financial management - aba8c54

CHAPTER – I – INTRODUCTION – UNIT I:

Finance Functions The finance functions can be divided into three broad

categories: (1) investment decision, (2) financing decision, and (3) dividend

decision. In other words, the firm decides how much to invest in short-term

and long-term assets and how to raise the required funds.

Shareholders’ Wealth Maximisation (SWM) In making financial decisions,

the financial manager should aim at increasing the value of the shareholders‘

stake in the firm. This is referred to as the principle of Shareholders’

Wealth Maximisation (SWM).

Wealth Wealth is precisely defined as net present value and it accounts for

time value of money and risk.

Agency Problem and Agency Costs Shareholders and managers have the

principal-agent relationship. In practice, there may arise a conflict between

the interests of shareholders and managers. This is referred to the agency

problem and the associated costs are called agency costs. Offering

ownership rights (in the form of stock options) to managers can mitigate

agency costs.

Financial Manager The financial manager raises capital from the capital

markets. He or she should therefore know-how the capital markets function to

allocate capital to the competing firms and how security prices are determined

in the capital markets.

Chief Financial Officer A number of companies in India either have a

finance director or a vice-president of finance as the Chief Financial Officer

(CFO). Most companies have only one CFO. But a large company may have

both a treasurer and a controller, who may or may not operate under the CFO.

Treasurer and Controller The treasurer’s function is to raise and manage

company funds while the controller oversees whether funds are correctly

applied.

1Financial Management, Ninth Edition © I M PandeyVikas Publishing House Pvt. Ltd.

Finance Functions

Investment or Long Term Asset Mix Decision

Financing or Capital Mix Decision

Dividend or Profit Allocation Decision

Liquidity or Short Term Asset Mix Decision


Finance Manager‘s Role

Raising of Funds

Allocation of Funds

Profit Planning

Understanding Capital Markets


Financial Goals

Profit maximization (profit after tax)

Maximizing Earnings per Share

Shareholder’s Wealth Maximization


Profit Maximization

Maximizing the Rupee Income of Firm

Resources are efficiently utilized

Appropriate measure of firm performance

Serves interest of society also


Objections to Profit Maximization

It is Vague

It Ignores the Timing of Returns

It Ignores Risk

Assumes Perfect Competition

In new business environment profit maximization is regarded as Unrealistic

Difficult

Inappropriate

Immoral.


Maximizing EPS

Ignores timing and risk of the expected benefit

Market value is not a function of EPS. Hence maximizing EPS will not result in highest price for company's shares

Maximizing EPS implies that the firm should make no dividend payment so long as funds can be invested at positive rate of return—such a policy may not always work


Shareholders‘ Wealth Maximization

Maximizes the net present value of a course

of action to shareholders.

Accounts for the timing and risk of the

expected benefits.

Benefits are measured in terms of cash flows.

Fundamental objective—maximize the market value of the firm’s shares.


Risk-return Trade-off

Risk and expected return move in tandem;

the greater the risk, the greater the expected return.

Financial decisions of the firm are guided by the risk-return trade-off.

The return and risk relationship:

Return = Risk-free rate + Risk premium

Risk-free rate is a compensation for time and

risk premium for risk.


Organisation of the Finance Functions

Reason for placing the finance functions in

the hands of top management

Financial decisions are crucial for the survival of

the firm.

The financial actions determine solvency of the

firm

Centralisation of the finance functions can result in

a number of economies to the firm.


Status and Duties of Finance Executives

The exact organisation structure for financial

management will differ across firms.

The financial officer may be known as the

financial manager in some organisations,while in others as the vice-president of

finance or the director of finance or thefinancial controller.


Role of Treasurer and Controller

Two more officers—the treasurer and the

controller—may be appointed under thedirect supervision of CFO to assist him or her.

The treasurer’s function is to raise and manage company funds while the controller

oversees whether funds are correctly applied.

CHAPTER – II

Time Value for Money Individual investors generally prefer possession of a

given amount of cash now, rather than the same amount at some future time.

This time preference for money may arise because of (a) uncertainty of cash flows,

(b) subjective preference for consumption, and (c) availability of investment

opportunities. The last reason is the most sensible justification for the time value

of money.

Risk Premium Interest rate demanded, over and above the risk-free rate as

compensation for time, to account for the uncertainty of cash flows.

Interest Rate or Time Preference Rate Rate which gives money its value,

and facilitates the comparison of cash flows occurring at different time periods.

Required Interest Rate A risk-premium rate is added to the risk- free time

preference rate to derive required interest rate from risky investments.

Compounding Compounding means calculating future values of cash flows at

a given interest rate at the end of a given period of time.

Sinking Fund An annuity to be deposited for n periods at i rate of interest to

accumulate to a given sum. The following equation can be used:

Discounting Discounting means calculating the present value of cash flows at a

given interest rate at the beginning of a given period of time..

Capital Recovery determining annual cash flows to be earned to recover a

given investment.

