fiinancial management contd

8/14/2019 Fiinancial Management Contd

http://slidepdf.com/reader/full/fiinancial-management-contd 1/28

Theories of capital structure Theories of capital structure

Net Income ApproachNet Income Approach

Net Operating Income ApproachNet Operating Income Approach

The Traditional Approach The Traditional Approach Modiglianni and Miller ApprachModiglianni and Miller Apprach



Net Income ApproachNet Income Approach

A firm canA firm can

minimize theminimize the

weighted averageweighted average

cost of capital andcost of capital andincrease the valueincrease the value

of the firm as wellof the firm as well

as market price of as market price of

equity shares byequity shares byusing debtusing debt

financingfinancing to theto the

maximum possiblemaximum possible

extent.extent.

ASSUMPTIONSASSUMPTIONS

The cost of debt is The cost of debt is

less than the costless than the cost

of equityof equity There are no taxes There are no taxes

The risk perception The risk perception

of investors in notof investors in notchanged by thechanged by the

use of debt.use of debt.



Value of Firm (N I Approach)Value of Firm (N I Approach)

Total Value of firm (V)= S + D Total Value of firm (V)= S + D S= Market Value of equity sharesS= Market Value of equity shares

= Earning available to equity shareholders= Earning available to equity shareholders

Equity Capitalisation rateEquity Capitalisation rate

D= Market Value of debtD= Market Value of debt

And overall weighted avg cost of capital will be calculated as:And overall weighted avg cost of capital will be calculated as:

K K 00== EBIT / VEBIT / V

For example:For example:

(k)(k) A company expects a net income of Rs 80,000. It has RsA company expects a net income of Rs 80,000. It has Rs2,00,000, 8% debentures. The equity capitalisation rate of the2,00,000, 8% debentures. The equity capitalisation rate of thecompany is 10%. Calculate the value of the firm and overallcompany is 10%. Calculate the value of the firm and overallcapitalisation rate according to the Net Income Approachcapitalisation rate according to the Net Income Approach(ignoring income tax)(ignoring income tax)

(l)(l) If the company debt is increased to Rs 3,00,000, what will beIf the company debt is increased to Rs 3,00,000, what will be

the value of the firm and the overall capitalisation rate.the value of the firm and the overall capitalisation rate.



80,000

24,000

56,000

10%

5,60,000

3,00,000

8,60,000

(b) Net income

Less: interest on 8% debentures of Rs 3,00,000

Earning available to equity shareholders

Equity capitalisation rate

Market value of equity (S)= 56,000 x (100/10)

Market value of debentures (D)

Value of firm (S+D)

Overall cost of capital (EBIT/ V) = 80,000/8,60,000) x 100

= 9.30%

80,000

16,000

64,000

10%

6,40,000

2,00,000

8,40,00

0

(a) Net income

Less: interest on 8% debentures of Rs 2,00,000

Earning available to equity shareholders


Market value of equity (S)= 64,000 x (100/10)

Market value of debentures (D)

Value of firm (S+D)

Overall cost of capital (EBIT/ V) = 80,000/8,40,000) x 100= 9.52%



Net Operating Income ApproachNet Operating Income Approach

Change in capital structure of a companyChange in capital structure of a companydoes not effect the market value of thedoes not effect the market value of thefirm and the overall cost of capital remainsfirm and the overall cost of capital remainsconstant irrespective of the method of constant irrespective of the method of financing.financing.

Increased use of debt increases theIncreased use of debt increases thefinancial risk of the equity shareholdersfinancial risk of the equity shareholdersand hence the cost of equity increases.and hence the cost of equity increases.

On the other hand, the cost of debtOn the other hand, the cost of debtremains constant with the increasingremains constant with the increasingproportion of debt as the financial risk of proportion of debt as the financial risk of lenders is not affected.lenders is not affected.

Thus, the advantage of using the cheaper Thus, the advantage of using the cheapersource of funds i.e. debt is exactl offsetsource of funds, i.e. debt is exactl offset



Value of Firm (N O- I Approach)Value of Firm (N O- I Approach)

V=EBIT/K V=EBIT/K 00 where, V=Value of firm & K where, V=Value of firm & K 00 is cost of capitalis cost of capital

The market value of equity, according to this approach is The market value of equity, according to this approach is

the residual value which is determined by deducting thethe residual value which is determined by deducting the

market value of debentures from the total market value of market value of debentures from the total market value of the firm.the firm.

