finanacial management and analysis- department of economics 2013 mahendra

8/12/2019 Finanacial Management and Analysis- Department of Economics 2013 Mahendra

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Financial Analysis is the process of identifying the financialstrengths and weaknesses of the firm by properly

establishing relationships between the items of the balance

sheet and the profit and loss account.

Financial Analysis is about how to analyse the financial

performance of a firm and how to manage corporate funds

and liquidity.

Financial Analysis focuses on the financial decision-making

and the role of financial manager as the efficient user of

financial resources.


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USERS OF FINANCIAL ANALYSIS

Financial analysis can be undertaken by management of the

firm, or by parties outside the firm, viz, owners, creditors,

investors and others. The nature of analysis will differdepending on the purpose of the analyst:

TRADE CREDITORS

SUPPLIERS OF LONG TERM-DEBT

INVESTORS

MANAGEMENT


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Accounting is concerned with the recording,classifying, summarising, analysis andinterpretation of the business transaction.

According to the American Institute of CertifiedPublic Accountants Accounting is a art ofrecording, classifying and summarising in asignificant manner and in terms of money,

transactions and events, which are in partatleast, of a financial character and interpretingthe result thereof.


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FINANCIAL

ACCOUNTING

MANAGEMENT

ACCOUNTING

PROFIT &

LOSS

ACCOUNT

BALANCE

SHEET

CASH

FLOW

STATEMEN

T

COST

ACCOUNTIN

G

DECISION

MAKING

COSTING & PLANNING

AND CONTROL

BUDGETING &

STANDARD

COSTING

SHORT

TERM

LONG

TERM


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SOME CONCEPTS


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CONTD.

Authorized capital: The authorized capitalof a company (sometimes,

referred to as the authorizes share capital or the nominal capital,

particularly in the United States) is the maximum amount of share capital

that the company is authorized by its constitutional documents to issueto shareholders. Part of the authorized capital can (and frequently does)

remain unissued. (say Rs. 100 cr.).

Issued capital: The part of authorized capital which has been issued to

shareholders is referred to as the issued capital of the company. (say

Rs. 80 cr.). Subscribed capital: The subscribed capitalis that part of the issued

capital that is actually subscribed by the public. (say Rs. 60 cr.).

Paid-up-capital: The amount of shareholders capital that has been paid

in fully by shareholders.

or,Paid-up-capitalis essentially the portion of authorized stock that the

company has issued and received payment for.


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CONTD. EQUITIES:The claim against, or interest in, an organisation assets.

OWNERS EQUITY: The excess of assets over the liabilities.

STOCK HOLDERS EQUITY: The owners equity of a corporation.

PAID-IN-CAPITAL:The ownership claim arising from funds paid-in by the owners.

or,

PAID-IN-CAPITAL(or, CONTRIBUTED CAPITAL) refers to the capital contributed to acorporation by investors through purchase of stock from the corporation (PRIMARYMARKET) (not through purchase of stock in the OPEN MARKET from otherstockholders i.e. SECONDARY MARKET).

RETAINED INCOME (RETAINED EARNINGS): The ownership claims arising from thereinvestment of previous profits.

ACCOUNT PAYABLE:Amounts owed to vendors for purchase on open account.

ACCOUNT RECEIVABLE:Amounts due from customers for sale on open accounts.

AUDIT:An examination or in-depth inspection of financial statements and company'srecords that is made in accordance with GENERALLY ACCEPTED ACCOUNTINGPRINCIPLES(GAAP).


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CONTD

REVENUE: Increase in ownership claims arising from the delivery of goods andservices.

EXPENSES: Decrease in ownership claims arising from delivering goods or servicesor using up assets.

PROFITS (EARNINGS, INCOME): The excess of revenue over expenses.

CASH BASIS:A process of accounting where revenue and expenses recognitionwould occur when cash is received and disbursed.

UNEXPIRED COST:Any asset that ordinarily becomes an expenses in futureperiods, e.g. inventory and pre-paid rent.