Wealth or Net Present Value It is defined as the difference between the

present value of cash inflows (benefits) and the present value of cash outflows

(costs). Wealth maximisation principle uses interest rate to find out the present

value of benefits and costs, and as such, it considers their timing and risk.

Multi-period Compounding When interest compounds for more than once in a

given period of time, it is called multi-period compounding. If r is the nominal

interest rate for a period, the effective interest rate (EIR) will be more than the

nominal rate r in multi-period compounding since interest on interest within a

year will also be earned, EIR is given as follows:

where m is the number of compounding in a year and n is number of years.

Internal Rate of Return (IRR) IRR is the rate, which equates the present

value of cash flows to the initial investment. Thus in operational terms, in the

present value equation, all variables are known except r; r can be found out by

trial and error method.


Time Preference for Money

Time preference for money is an individual’s preference for possession of a given amount of money now, rather than the same amount at some future time.

Three reasons may be attributed to the individual’s time preference for money: risk

preference for consumption

investment opportunities


Required Rate of Return

The time preference for money is generally

expressed by an interest rate. This rate will be positive even in the absence of any risk. It may be therefore called the risk-free rate.

An investor requires compensation for assuming

risk, which is called risk premium.

The investor’s required rate of return is:

Risk-free rate + Risk premium.


Present Value

Present value of a future cash flow (inflow or outflow) is the amount of current cash that is of equivalent value to the decision-maker.

Discounting is the process of determining present value of a series of future cash flows.

The interest rate used for discounting cash flows is also called the discount rate.


Present Value of a Single Cash Flow

The following general formula can be employed to

calculate the present value of a lump sum to be

received after some future periods:

The term in parentheses is the discount factor or

present value factor (PVF), and it is always less

than 1.0 for positive i, indicating that a future amount

has a smaller present value.

(1 )(1 )

nnnn

FP F i

i

,PVFn n iPV F


Example

Suppose that an investor wants to find out

the present value of Rs 50,000 to be received after 15 years. Her interest rate is 9 per cent. First, we will find out the present

value factor, which is 0.275. Multiplying 0.275 by Rs 50,000, we obtain Rs 13,750 as

the present value:

15, 0.09PV = 50,000 PVF = 50,000 0.275 = Rs 13,750


Net Present Value

Net present value (NPV) of a financial

decision is the difference between the present value of cash inflows and the present value of cash outflows.

0

1

NPV = (1 + )

nt

tt

CC

k


Present Value and Rate of Return

A bond that pays some specified amount infuture (without periodic interest) in exchange forthe current price today is called a zero-interestbond or zero-coupon bond. In such situations,you would be interested to know what rate ofinterest the advertiser is offering. You can usethe concept of present value to find out the rateof return or yield of these offers.

The rate of return of an investment is called internal rate of return since it depends exclusively on the cash flows of the investment.


Internal Rate of Return

The formula for Internal Rate of Return is given below. Here, all parameters are given except ‘r’ which can be found by trial and error.

0

1

NPV = 0(1 + )

nt

tt

CC

r

CHAPTER – III

Discount Rate being the rate of return that investors expect from securities of

comparable risk.

Bonds or Debentures are debt instruments or securities. In case of a

bond/debenture the stream of cash flows consists of annual interest payments

and repayment of principal. These flows are fixed and known.

The Value of the Bond can be found by capitalising cash flows at a rate of

return, which reflects their risk. The market interest rate or yield is used as the

discount rate in case of bonds (or debentures).

Yield to Maturity A bond‘s yield to maturity or internal rate of return can be

found by equating the present value of the bond‘s cash outflows with its price in

the above equation.

Zero-Interest Bonds (called zero-coupon bonds in USA) do not have explicit

rate of interest. They are issued for a discounted price; their issue price is much

less than the face value. Therefore, they are also called deep-discount bonds.

The basic discounting principles apply in determining the value or yield of these

bonds.

Preference shares have a preference over ordinary shareholders with regard

to dividends. The preference dividend is specified and known. Similarly, in the

case of redeemable preference share the redemption or maturity value is also

known. Preference share value can be determined in the same way as the bond

value. Here the discount rate will be the rate expected by the preference

shareholders given their risk. This risk is more than the risk of bondholders and

less than the equity shareholders.

Value of the Share (General) Cash flows of an ordinary (or equity) share

consist of the stream of dividends and terminal price of the share. Unlike the

case of a bond, cash flows of a share are not known. Thus, the risk of holding a

share is higher than the risk of a bond. Consequently, equity capitalisation rate

will be higher than that of a bond.

CHAPTER – IV

Return on a Security consists of two parts, the dividend and capital gain.

Expected Rate of Return on a Security is the sum of the products of possible

rates of return and their probabilities.

Dispersion When the expected rate of return (also called average rate of

return) deviate from the possible outcomes (rates of return), this is referred to

as dispersion.