S = V - D where, S is Market value of equity, V is Market valueS = V - D where, S is Market value of equity, V is Market value

of firm and D is Market value of debt.of firm and D is Market value of debt.

For example; A company expects a net operating income of RsFor example; A company expects a net operating income of Rs1,00,000. It has Rs 5,00,000, 6% Debentures. The overall1,00,000. It has Rs 5,00,000, 6% Debentures. The overall

capitalization rate is 10%. Calculate the value of the firmcapitalization rate is 10%. Calculate the value of the firm

and the equity capitalization rate (cost of equity).and the equity capitalization rate (cost of equity).

If debenture debt is increased to Rs 7,50,000, what will be theIf debenture debt is increased to Rs 7,50,000, what will be the

effect on the value of the firm and the equity capitalizationeffect on the value of the firm and the equity capitalization



1,00,000

10%10,00,0

00

5,00,000

5,00,000

Net Operating income

Overall cost of capital

Market value of firm (V) = 1,00,000x(100/10)Less: Market value of debentures (D)

Total Market value of Equity

Equity capitalisation rate or Cost of equity (Ke) is:

(EBIT - I / V - D) = (1,00,000 – 30,000/5,00,000)x100= 14%

If the debt is increased to Rs 7,50,000, the value of the firm shall remain unchanged at Rs10,00,000, the equity capitalization rate willincrease as follows:

Equity capitalization rate (Ke) is as follows:

(EBIT - I / V - D) = (1,00,000 – 45,000/2,50,000)x100

= 22%



The Traditional Approach The Traditional Approach

This is an intermediate approach This is an intermediate approach

According to this theory, overall costAccording to this theory, overall cost

of capital decreases up to a certainof capital decreases up to a certain

point, remains more or lesspoint, remains more or less

unchanged for moderate increase inunchanged for moderate increase in

debt thereafter, and increases ordebt thereafter, and increases or

rises beyond a certain point.rises beyond a certain point. Thus, the optimum capital structure Thus, the optimum capital structure

can be reached by a proper debt-can be reached by a proper debt-

equity mix.equity mix.



Value of firm (Traditional Approach)Value of firm (Traditional Approach)

Net operating incomeNet operating income Rs 2,00,000Rs 2,00,000 Total investmentTotal investment Rs 10,00,000Rs 10,00,000

Equity capitalisation rate, if;Equity capitalisation rate, if;(d)(d) The firm uses no debtThe firm uses no debt 10%10%

(e)(e) The firm uses Rs 4,00,000 debenturesThe firm uses Rs 4,00,000 debentures 11%11%

(f)(f) The firm uses Rs 6,00,000 debenturesThe firm uses Rs 6,00,000 debentures 13%13%

Assume that Rs 4 lacs debentures can be raised at 5% rate of Assume that Rs 4 lacs debentures can be raised at 5% rate of interest whereas Rs 6 lacs debentures can be raised at 6% rateinterest whereas Rs 6 lacs debentures can be raised at 6% rateof inerest.of inerest.

2,00,000

36,000

1,64,000

13%

12,61,538

6,00,000

18,61,538

10.7%

2,00,000

20,000

1,80,000

11%

16,36,000

4,00,000

20,36,363

9.8%

2,00,000

2,00,000

10%

20,00,000

20,00,000

10%

Net operating income

Less: Interest

Earning available to equity shareholders(a)


Market Value of share (a x 100/captrate)

Market value of debt

Market value of firm

Average cost of capital (EBIT/V)

(c)(b)(a) nodebt



Modigliani and Miller ApproachModigliani and Miller Approach

If taxes are ignored, it is identicalIf taxes are ignored, it is identical

with Net Operating approach.with Net Operating approach.

If taxes are assumed to exist, it isIf taxes are assumed to exist, it is

similar to the Net Income Approach.similar to the Net Income Approach.



Point of IndifferencePoint of Indifference

A project under consideration by your company requires a capitalA project under consideration by your company requires a capital

investment of Rs 60 Lakhs. Interest on term loan is 10% p.a. andinvestment of Rs 60 Lakhs. Interest on term loan is 10% p.a. andtax rate is 50%. Calculate the point of indifference for the project,tax rate is 50%. Calculate the point of indifference for the project,

if the debt-equity ratio is insisted by financing agencies 2:1.if the debt-equity ratio is insisted by financing agencies 2:1.