UNEARNED REVENUE (DEFFERED REVENUE): Collections from customers

received and recorded before they are earned.

DIVIDINDS:Distributions of assets to stockholders that reduce retained income.


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FINANCIAL STATEMENTS

1. BALANCE SHEET: A snapshot of the financial status of an

organization at an instant of time. It records the assets, liabilities and

capital of a business at a certain point in time. Assets less liabilities will

equal capital. Capital is thus the ownersinterest in the business.

2. INCOME STATEMENT (PROFIT & LOSS ACCOUNT): A statement

that summarizes a companys revenues and expenses. It measures

the performance of an organization by matching its accomplishments

and its efforts. Hence, a profit and loss account, as its simplest,

records the income and expenses of a business over time.

3. CASH FLOW STATEMENT: A cash flow statement shows the cash

inflows and outflows of the business.


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SUMMARY BALANCE SHEET AT 31 MARCH 20XX

20X1 20X2Rs. Rs.

FIXED ASSETS

TANGIBLE & INTANGIBLE ASSETS 4243.4 4387.5Investments 55.0 61.2

4298.4 4448.7

Current assetsStocks 474.4 514.7

Debtors 2555.2 2355.7

Cash & Investments 687.5 485.5

3717.1 3355.9Current liabilitiesCreditors: amounts falling due within one year 2162.8 2029.8

NET CURRENT ASSETS 1554.3 1326.1

TOTAL ASSETS LESS CURRENT LIABILITIES 5852.75774.8

Creditors: amount falling due after more than one year 804.3 772.6Provisions for liabilities and charges 126.6 105.0

NET ASSETS 4921.8 4897.2

SHAREHOLDERS FUNDS (all equity) 4905.3 4883.9Interests/Profit (all equity) 16.5 13.3

TOTAL CAPITAL EMPLOYED 4921.84897.2


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SUMMARY PROFIT & LOSS A/C FOR THE YEAR ENDED 31 MARCH 20XX

20X1

20X2Rs.

Rs.

Sales 8224

8243

Add: Other income 34

104

82588347

Less: Expenses 7712

7192

Profit before Taxation 546 1155

TAXATION (176)(339)

Profit after Taxation 370 816

Other 2 -

DIVIDENDS (413)


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SUMMARY CASH FLOW INFORMATION FOR THE YEAR ENDED 31 MARCH 20XX

20X1

20X2

Rs.Rs.

OPERATING ACTIVITIES

Received from customers 7989.9

7884.1

Payments to suppliers (5357.1)

(5464.2)

Payments to and on behalf of employees (1138.3)

(1153.9)

Other payments (803.8)

(793.1)

Exceptional operating cash flows (49.2)

(0.6)

CASH INFLOW FROM OPERATING ACTIVITIES 641.5

472.3

Returns on investments and servicing of finance 15.2

29.0Taxation (145.7)


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FUNDS FLOW STATEMENT

The statement of changes in financial position, prepared to determine only the

sources and uses of working capital between dates of two balance sheets, is

known as the funds f low statement .

Funds flow statement is referred to as the statement of changes in financial

positions. Thus, the statement is intended to summarize:

Changes in assets and l iabi l i t ies resul t ing from f inancia l and investment

t ransact ions du r ing the per iod, as wel l as those changes wh ich resul ted due to

change in ownersequi ty; and

The way in which the f i rm used i ts f inancia l resou rces dur ing the per iod (for

example to acquire f ixed assets, to pay debts, to pay d ividends to shareholders and

so on ).


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B L NCE SHEET CH NGES SOURCES ND USES OF FUNDS(Rs.

000)

March 31, 20X1 March 31, 20X2

Change

ASSETS

Cash 54 135 (+)

81

Debtors 6750 8235 (+)

1485

Stock 10125 22680 (+)

12555

Total Current

Assets 16929 31050 (+)

14121

Fixed assets 2970 6075 (+)

3105

Other assets 945 1890 (+)

945

Total Assets 20844 39015 (+)

18171

LIABILITIES & CAPITAL

Bank borrowings 3510 8664 (+)

5154

Creditors 2835 6615 (+)

3780

Provision for taxes 270 972 (+)

702

Accrued expenses 810 2700 (+)

1890

(Rs.