Variance and Standard Deviation Dispersion can be measured by

variance and standard deviation of returns of a security. Variance (2) or

standard deviation () is a measure of the risk of returns on a security.

Treasury Bills Government issued bonds with guarantees which offers riskfree

rate, as they do not have risk of default.

Risk Premium The difference between the (long-term) average share return

and (long-term) return on government bonds or treasury bills is the risk

premium.

Risk Preferences of Investors Investors have different risk preferences.

Investors may be risk averse, risk seeker or risk neutral. Most of them are,

however, risk averse.

Normal Distribution is a smoothed, symmetric curve. It best describes the

mean-variance (or standard deviation). We generally assume that returns on

shares are normally distributed.

CHAPTER – V

Return on a Security consists of the dividend yield and capital gain.

Expected Rate of Return on a Security is the sum of the products of possible

rates of return and their probabilities.

Variance or standard deviation is a measure of the risk of returns on a security.

Portfolios Generally, investors in practice hold multiple securities.

Combinations of multiple securities are called portfolios.

Expected Return on a Portfolio is the sum of the returns on individual

securities multiplied by their respective weights (proportionate investment).

That is, it is a weighted average rate of return.

Covariance is the product of the standard deviations of individual securities

times their correlation coefficient.

Portfolio Risk is not a weighted average risk. Securities included in a portfolio

are associated with each other. Therefore, the portfolio risk also accounts for the

covariance between the returns of securities.

Magnitude of Portfolio Risk will depend on the correlation between the

securities. The portfolio risk will be equal to the weighted risk of individual

securities if the correlation coefficient is +1.0. For correlation coefficient of less

than 1, the portfolio risk will be less than the weighted average risk. When the

two securities are perfectly negatively correlated, i.e., the correlation coefficient

is –1.0, the portfolio risk becomes zero.

Minimum Variance Portfolio is called the optimum portfolio.

Investment or Portfolio Opportunity Set represents all possible

combinations of risk and return resulting from portfolios formed by varying

proportions of individual securities. It presents the investor with the risk-return

trade-off.

Mean-Variance Criterion for a given risk, an investor would prefer a portfolio

with higher expected rate of return. Similarly, when the expected returns are

same, she would prefer a portfolio with lower risk. The choice between high risk–

high return or low risk–low return portfolios will depend on the investor‘s risk

preference. This is referred to as the mean-variance criterion.

Efficient Portfolio is one that has the highest expected returns for a given

level of risk. The efficient frontier is the frontier formed by the set of efficient

portfolios.

Optimum Risky Portfolio and Separation Theorem is the market portfolio

of all risky assets where each asset is held in proportion of its market value. It is

the best portfolio since it dominates all other portfolios. An investor can thus mix

her borrowing and lending with the best portfolio according to her risk

preferences. She can invest in two separate investments—a risk free asset and a

portfolio of risky securities. This is known as the separation theorem.

Unsystematic Risk can be eliminated through diversification. It is a risk

unique to a specific security. When individual securities are combined, their

unique risks cancel out.

Systematic Risk cannot be eliminated through diversification. It is a marketrelated

risk. It arises because individual securities move with the changes in the

market. Investors are risk averse. They will take risk only if they are

compensated for the risk, which they bear. Since systematic risk can be

eliminated through diversification, they will be compensated for assuming

systematic risk.

Capital Market Line the market prices securities in a manner that they yield

higher expected returns than the risk-free securities. The risk-averse investors

can be induced to hold risky securities when they are offered risk premium. The

capital market line (CML) defines this relationship.

Capital Asset Pricing Model (CAPM) the model explaining the risk-return

relationship is called the capital asset pricing model (CAPM). It provides that in

a well-functioning capital market, the risk premium varies in direct proportion

to risk.

Security’s Beta CAPM provides a measure of risk and a method of estimating

the market‘s risk-return line. The market (systematic) risk of a security is

measured in terms of its sensitivity to the market movements. This sensitivity is

referred to the security‘s beta.

Beta reflects the systematic risk, which cannot be reduced. Investors can

eliminate unsystematic risk when they invest their wealth in a well-diversified

market portfolio. A beta of 1.0 indicates average level of risk while more than 1.0

means that the security‘s return fluctuates more than that of the market

portfolio. A zero beta means no risk.

Characteristics Line a line that is called the characteristics line can represent

the relationship between the security returns and the market returns. The slope

of the characteristics line is the sensitivity coefficient, which, as stated earlier, is

referred to as beta.

Expected Return on a Security (Security Market Line (SML)) is given by

the following equation: E(Rj ) Rf (Rm Rf )b j

where Rf is the risk-free rate, Rm the market return and the measure of the

security‘s systematic risk. This equation gives a line called the security market

line (SML).

Arbitrage Pricing Theory (APT) the differences of securities‘ returns may not

be fully explained by their betas. The arbitrage pricing theory (APT), resulting

from the limitations of CAPM, assumes that many macro-economic factors may

affect the system risk of a security (or an asset). Thus, APM is a multi-factor

model to explain the return and return of a security. The factors influencing

security return may include industrial production, growth in gross domestic

product, the interest rate, inflation, default premium, and the real rate of return.