Company has two options, 1) to raise entire amount throughCompany has two options, 1) to raise entire amount through

equity, 2) raising Rs 40 lakhs by way of debt and Rs 20 lakhs byequity, 2) raising Rs 40 lakhs by way of debt and Rs 20 lakhs by

way of equity. The point of indifference would be:way of equity. The point of indifference would be:

{(X-I{(X-I11) (1-t) – PD}/S) (1-t) – PD}/S11 = {(X-I= {(X-I22) (1-t) – PD}/S) (1-t) – PD}/S22 , where; X is point of , where; X is point of

indifferenceindifference

II1,1, II22 is interest under both alternatives, t is tax rate assume to beis interest under both alternatives, t is tax rate assume to be

50%50%

PD is preference dividend and SPD is preference dividend and S1,1, SS22 is amount of equity underis amount of equity under

different alternativesdifferent alternatives

{(X- 0) (1-.5) – 0}/60 = {(X-4) (1-.5) – 0}/20{(X- 0) (1-.5) – 0}/60 = {(X-4) (1-.5) – 0}/20

.5X/60 = .5X – 2/20.5X/60 = .5X – 2/20

10X = 30X-12010X = 30X-120

X = 6X = 6

In case, the firm has EBIT level below Rs 6 lakhs then equityIn case, the firm has EBIT level below Rs 6 lakhs then equityfinancing is preferable to debt financing; but if the EBIT is higherfinancing is preferable to debt financing; but if the EBIT is higher



Factors Determining the Capital StructureFactors Determining the Capital Structure

1.1. Financial LeverageFinancial Leverage

2.2. Growth and stabilityGrowth and stabilityof salesof sales

3.3. Cost of CapitalCost of Capital

4.4. Cash Flow ability toCash Flow ability toservice debtservice debt

5.5. Nature and size of Nature and size of firmfirm

6.6. ControlControl7.7. FlexibilityFlexibility

8.8. Requirements of Requirements of investorsinvestors

1.1. Capital MarketCapital MarketConditionsConditions

2.2. Assets StructureAssets Structure

3.3. Purpose of financingPurpose of financing

4.4. Period of financePeriod of finance

5.5. Costs of floatationCosts of floatation

6.6. Legal requirementsLegal requirements



Cost of debtCost of debt

Cost of preference capitalCost of preference capital Cost of equity capitalCost of equity capital

Cost of retained earningCost of retained earning

And weighted average cost of capitalAnd weighted average cost of capitalis the average cost of the costs of is the average cost of the costs of above sources. It is also known asabove sources. It is also known as‘overall cost of capital’.‘overall cost of capital’.



EVALUATION OFEVALUATION OF

INVESTMENT DECISIONSINVESTMENT DECISIONS

Estimation of Cash FlowsEstimation of Cash Flows

Determining the Rate of Discount orDetermining the Rate of Discount or

Cost of CapitalCost of Capital

Applying the technique of CapitalApplying the technique of Capital

Budgeting to determine the viabilityBudgeting to determine the viability

of Investment Proposalof Investment Proposal



Types Of Cash FlowsTypes Of Cash Flows

Initial Investment or Cash OutlayInitial Investment or Cash Outlay

Operating Cash Flows or Net AnnualOperating Cash Flows or Net Annual

Cash FlowsCash Flows

Terminal Cash Flows Terminal Cash Flows



Capital BudgetingCapital Budgeting

TechniquesTechniques Capital budgeting is concerned withCapital budgeting is concerned with

the allocation of the firm’s scarcethe allocation of the firm’s scarce

financial resources among thefinancial resources among the

available market opportunities. Theavailable market opportunities. Theconsideration of investmentconsideration of investment

opportunities involve the comparisonopportunities involve the comparison

of the expected future streams of of the expected future streams of earnings from a project, with theearnings from a project, with the

immediate and subsequent streamsimmediate and subsequent streams

of expenditures for it.of expenditures for it.