000)

Amount

%

SOURCES

INCREASE IN CURRENT LIABILITIES:

Bank borrowings 5154

27.5

Creditors 3780

20.2

provision for taxes 702

3.8

Accrued expenses 1890

10.1

Total 11526

61.6

Increase in share holders equity:

Reserves (retained income) 7185

38.4

TOTAL SOURCES 18711

100.0

USES

INCREASE IN CURRENT ASSETS:

Cash 81

0.4

Debtors 14857.9

WORKING CAPITAL


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WORKING CAPITALWorking Capital is defined as the difference between current assets and current

liabilities.

Working capital determines the liquidity position of the firm.

As a historically analysis, the statement of changes in working capital reveals to management

the way in which working capital was obtained and used.

Sources of working capital (Funds)

1) Funds from operations (adjusted net income).

2) Sale of non-current assets:i) sale of long-term investments (shares, bonds/debentures)

ii) sale of tangible fixed assets like land, building, plants, or equipments.

iii) sale if intangible fixed assets like goodwill, patents, or copyrights.

3) Long term financing:

i) long-term borrowings (institutional loans, debentures, bonds etc.).

ii) issuance of equity and preference shares.

4) Short-term financing such as bank borrowings.


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USES OF FUNDS ND C SH FLOW N LYSIS

1. LIQUIDITY:What is the position of the firm?

2. CHANGES IN FINANCIAL POSITION: What are the causes of changes in the firms workingcapital or cash position?

3. ACQUISITION OF FIXED ASSETS: What fixed assets are acquired by the firm?

4. DIVIDEND PAYMENT: Did the firm pay dividends to its shareholders or not? If not, was it due toshortage of funds?

5. INTERNAL FUNDS: How much of the firms working capital needs were met by the fundsgenerated from current operations?

6. EXTERNAL FUNDS: Did the firm use external sources of finance to meet its needs of fund?

7. DEBT-EQUITY: If the external financing was used, what ratio of debt and equity was maintained?

8. SALES OF NON-CURRENT ASSETS: Did the firm sell any of its non-current assets? If so, whatwere the proceeds from such sales?

9. DEBT PAYMENT: Could the firm pay its long-term debt as per the schedules?

10. INVESTMENTS AND FINANCING: What were the significant investment and financing activitiesof the firm which did not involve working capital?


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RATIO ANALYSIS

A Ratio is defined as the indicated relationship of two mathematical

expressionsand as therelationship between two or more things.

RATIOANALYSIS IS A POWERFUL TOOL OF FINANCIALANALYSIS

The relationship between two accounting figures, expressed

mathematically, is known as a FINANCIAL RATIO (or simply as RATIO).

In financial analysis, a ratio is used as a benchmark for evaluating the

financial position and performance of a firm, because the absolute

accounting figures reported in the financial statements do not provide a

meaningful understanding of the performance and financial position of a

firm.


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TYPES OF RATIOS

LIQUIDITY RATIOS: measure the firms ability to meet current

obligations.

LEVERAGE RATIOS: show the proportions of debt and equity in

financing the firms assets.

ACTIVITY RATIOS: reflect the firms efficiency in utilising its assets.

PROFITABILITY RATIOS: measure overall performance and

effectiveness of the firm.


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LIQUIDITY RATIOS

1.CURRENT RATIO : The current ratio is a measure of the firms short-term

solvency. It indicates the availability of current assets in rupees for every

one rupee of current liability.

CURRENT RATIO = CURRENT ASSETSCURRENT LIABILITIES

2. QUICK RATIO: This ratio establishes a relationship between quick, or liquid,

assets and current liabilities.