Price-to-book-value ratio and size have also been found to explain to the

differences in the security returns.

CHAPTER – VI

Security’s Beta The market or systematic risk of a security is measured in

terms of its sensitivity to the market movements. This sensitivity is referred to

the security‘s beta.

Determinants of Beta The beta of a firm depends on a number of factors. The

three most important factors are: (a) nature of business, (b) operating leverage

and (c) financial leverage. Beta increases with the degree of operating and

financial leverage.

Market Portfolio may be approximated by a well-diversified share price index

such as the Bombay Stock Exchange‘s National Index or Sensitivity Index

(Sensex).

Accounting Beta A cyclical firm would have higher beta. If we relate the

cyclical firm‘s earnings with the aggregate earnings, we would obtain accounting

beta. Higher the accounting beta, higher the market beta.

Asset Beta and Equity Beta The calculated beta of a firm is the beta of its

equity. In case of a firm that does not employ debt; the equity beta is the same as

the firm‘s asset beta. However, in case of a firm with debt, the asset beta is the

weighted average of the equity beta and the debt beta. Since debt is less risky,

the debt beta would be less than the equity beta.

Cost of Equity The firm uses capital supplied by shareholders. Alternatively,

shareholders could invest their funds in securities in the capital market. Thus,

they would require firm to earn a return equal to the expected rate of return on

security of the equivalent risk. Hence, the cost of equity is equal to the expected

rate of return, and can be calculated using SML. The risk-free rate and market

premium is common to all firms; betas of firms would be different.

CHAPTER – VII

Option is a contract that gives the holder a right, without any obligation, to buy

or sell an underlying asset at a given exercise (or strike) price on or before a

specified expiration period. The underlying asset (i.e., asset on which right is

written) could be a share or any other asset.

Call Option is a right to buy an asset. A buyer of a call option on a share will

exercise his right when the actual share price at expiration (St) is higher than

the exercise price (E), otherwise, he will forgo his right.

Put Option is a right to sell an asset. The buyer of a put option will exercise his

right if the exercise price is higher than the share price; he will not exercise his

option if the share price is equal to or greater than the exercise price.

American Option can be exercised at expiration or any time before expiration

while European options can be exercised only at expiration.

Value of a Share Option There are five factors that affect the value of a share

option: (1) the share price, (2) the exercise price, (3) the volatility (standard

deviation) of the share return, (4) the risk-free rate of interest, and (5) the

option‘s time to expiration.

Value of a Call At expiration the maximum value of a call option is: Value of call option at expiration = Max [(St – E), 0]

Call Option‘s Value will increase with increase in the share price, the rate of

interest, volatility and time to expiration. It will decline with increase in the

exercise price.

Value of Put Option at expiration is: Value of put option at expiration = Max [(E – St), 0]

Put Option‘s Value will increase with increase in the exercise price, volatility

and time to expiration. It will decrease with increase in the share price, and the

rate of interest.

Several Trading Strategies (Hedged Position) An investor can create a

hedged position by combining a long position in the share with a long position in

a protective put—a put that is purchased at-the-money (exercise and current

share prices being the same).

Straddle The investor can also create a portfolio of a call and a put with the

same exercise price. This is called a straddle.

Spread If call and put with different exercise price are combined, it is called a

spread.

Put-Call Parity There is a fixed relationship between put and call on the same

share with similar exercise price and maturity period. This relationship, called

put-call parity, is given as follows: Value of put + value of share = value of call + PV of exercise price

Option in Case of an Ordinary Share There is a hidden option in the case of

an ordinary share that arises because of the limited liability of the shareholders.

Shareholders have a call option on the firm with an exercise price equal to the

required payment for debt. Shareholders will exercise their option to keep the

firm (by making required payment to debt-holders) if the value of the firm is

higher than the debt payment.

CHAPTER – VIII – UNIT V:

Discounted Cash Flow (DCF) Technique NPV, IRR and PI are the

discounted cash flow (DCF) criteria for appraising the worth of an investment

project.

Net Present Value (NPV) method is a process of calculating the present value

of the project‘s cash flows, using the opportunity cost of capital as the discount

rate, and finding out the net present value by subtracting the initial investment

from the present value of cash flows.

Under the NPV method, the investment project is accepted if its net present

value is positive (NPV > 0). The market value of the firm‘s share is expected to

increase by the project‘s positive NPV. Between the mutually exclusive projects,

the one with the highest NPV will be chosen.

NPV methods account for the time value of money and are generally consistent

with the wealth maximisation objective.

Internal Rate of Return (IRR) is that discount rate at which the project‘s net

present value is zero. Under the IRR rule, the project will be accepted when its

internal rate of return is higher than the opportunity cost of capital (IRR > k).

IRR methods account for the time value of money and are generally consistent

with the wealth maximisation objective.