Capital BudgetingCapital Budgeting

TechniquesTechniques Non Discounted MethodNon Discounted Method

(2)(2) Pay Back MethodPay Back Method

(3)(3) Rate of return or Accounting methodRate of return or Accounting method

(4)(4) Urgency MethodUrgency Method Discounted MethodDiscounted Method

(6)(6) Discounted pay back methodDiscounted pay back method

(7)(7)

Net Present Value MethodNet Present Value Method(8)(8) Internal Rate of Return MethodInternal Rate of Return Method

(9)(9) Profitability IndexProfitability Index



Risk Analysis in Capital BudgetingRisk Analysis in Capital Budgeting

Risk Adjusted Discount RateRisk Adjusted Discount Rate

Certainity Equivalent MethodCertainity Equivalent Method

Sensitivity AnalysisSensitivity Analysis Probability AnalysisProbability Analysis

Standard Deviation methodStandard Deviation method

Decision Tree AnalysisDecision Tree Analysis



Working Capital ManagementWorking Capital Management

Working Capital is the amount of Working Capital is the amount of

funds necessary to cover the cost of funds necessary to cover the cost of

operating the enterprise.operating the enterprise.

Gross Vs Net Working CapitalGross Vs Net Working Capital

Gross is total of Current AssetsGross is total of Current Assets

Net Working Capital = C.A. – C.L.Net Working Capital = C.A. – C.L. Permanent Vs Temporary WorkingPermanent Vs Temporary Working

CapitalCapital



Factors affecting WorkingFactors affecting Working

Capital RequirementCapital Requirement Nature of BusinessNature of Business Size of BusinessSize of Business Production PolicyProduction Policy Manufacturing ProcessManufacturing Process

Seasonal VariationsSeasonal Variations Operating cycleOperating cycle Rate of Stock TurnoverRate of Stock Turnover Credit policyCredit policy

Business CyclesBusiness Cycles Rate of growth of BusinessRate of growth of Business Earning capacity and Dividend PolicyEarning capacity and Dividend Policy Price never changesPrice never changes



Financing of WorkingFinancing of Working

CapitalCapital Permanent Vs Temporary WorkingPermanent Vs Temporary Working

Capital RequirementCapital Requirement

Long Term Vs Short Term SourcesLong Term Vs Short Term Sources

Approaches for determining W.C.Approaches for determining W.C.

financing mixfinancing mix

(d)(d)

Conservative approachConservative approach(e)(e) Aggressive approachAggressive approach

(f)(f) Hedging or Matching approachHedging or Matching approach



Motives for Holding CashMotives for Holding Cash

Transaction motive Transaction motive

Precautionary motivePrecautionary motive

Speculative motiveSpeculative motive Compensatory motiveCompensatory motive



Managing Cash flowsManaging Cash flows

Accelerating Cash InflowsAccelerating Cash Inflows

(2)(2) Prompt payment by customersPrompt payment by customers

(3)(3) Quick conversion of payment intoQuick conversion of payment intocashcash

(4)(4) Decentralized collectionsDecentralized collections

(5)(5) Lock box systemsLock box systems Delaying Cash OutflowsDelaying Cash Outflows

(7)(7) Paying on last datePaying on last date

(8)(8) Centralization of paymentsCentralization of payments



Investment of SurplusInvestment of Surplus

FundsFunds Treasury bills Treasury bills

Certificate of depositsCertificate of deposits

Inter-corporate depositsInter-corporate deposits Commercial papersCommercial papers

Money market mutual fundsMoney market mutual funds



ReceivablesReceivables

ManagementManagement Receivables represent amountsReceivables represent amounts

owed to the firm as a result of saleowed to the firm as a result of sale

of goods or service on credit in theof goods or service on credit in the

ordinary course of business.ordinary course of business. Cost of maintaining receivablesCost of maintaining receivables

(iii)(iii) Cost of financing receivablesCost of financing receivables

(iv)(iv) Cost of collectionCost of collection

(v)(v) Bad debtsBad debts



Factor Affecting the Size of Factor Affecting the Size of

ReceivablesReceivables

Size of credit salesSize of credit sales

Credit policyCredit policy

Terms of trade Terms of trade Expansion plansExpansion plans

Relation with profitsRelation with profits

Credit collection effortsCredit collection efforts Habits of cutomersHabits of cutomers



Dimension of ReceivablesDimension of Receivables

ManagementManagement

Forming a Credit PolicyForming a Credit Policy

Executing a Credit PolicyExecuting a Credit Policy

Formulating and Executing CollectionFormulating and Executing Collectionpolicypolicy

fiinancial management contd

Documents