QUICK RATIO = CURRENT ASSETSINVENTORIES

CURRENT LIABILITIES

3. CASH RATIO: This ratio indicates the relationship between the availability of

cash including trade investment or marketable securities to the current

liabilities.

CASH RATIO = CASH + MARKETABLE SECURITIES

CURRENT LIABILITIES

4. NET WORKING CAPITAL RATIO:The difference between current assets and

current liabilities excluding short-term borrowings is called net working

capital (NWC) or net current assets (NCA). It is used as a measure of firms

liquidity.

NWC RATIO = NET WORKING CAPITAL


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ACTIVITY RATIO

1. INVENTORY TURNOVER: This ratio indicates the efficiency of the firm in

selling its products. It is calculated by dividing the cost of goods sold by

the average inventory.

INVENTORY TURNOVER = COST OF GOODS SOLD

AVERAGE INVENTORY

DAYS OF INVENTORY HOLDINGS = AVERAGE INVENTORY X 360

COST OF GOODS SOLD2. DEBTOR RATIO: Debtor turnover indicates the number of times debtor

turnover each year.

Debtor turnover = SALES

DEBTORS

3. ASSETS TURNOVER: The relationship between sales and assets iscalled assets turnover.

ASSETS TURNOVER = SALES

ASSETS

PROFITABILITY RATIOS


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PROFITABILITY RATIOS

GROSS PROFIT MARGIN = SALESCOST OF GOODS SOLD

SALES

NET PROFIT MARGIN = PROFIT AFTER TAX

SALES

OPERATING EXPENSES RATIO = OPERATING EXPENSES

SALES

RETURN ON INVESTMENT(ROI):(I) ROI = ROTA = EBIT (1-T) = EBIT (1-T)

(Return on total assets) TOTAL ASSETS TA

(II) ROI = RONA = EBIT (1-T) = EBIT (1-T)

( Return on net assets) NET ASSETS NA

DIVIDEND PER SHARE = EARNINGS PAID TO SHARE HOLDERSNUMBER OF ORDINARY SHARES OUTSTANDINGS

DIVIDEND PAYOUT RATIO = DIVIDENDS PER SHARE

EARNINGS PER SHARE

COMPOUNDING


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COMPOUNDING

The interest that is paid on the principal as well as on any interest earned but

not withdrawn during earlier periods is called compound interest.

The process of finding the future value of payment (or receipt) or series ofpayments (or receipts) when applying the concept of compound interest is

known as compounding.

Time Preference for MoneyAn individuals preference for possession of a given amount of cash now,

rather than the same amount at some future time is called timepreference for money.

Three reasons may be advanced to account for the individual's timepreference for money:

1)Uncertainty

2)Preference for consumption

3) Investment opportunities.


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HOW IS COMPOUND VALUE OF A LUMP SUM CALCULATED?

1) Suppose Rs.100 deposited in a bank at 10% rate of interest for 1 year. Howmuch future sum would you receive after one year?

you would receive:

FUTURE SUM = 100 + .10 X 100

= 100 (1.10) = 110.

Therefore, F1 = P (1 + i )

2) AFTER 2 YEARS:

FUTURE SUM = (100 + .10 x 100) + .10(100 + .10 x 100)

= 100 (1.10) (1.10)

= 121.

Therefore, F2 = P (1 + i )2

3) AFTER nYEARS:

Fn = P (1 + i ) n

HOW IS COMPOUND VALUE OF AN ANNUITY CALCULATED?


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HOW IS COMPOUND VALUE OF AN ANNUITY CALCULATED?

An annuity is a fixed payment (or receipt) each year for a

specified number of years. For example, the equal

installment loans from the housing finance companies oremployers, etc.

Thus, the compound value of an annuity of Re 1 for 4 years at 6% rate of

interest computed and expressed as follows:

F4 = A (1+i)3+ A(1+i)2+ A(1+i) + A

= A [ (1+i)3+ (1+i)2 + (1+i) + 1 ]

Where A is the annuity, we can extend the equation for n periods and rewrite

it as follows:

Fn = A (1 + i)n1

iSINKING FUND: The fund which is created out of fixed payments each year

to accumulate to a future sum after a specified period is called sinking

fund. The factor used to calculate the annuity for a given future sum is

called the sinking fund factor. i.e.