NPV and IRR NPV and IRR give same accept-reject results in case of

conventional independent projects. Under a number of situations, the IRR rule

can give a misleading signal for mutually exclusive projects. The IRR rule also

yields multiple rates of return for non-conventional projects and fails to work

under varying cost of capital conditions. Since the IRR violates the valueadditivity

principle; since it may fail to maximise wealth under certain

conditions; and since it is cumbersome, the use of the NPV rule is recommended.

Profitability index (PI) is the ratio of the present value of cash inflows to

initial cash outlay. It is a variation of the NPV rule. PI specifies that the project

should be accepted when it has a profitability index greater than one (PI > 1.0)

since this implies a positive NPV.

NPV and PI A conflict of ranking can arise between the NPV and PI rules in

case of mutually exclusive projects. Under such a situation, the NPV rule should

be preferred since it is consistent with the wealth maximisation principle.

Payback is the number of years required to recoup the initial cash outlay of an

investment project. The project would be accepted if its payback is less than the

standard payback. The greatest limitations of this method are that it does not

consider the time value of money, and does not consider cash flows after the

payback period.

Discounted Payback considers the time value of money, but like the simple

payback it also ignores cash flows after the payback period. Under the conditions

of constant cash flows and a long life of the project, the reciprocal of payback can

be a good approximation of the project‘s rate of return.

Accounting Rate of Return is found out by dividing the average profit aftertax

by the average amount of investment. A project is accepted if its ARR is

greater than a cut off rate (arbitrarily selected). This method is based on

accounting flows rather than cash flows; therefore, it does not account for the

time value of money. Like PB, it is also not consistent with the objective of the

shareholders‘ wealth maximisation.

Following table provides a summary of the features of various investment

criteria.

SUMMARY OF INVESTMENT CRITERIA

I. Discounted Cash Flow Methods

1. Net present value (NPV): The difference between PV of cash flows and PV of

cash outflows is equal to NPV; the firm‘s opportunity cost of capital being the

discount rate.

Acceptance rule

Accept if NPV > 0 (i.e., NPV is positive)

Reject if NPV < 0 (i.e., NPV is negative)

Project may be accepted if NPV = 0

Merits Demerits

Considers all cash flows.

Requires estimates of cash flows which is a

tedious task.

True measure of profitability.

Requires computation of the opportunity cost

of capital which poses practical difficulties.

Based on the concept of the time

Sensitive to discount rates.

value of money.

Satisfies the value-additivity

principle (i.e., NPV‘s of two or

more projects can be added).

Consistent with the shareholders‘

wealth maximisation

(SWM) principle.

2. Internal rate of return (IRR): The discount rate which equates the present

value of an investment‘s cash inflows and outflows is its internal rate of

return.

Acceptance rule

Accept if IRR > k

Reject if IRR < k

Project may be accepted if IRR = k

Merits Demerits

Considers all cash flows.

Requires estimates of cash flows which is a

tedious task.

True measure of profitability.

Does not hold the value-additivity principle

(i.e., IRRs of two or more projects do not add)

Based on the concept of the time

At times fails to indicate correct choice between

value of money. mutually exclusive projects.

Generally, consistent with wealth

At times yields multiple rates.

maximisation principle.

Relatively difficult to compute.

3. Profitability index (PI): The ratio of the present value of the cash flows to the

initial outlay is profitability index or benefit-cost ratio:

Acceptance rule

Accept if PI > 1.0

Reject if PI < 1.0

Project may be accepted if PI = 1.0

Merits Demerits

Considers all cash flows. Requires estimates of the cash flows which

is a tedious task.

Recognises the time value of At times fails to indicate correct choice between

money. mutually exclusive projects.

Relative measure of profitability.

Generally consistent with the

wealth maximisation principle.

II. Non-Discounted Cash Flow Criteria

4. Payback (PB): The number of years required to recover the initial outlay of

the investment is called payback.

Acceptance rule

Accept if PB < standard payback

Reject if PB > standard payback

Merits Demerits

Easy to understand and compute Ignores the time value of money.

and inexpensive to use.

Emphasises liquidity. Ignores cash flows occurring after the

payback period.

Easy and crude way to cope with risk. Not a measure of profitability.

Uses cash flows information. No objective way to determine the

standard payback.

No relation with the wealth maximisation

principle.

5. Discount payback: The number of years required in recovering the cash outlay

on the present value basis is the discounted payable period. Except using

discounted cash flows in calculating payback, this method has all the

demerits of payback method.

6. Accounting rate of return (ARR): An average rate of return found by dividing

the average net operating profit [EBIT (1 – T )] by the average investment.

Average investment

Average net operating profit after tax

ARR

Acceptance rule

Accept if ARR > minimum rate

Reject if ARR < minimum rate

Merits Demerits

Uses accounting data with which Ignores the time value of money

executives are familiar.

Easy to understand and calculate.

Does not use cash flows.

