be raised=200/(1-0.08)=
217.39
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FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
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FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
CAPITAL STRUCTURE DECISION
Two principal sources of finance for a businessfirm are equity and debt.
What should be proportions of equity and debt incapital structure of a firm?
It is essentially concerned with how the firmdecides to divide its cash flows into two broadcomponents, a fixed component to meet thedebt obligations and residual component thatbelongs to equity shareholders.
No single method which can ensure optimalcapital structure
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FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
GUIDELINES
It is a difficult decision
which requires trade off
between income, risk,flexibility, control, timing,
etc.
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CRITERIA FOR CAPITAL
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CRITERIA FOR CAPITAL
STRUCTURECost principle
– Minimize cost of financing and maximize value per
share
– Debt capital more preferable as it is cheaper
Risk principle
– Avoid bankruptcy
– More dependence to be on equity financing
Control principle – Owners desirous to hold on the control will depend
more on bonds and preference capital
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CRITERIA FOR CAPITAL
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CRITERIA FOR CAPITAL
STRUCTUREFlexibility principle
– Maneuverability should be possible according to major
changes in needs of funds
– Combination of funds to be such that there is bargainability
in dealing with the suppliers of funds (bonds)
Timing principle
– Offer securities which are in great demand like in boom
equity issue is welcome
– Appropriate time to be chosen for raising the funds To take advantage of market opportunities
To minimize cost of funds
To obtain substantial savings
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
FACTORS INFLUENCING
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FACTORS INFLUENCING
CAPITAL STRUCTURE Size of business
– Problems in raising funds by small firms
– Investors are not enthusiastic in putting funds in small
firms
Form of business organisation
– Control principle is important in Pvt. Ltd., proprietory and
partnership firms but not much in public ltd. companies
Stability of earnings
– Firms with stable earnings and public utility concerens faceless problems in raising funds as they have adequate
profits
– Manuf.and other firms have to mainly depend on equity
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
FACTORS INFLUENCING
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FACTORS INFLUENCING
CAPITAL STRUCTURE Age of company
– Younger firms find it difficult to raise funds
– Established firms can raise funds from any source
Purpose of financing – If productive purpose the difficulty is less
– For welfare activities funds have to from equity
Market sentiments
– Times of boom and times of slacknessCredit standing
– High credit standing the problems are less
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
FACTORS INFLUENCING
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FACTORS INFLUENCING
CAPITAL STRUCTUREPeriod of finance
– For temporary period or few years than raise through bonds
– Permanent requirement to be raised through equity
Legal requirements
– Companies Act, Banking companies Act, Income Tax Act etc.influence the capital structure
– Debenture/Preference shares are issued to increase the earning
of equity shares
– Equity shares are issued to absorb shocks of business cycles
and to afford flexibility
Tax consideration
– Debt is more advantageneous
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FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Avail of Tax advantage of debt
Interest of debt is tax deductible
If the debt is perpetual the tax shield is
available on full loan i.e. present value of
tax shield will be = (tcr dD)/r d = tcD
Debt financing provides tax shelter which
increases firm value i.e.=tcD
where tc = corporate tax rate, r d=interest
rate on debt, D = debt financing
CONTROL IMPLICATIONS OF
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FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
CONTROL IMPLICATIONS OF
ALTERNATIVE FINANCING PLAN
e.g. ABC Ltd. has equity capital of 10,00,000 totallyowned by promoters. Now additional Capital of10,00,000 can be in the form of total debt or right issueor public issue or a combination of two or more.Consider the following
Pros ConsRights issue No dilution of control limits on financing
ability of promoters
No financial risk High cost
Debt financing No dilution of control Financial risk
Lower cost
Public issue No financial risk Dilution of control
Higher cost
CONTROL IMPLICATIONS OF
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FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
CONTROL IMPLICATIONS OF
ALTERNATIVE FINANCING PLAN
Due to financing limits of right issue,
decision is to be taken between debt and
public issue and in this control is
important componentControl is related to equity holding below
100%, 50%, 26%. 50% for control over
the firm and 26% for stopping specialresolutions
NORMS OF LENDERS & CREDIT
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NORMS OF LENDERS & CREDIT
RATING AGENCIES
Lenders normally want tangible assets like
plant & machinery as security hence if such
assets are available borrowing is possible
Rating agencies normally consider thefollowing
– Earning power, business and financial risk
– Asset protection, cash flow adequacy
– Financial flexibility, quality of accounting
Do not be obsessed about credit rating