A = F i+ -

PRESENT VALUE


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PRESENT VALUE

The present valueof a future cash inflow and outflow is the amount of

current cash that is of equivalent desirability, to the decision maker, to a

specified amount of cash to be received or paid at a future date.

The process of determining present value of a future payment (or receipts)

or a series of future payments (or receipts) is called discounting.

The compound interest rate used for discounting cash flows is called the

discount rate.

F1 = P (1 + i )

where, F1= Future value, P= Present value, i= Rate of interest.

therefore,P = F1

(1 + i )


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PRESENT VALUE: HOW MUCH WOULD THE INVESTOR GIVE UP NOW TO GET AN

AMOUNT OF RUPEE 1 AT THE END OF ONE, TWO, OR THREE YEARS ?

If the amount grows to F1 = Re 1 after a year at 10%, the amount to bedeposited or sacrificed in the beginning:

F1 = P( 1 + i )therefore, P = F1

(1 + i )

The present value of Re.1 inflow at the end of two years:

F2 = P (1 + i )2

therefore, P = F2(1 + i)2

The present value of Re.1 to be received after three years:

F3 = P(1 + i)3

therefore, P = F3

(1 + i)3

The present value can be worked out for any number of years and for anyinterest rate:

P = Fn

(1 + i)n or P = Fn [ (1+i)n]

The term in brackets is thepresent value factor (PVF), and it is always less than1.0for positive i, indicating that a future amount has a smaller present value.

WHAT IS PRESENT VALUE OF AN ANNUITY?


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WHAT IS PRESENT VALUE OF AN ANNUITY?

The computation of the present value of an annuity can be written in the

following general form:

P = A + A + A + . + A

(1+i) (1+i)2 (1+i)3 (1+i)n

= A 1 + 1 + 1 + ... + 1

(1+i) (1+i)2 (1+i)3 (1+i)n

Where, A is a constant payment (or receipt) each year. Therefore, above

equation can be solved and expressed as

= A 1- 1(1-i)n

i

= A (1+i)n-1

i (1+i)n

CAPITAL RECOVERY


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CAPITAL RECOVERY

The reciprocal of the present value annuity factor is called the capital

recovery factor. It is useful in determining income to be earned to recoveran investment at a given rate of interest.

For example: suppose that you plan to invest Rs. 10,000 today for a period

of four years. If your interest rate is 10 percent, how much income per

year should you receive to recover your investment?

A = P i (1+i)n

(1+i)n- 1


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WHAT IS AN ANNUITY DUE?

The concept of compound value and present value of an annuity are based

on the assumption that series of payments are made at the end of theyear.

In practice, payments could be made at the beginningof the year. When you

buy a fridge on installment sale, the dealer requires you to make the first

payment immediately (viz. in the beginning of the first period) andsubsequent installments in the beginning of each period.

Therefore,

A series of fixed payments starting at the beginning of each

period for a specified number of periods is called anannuity due.

Fn = A (1+i)n1 (1+i)

i


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MULTIPLE COMPOUNDING

Multiple compounding indicates that the cash flow can occur

more than once a year rather than once in a year. Forexample, banks may pay interest on saving accounting

quarterly. On bonds or debentures and public deposit,

companies may pay interest semi-annually.

The interest rate is usually specified on an annual basis in a

loan agreement or security (such as bonds), and is known as

the nominal interest rate. If the compounding is done more

than once a year, the actual rate of interest paid (or received)is called the effective interest rate (EIR); effective interest rate

would be higher than the nominal interest rate.

THE FORMULA FOR CALCULATING EIR IN THE FOLLOWING GENERAL FORM


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THE FORMULA FOR CALCULATING EIRIN THE FOLLOWING GENERAL FORM

EIR = 1 + i n x m - 1

m

Where i = annual nominal rate if interest, n = number of years and m =number of compounding per year.