Gives more weightage to future

No objective way to determine the

receipts. minimum acceptable rate of return.

Net present value (NPV) method is the most superior investment criterion as it is always

consistent with the wealth maximisation principle.

CHAPTER – IX – UNIT IV:

Cost of Capital to a firm is the minimum return, which the suppliers of capital

require. In other words, it is a price of obtaining capital; it is a compensation for

time and risk.

The cost of capital concept is of vital significance in the financial decisionmaking.

It is used: (a) as a discount, or cut-off, rate for evaluating investment

projects, (b) for designing the firm‘s debt-equity mix and (c) for appraising the

top management‘s financial performance.

Firms obtain capital for financing investments in the form of equity or debt or

both. Also, in practice, they maintain a target debt-equity mix. Therefore, the

firm‘s cost of capital means the weighted average cost of debt and equity.

Cost of Debt includes all interest-bearing borrowings. Its cost is the yield

(return), which lenders expect from their investment. In most cases, return is

equal to annual contractual rate of interest (also called coupon rate). Interest

charges are tax deductible. Therefore, cost of debt to the firm should be

calculated after adjusting for interest tax shield: kd (1 T)

where kd is before-tax cost of debt and T is the corporate tax rate.

Cost of Equity Equity has no explicit cost, as payment of dividends is not

obligatory. However, it involves an opportunity cost.

The opportunity cost of equity is the rate of return required by shareholders on

securities of comparable risk. Thus, it is a price, which the company must pay to

attract capital from shareholders.

In practice, shareholders expect to receive dividends and capital gains.

Cost of Retained Earnings When a company issues new share capital, it has

to offer shares at a price, which is much less than the prevailing market price.

Therefore, the cost of retained earnings will be less than the cost of new issue of

equity.

Weighted Average Cost of Capital Three steps are involved in calculating the

firm‘s weighted average cost of capital (WACC). First, the component costs of

debt and equity are calculated. Second, weights to the each component of capital

are assigned according to the target capital structure. Third, the product of

component costs and weights is summed up to determine WACC. The weighted

average cost of new capital is the weighted marginal cost of capital (WMCC).

Divisional or Project’s Cost of Capital A firm may have several divisions or

product lines with different risks. Therefore, the firm‘s WACC cannot be used to

evaluate divisions or projects.

CHAPTER – X

Profits vs. Cash Flows Cash flows are different from profits. Profit is not

necessarily a cash flow; it is the difference between revenue earned and expenses

incurred rather than cash received and cash paid. Also, in the calculation of

profits, an arbitrary distinction between revenue expenditure and capital

expenditure is made.

Incremental Cash Flows Cash flows should be estimated on incremental

basis. Incremental cash flows are found out by comparing alternative investment

projects. The comparison may simply be between cash flows with and without

the investment proposal under consideration when real alternatives do not exist.

The term incremental cash flows should be interpreted carefully. The concept

should be extended to include the opportunity cost of the existing facilities used

by the proposal. Sunk costs and allocated overheads are irrelevant in computing

cash flows. Similarly, a new project may cannibalise sales of the existing

products. The project‘s cash flows should be adjusted for the reduction in cash

flows on account of the cannibalisation.

Components of Cash Flows Three components of cash flows can be identified:

(1) initial investment, (2) annual cash flows, and (3) terminal cash flows.

Initial Investment Initial investment will comprise the original cost (including

freight and installation charges) of the project, plus any increase in working

capital. In the case of replacement decision, the after-tax salvage value of the old

asset should also be adjusted to compute the initial investment.

Net Cash Flow Annual net cash flow is the difference between cash inflows and

cash outflows including taxes. Tax computations are based on accounting profits.

Care should be taken in properly adjusting depreciation while computing net

cash flows.

Change in Net Cash Flow from Operations Depreciation is a non-cash item,

but it affects cash flows through tax shield.

Free Cash Flows In practice, changes in working capital items—debtors

(receivable), creditors (payable) and stock (inventory)—affect cash flows. Also,

the firm may be required to incur capital expenditure during the operation of the

investment project.

Free Cash Flows and the Discount Rate Free cash flows are available to

service both the shareholders and the debt holders. Therefore, debt flows

(interest charges and repayment of principal) are not considered in the

computation of free cash flows. The financing effect is captured by the firm‘s

weighted cost of debt and equity, which is used to discount the project‘s cash

flows. This approach is based on two assumptions: (1) the project‘s risk is the

same as the firm‘s risk, and (2) the firm‘s debt ratio is constant and the project‘s

debt capacity is the same as the firm‘s.

Terminal Cash Flows are those, which occur in the project‘s last year in

addition to annual cash flows. They would consist of the after-tax salvage value

of the project and working capital released (if any). In case of replacement

decision, the foregone salvage value of old asset should also be taken into

account.

Terminal Value of a New Product may depend on the cash flows, which could

be generated much beyond the assumed analysis or horizon period. The firm

may make a reasonable assumption regarding the cash flow growth rate after

the horizon period.