The effective rate of interest if the compounding is done:

A. For the half-yearly compounding , EIR will be:

EIR = 1 + i 2 - 1

2

B. For quarterly compounding, EIR will be:

EIR = 1 + i 4 -1

4

C. For weekly compounding, EIR will be:

EIR = 1 + i 52 -1

52


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NET PRESENT VALUENet Present Value of a financial decision is the difference between the

present value of cash inflows and the present value of cash out flows.

The Net Present Value (NPV) Method is the classical economic model of

evaluating the investment proposals. It is one of the discounted cash flow

(DCF) techniques explicitly recognising the time value of money.

NPV = A1 + A2 + .. + An - Co

(1+i) (1+i)2 (1+i)n

n

NPV = At - Co

t=1 (1+k)t

WhereAtis cash inflow in period t, Cocash outflow, kopportunity cost of capital and tthe time

period.


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THE FOLLOWING STEPS ARE INVOLVED IN THE CALCULATION OF NPV:

Cash flows of the investment projected should be forecasted based on

realistic assumptions.

Appropriate discount rate should be identified to discount the forecasted

cash flow. The appropriate discount rate is the firmsopportunity cost of

capital which is equal to the required rate of return expected by investors

on investments of equivalent risk.

Present value of cash flows should be calculated using opportunity cost

of capital as the discount rate.

Net present value should be found out by subtracting present value of

cash out flows from present value of cash inflows.

The project should be accepted if NPV is positive (i.e. NPV >0)


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ACCEPTANCE RULE : NPV METHOD

It should be clear that the acceptance rule using the NPV method is to

accept the investment project if its net present value is positive (NPV>0)and to reject it if the net present value is negative (NPV 0

Reject NPV < 0

May accept NPV = 0


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INTERNAL RATE OF RETURN (IRR) METHOD

The internal rate of return can be defined as that rate

which equates the present value of cash inflows withthe present value of cash out flows of an investment.

In other words, it is the rate at which the net present

value of the investment is zero.

It is called internal rate because it depends solely on the outlay and

proceeds associated with the investment and not on any rate determined

outside the investment.

Hence, the internal rate of return (IRR) method is another discounted cash

flow technique which takes account of the magnitude and timing of cash

flows.

CONTD


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CONTD..

The IRRcan be determined by solving the following equation for r :

Co = C1 + C2 + C3 + .. + Cn(1+r) (1+r)2 (1+r)3 (1+r)n

n

C0 = Ctt=1 (1+r)t

or,

n

Ct - C0 = 0

t=1 (1+r)tIt can be noticed that the IRR equation is the same as the one used for the NPV method with the difference

that in the NPV method the required rate of return, k, is assumed to be known and the net presentvalue is found, while in the IRRmethod the value of r has to be determined at which the net presentvalue is zero.


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ACCEPTANCE RULE : IRR METHOD

The accept-or-reject rule, using the IRR method, is to accept

the project if its internal rate of return is higher than theopportunity cost of capital (r > k). Note that k is also knownas the required rate of return, or the cutoff, or hurdle rate.The project shall be rejected if its internal rate of return islower than the opportunity cost of capital (r < k). The

decision maker may remain indifferent if the internal rate ofreturn is equal to the opportunity coat of capital.

Thus the IRR acceptance rules are:

Accept r > k

Reject r < k

May accept r = k


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PAYBACK (PB) METHOD

The payback (PB) is one of the most popular and widely recognized

traditional methods of evaluating investment proposals.It is defined as the number of years required to recover the

original cash outlay invested in aproject.

If the project generates constant annual cash inflows, the payback period

can be computed by dividing cash outlay by the annual cash inflow i.e.

PAYBACK = INITIAL INVESTMENT = C0

ANNUAL CASH INFLOW C

In case of unequal cash inflows, the payback period can be found out byadding up the cash inflows until the total is equal to the initial cash outlay.