Inflation and NPV The NPV rule gives correct answer to choose an investment

under inflation if it is treated consistently in cash flows and discount rate. The

discount rate is a market-determined rate and therefore, includes the expected

inflation rate. It is thus generally stated in nominal terms. The cash flows

should also be stated in nominal terms to obtain an unbiased NPV.

Alternatively, the real cash flows can be discounted at the real discount rate to

calculate unbiased NPV.

CHAPTER – XI

Complicated Investment Decisions A firm in practice faces complicated

investment decisions. The most common situations include choosing among

investments with different lives, deciding about the replacement of an existing

asset or timing of an investment and evaluating investments under capital

rationing. The NPV rule can be extended to handle such situations.

Annual Equivalent Values (AEVs) AEV is the NPV of an investment divided

by the annuity factor given its life and risk-free discount rate.

Capital Rationing occurs because of either the external or internal constrain

on the supply of funds. In capital rationing situations, the firm cannot accept all

profitable projects. Therefore, the firm will aim at maximising NPV subject to

the funds constraint.

In simple one-period capital rationing situations, the profitability index (PI)

rule can be used. PI rule breaks in the case of multi-period funds constraints and

project indivisibility.

A more sophisticated approach—either linear programming or integer

programming—can be used to select investment under capital rationing.

However, two factors limit the use of these approaches in practice. First, they

are costly, and second, they assume investment opportunities as known. Also,

large companies in reality hardly face the real capital shortage situations.

Mostly it arises on account of the internal constraints imposed by the

management for control purposes.

CHAPTER – XII

Risk arises in the investment evaluation because the forecasts of cash flows can

go wrong. Risk can be defined as variability of returns (NPV or IRR) of an

investment project.

Decision-makers in practice may handle risk in conventional ways. For

example, they may use a shorter payback period, or use conservative forecasts of

cash flows, or discount net cash flows at the risk-adjusted discount rates.

Statistical techniques are used to measure and incorporate risk in capital

budgeting. Two important statistics in this regard are the expected monetary

value and standard deviation.

Expected Monetary Value is the weighted average of returns where

probabilities of possible outcomes are used as weights.

Sensitivity Analysis It is a method of analysing change in the project‘s NPV

for a given change in one variable at a time. It helps in asking ―what if‖

questions and calculates NPV under different assumptions.

Scenario Analysis considers a few combinations of variables and calculates

NPV for each of them. It is a usual practice to calculate NPV under normal,

optimistic or pessimistic scenario.

Sensitivity or scenario analysis forces the decision-maker to identify underlying

variables, indicates critical variables and helps in strengthening the project by

pointing out its weak links. Its limitations are that it cannot handle a large

number of interdependent variables and at times, fails to give unambiguous

results.

Simulation Analysis The analyst specifies probability distributions for

variables and computer generates several hundred scenarios, probability

distribution for the project‘s NPV along with the expected NPV and standard

deviation. It overcomes the limitations of sensitivity or scenario analysis.

Decision Tree Analysis Another technique of resolving risk in capital

budgeting, particularly when the sequential decision-making is involved, is the

decision tree analysis. The decision tree provides a way to represent different

possibilities so that we can be sure that the decisions we make today, taking

proper account of what we can do in the future.

To draw a decision tree, branches from points marked with squares are used to

denote different possible decisions, and branches from points marked with

circles denote different possible outcomes. In a decision tree analysis, one has to

work out the best decisions at the second stage before one can choose the best

first stage decision.

Decision trees are valuable because they display links between today‘s and

tomorrow‘s decisions. Further, the decision-maker explicitly considers various

assumptions underlying the decision. The use of decision tree is, however,

limited because it can become complicated.

Utility Theory One important theory, which provides insight into risk handling

in capital budgeting, is the utility theory. It aims at including a decision-maker‘s

risk preferences explicitly into the capital expenditure decision. The underlying

principle is that an investor prefers a higher return to a lower return, and that

each successive identical increment of money is worth less to him than the

preceding one. The decision-maker‘s utility function is derived to determine the

decision‘s utility value.

The direct use of the utility theory in capital budgeting is not common. It is very

difficult to specify utility function in practice. Even if it is possible to derive

utility function, it does not remain constant over time. Problems are also

encountered when decision is taken by group of people. Individuals differ in their

risk preferences.

CHAPTER – XIII – UNIT V:

Important Aspects of Capital Budgeting Process are

Identification of investment ideas is the most critical aspect of the

investment process, and should be guided by the overall strategic

considerations of a firm. It needs appropriate managerial focus. Each

potential idea should be developed into a project.

Development A company should have systems for estimating cash flows of

projects. A multi-disciplinary team of managers should be assigned the task

of developing cash flow estimates.

Evaluation Once cash flows have been estimated, projects should be

evaluated to determine their profitability. Evaluation criteria chosen should

correctly rank the projects.

Authorisation Once the projects have been selected they should be

monitored and controlled to ensure that they are properly implemented and

estimates are realised. Proper authority should exist for capital spending.