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ACCEPTANCE RULE: PAYBACK METHOD

Many firms use the payback period as an accept or

reject criterion as well as a method of ranking

projects. If the payback period calculated for a

project is less than the maximum payback period set

by management, it would be accepted; if not, itwould be rejected.

As a ranking method, it gives highest ranking to the

project which has shortest payback period andlowest ranking to the project with the highest

payback period. Thus, if the firm has to choose

among two mutually exclusive projects, project with

shorter a back eriod will be selected.


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DISCOUNTING PAYBACK PERIOD

The number of periods taken in recovering the

investment outlay on the present value basis is

called thediscounting payback period.

One of the serious objections of the payback method is that it

does not discount the cash flows for calculating the payback

period. However, the discounted payback period still fails to

consider the cash flows occurring after the payback period.

COST OF CAPITAL


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COST OF CAPITAL

CONCEPT OF COST OF CAPITAL:

The discount rate is the projects

opportunity cost of capital (or simply the cost of capital) for discountingits cash flow.

Theprojects cost of capital is the minimum acceptable rate of return on

funds committed to the project.

The firms cost of capital will be the overall, or average, required rate of

return on the aggregate of the investment projects.

Therefore,

The cost of capital is the minimum required rate of return on

the investment project that keeps the present wealth of the share

holders unchanged.

DETERMINING COMPONENT COST OF CAPITAL


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DETERMINING COMPONENT COST OF CAPITAL

The component cost of a specific source of capital is equal to the investors

required rate of return.

But the investors required rate of return should be adjusted for taxes in

practice for calculating the cost of specific source of capital to the firm. In

the investment analysis, net cash flows are computed on after-tax basis,

therefore, the component costs, used to determine the discount rate,should also be expressed on an after-tax basis.

Thus, the methods of computing the component costs of three major sources

of capital are:

Debt,

Preference shares,

Equity shares.

contd.

WEIGHTED AVERAGE COST OF CAPITAL (WACC)


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WEIGHTED AVERAGE COST OF CAPITAL (WACC)

The composite, or overall cost of capital is the weighted average of the costs

of various sources of funds, weights being the proportion of each sourceof funds in the capital structure.

Hence, once the component costs have been calculated, they are multiplied

by the weights of the various sources of capital to obtain a weighted

average cost of capital (WACC).

The following steps are used to calculate the weighted average cost of

capital:

To calculate the cost of the specific sources of funds (i.e. cost of debt,

cost of equity, cost of preference capital etc.).

To multiply the cost of each source by its proportion in the capital

structure.

To add the weighted component costs to get the firmsweighted average

cost of capital.

THE MECHANICS OF COMPUTING THE WEIGHTED AVERAGE COST


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OF CAPITAL IS SHOWN BELOW:

The following is the capital structure of the firm:

Source of finance Amount (Rs.)

Proportion (%)Equity (paid-in) share capital 450000 45

Retained earnings (Reserves) 150000 15

Preference share capital 100000 10

Debt 300000 30

1000000 100

The firms expected after-tax component costs of the various sources of

finance are as follows:

Source Cost (%)

Equity capital 18.0Retained earnings 18.0

Preference capital 11.0

Debt 8.0

contd.

CONTD.


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The weighted average cost of capital of the firm, based on the existingcapital structure is computed as follows:

COMPUTATION OF WEIGHTED AVERAGE COST OF CAPITAL

Source Amount Proportion After-tax Cost Weighted Cost

(1) (2) (3) (4) (5)=(3)X(4)Equity capital 450000 .45 .18 .081

Retained earnings 150000 .15 .18 .027

Preference capital 100000 .10 .11 .011

Debt 300000 .30 .08 .024

1000000 1.00 .143

Weighted Average Cost of Capital ko=14.3%

The weighted average cost of capital of the firm can alternatively be calculated asfollows:

COMPUTATION OF WEIGHTED AVERAGE COST OF CAPITAL

Source Amount After-tax Cost (Rate) After-tax Cost

(1) (2) (3) (4) =(2)X(3)

Equity capital 450000 .18 81000

Retained earnings 150000 .18 27000

Preference capital 100000 .11 11000

Debt 300000 .08 24000

1000000 143000

Weighted Average Cost of Capital, ko = Rs. 143000 X 100 = 14.3%

CAPITAL ASSET PRICING MODEL (CAPM)


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CAPITAL ASSET PRICING MODEL (CAPM)

Capital Asset Pricing Model (CAPM), an important tool used to analyze therelationship between risk and rate of return.

STEPS IN THE CAPM APPROACH

STEP 1: Estimate the risk-free rate, rRF.STEP 2: Estimate the current expected market risk premium, RPM, which is the

expected market return minus the risk-free rate.

STEP 3: Estimate the stocks beta coefficient, bi, and use it as an index of the

stocks risk. The isignifies the ithcompanys beta.(The relevant risk of an individual stock, which is called its beta

coefficient, is defined under the CAPM as the amount of risk that the

stock contribute to the market portfolio).

STEP 4: Substitute the preceding values into the CAPM equation to estimatethe

required rate of return on the stock:

rs= rRF+ (RPM)biWhere as, rsis the cost of common equity raised internally by reinvesting earnings. Thus, if a

company cannot earn atleast rson reinvested earnings, then it should pass those earningson to its stockholders and let them invest the money themselves in assets that do provide

rs.

AN ILLUSTRATION OF THE CAPM APPROACH


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AN ILLUSTRATION OF THE CAPM APPROACH

To illustrate the CAPM approach for firm ABC, assume that rRF=8%, RPM=6%,and bi=1.1, indicating that the firm ABC is some what riskier than average.Therefore, ABCs cost of equity is 14.6%:

rs = 8% + (6%) (1.1)= 8% + 6.6%

= 14.6%

It should be noted that although the CAPM approach appears to yield an

accurate, precise estimate of rs, it is hard to know the correct estimates ofthe inputs required to make it operational because:

1. It is hard to estimate precisely the beta that investors expect the company

to have in the future, and2. It is difficult to estimate the market risk premium.

Despite these difficulties, surveys indicate that CAPM is the preferred choicefor the vast majority of companies.

MODIGLIANI & MILLER (MM): MODERN CAPITAL


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MODIGLIANI & MILLER (MM): MODERN CAPITAL

STRUCTURE THEORY (1958)

Modigliani and Miller: No Taxes

Assumptions:

1. There are no brokerage cost.

2. There are no taxes.

3. There are no bankruptcy cost.

4. Investors can borrow at the same rate as

corporations.

5. All- investors have the same information asmanagement about the firms future investment

opportunities.

6. EBIT is not affected by the use of debt.

IF MM ASSUMPTIONS HOLD TRUE:


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IF MM ASSUMPTIONS HOLD TRUE:

MM proved that a firms value is unaffected by its capital structure, hence

the following situation must exist:

VL= VU= SL + D

Here VLis the value of a levered firm, which is equal to VU, the value of an

identical but unlevered firm. SLis the value of the levered firms stock,

and Dis the value of its debt.

Recall that the WACC is a combination of the cost of debt and the relativelyhigher cost of equity (rs)- if MM assumptions are correct, it does notmatter how a firm finances its operation, so capital structure decisions

would irrelevant

i.e. As leverage increases, more weight is given to low-cost debt, but

equity gets riskier, driving up rs. Under MMs assumptions, rsincreasesby exactly enough to keep the WACC constant.

WHAT IF SOME OF THE MM ASSUMPTIONS ARE


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WHAT IF SOME OF THE MM ASSUMPTIONS ARE

RELAXED:

1. Modigliani and Miller: The Effect of Corporate Tax

2. Modigliani and Miller: TradeOff Theory (relaxed the assumption of nobankruptcy cost).

3. Modigliani and Miller: Signaling Theory.

finanacial management and analysis- department of economics 2013 mahendra

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