The top management may supervise critical projects involving large sums of

money. The capital spending authority may be delegated subject to adequate

control and accountability.

Control A company should have a sound capital budgeting and reporting

system for this purpose. Based on the comparison of actual and expected

performance, projects should be reappraised and remedial action should be

taken.

Companies are increasingly using DCF techniques, but payback remains

universally popular for its simplicity and focus on recovery of funds and

liquidity. In practice, judgement and qualitative factors also play an

important role in investment analysis. A number of companies pay more

attention to strategy in the overall selection of projects.

Strategic Investments Decisions are large-scale expansion or diversification

projects, and they involve either by their nature or by managerial actions

valuable options. Such options include right to expand, right to abandon, right to

delay, right to build new businesses, or right to disinvest or harvest.

Real Options create managerial flexibility and commitment. In principle, they

can be valued in the same way as financial options are valued. But in practice, it

is difficult to get all input parameters for valuing real options. Since large

numbers of real assets are not traded in the market, it is quite difficult therefore

to get information on the value of the underlying assets and the volatility.

Since real options are valuable, managers must identify them, value them,

monitor them and exercise them when it is optimal to do so. Managers generally

strive to create flexibility and commitment by building real options into

investment projects.

CHAPTER – XIV – UNIT II:

Capital Structure The debt-equity mix of a firm is called its capital structure.

The capital structure decision is a significant financial decision since it affects

the shareholders‘ return and risk, and consequently, the market value of shares.

Financial Structure The term financial structure, on the other hand, is used

in a broader sense, and it includes equity and all liabilities of the firm.

Financial Leverage or Trading on Equity The use of the fixed-charges

capital like debt with equity capital in the capital structure is described as

financial leverage or trading on equity.

The main reason for using financial leverage is to increase the shareholders‘

return. Consider an example. Suppose you have an opportunity of earning 20 per

cent on an investment of Rs 100 for one year. If you invest your own money, your

return will be 20 per cent. On the other hand, you can borrow, say, Rs 50 at 10

per cent rate of interest from your friend and put your own money worth Rs 50.

You shall get total earnings of Rs 20, out of which you will have to pay Rs 5 as

interest to your friend. You shall be left with Rs 15 on your investment of Rs 50,

which gives you a return of 30 per cent. You have earned more at the cost of your

friend.

Financial leverage, on the one hand, increases shareholders‘ return and on the

other, it also increases their risk. For a given level of EBIT, EPS varies more

with more debt. Consider a simple example. Let us assume that a firm‘s expected

EBIT is Rs 120 with a standard deviation of Rs 63. This implies that earnings

could vary between Rs 57 to Rs 183 on an average. Suppose that the firm has

some debt on which it pays Rs 40 as interest. Now the shareholders‘ expected

earnings will be: Rs 120 – Rs 40 = Rs 80 (ignoring taxes) and standard deviation

will remain unchanged. Shareholders‘ earnings will, on an average, fluctuate

within a range of Rs 17 and Rs 143. If EBIT is less than Rs 40, the earnings of

shareholders will be negative. In the extreme situation if the firm is unable to

pay interest and principal, its solvency is threatened.

In the insolvency, shareholders are the worst sufferers. Thus, we find that

financial leverage is a double-edged sword. It increases return as well as risk. A

trade-off of between return and risk will have to be struck to determine the

appropriate amount of debt.

Earnings Per Share (EPS) A firm determines the advantage of financial

leverage by calculating its impact on earnings per share (EPS) or return on

equity (ROE).

where EBIT is earnings before interest and taxes, INT is interest charge which

is given by the product of interest rate (i) and the amount of debt (D), T is

corporate tax rate and N is number of shares. If the firm‘s overall profitability is

more than interest rate, EPS increases with debt. With increasing EBIT, EPS

increases faster with more debt.

Degree of Operating Leverage (DOL) EBIT depends on sales. A change in

sales will affect EBIT. The variability in EBIT due to a change in sales is

affected by the composition of fixed and variable costs.

Degree of Combined Leverage (DCL) DOL and DFL can be combined to see

the effect of total leverage on EPS.

CHAPTER – XV – UNIT II:

Capital Structure Decision of the firm can be characterised as a choice of that

combination of debt and equity, which maximises the market value of the firm.

Modigliani and Miller’s Theory According to MM‘s proposition I, the firm‘s

market value is not affected by capital structure; that is, any combination of debt

and equity is as good as any other. Firms borrow by offering investors various

types of securities. In M-M‘s world of perfect capital market, because of same

borrowing and lending rates for all investors and no taxes, investors can borrow

at their own. Why should they pay a premium for a firm‘s borrowing? M-M

accept that borrowing increases shareholders return, but, they argue, it also

increases risk. They show that increased risk exactly offsets the increased

return, thus leaving the position of shareholders unchanged. This is M–M‘s

proposition II.

Interest tax shield and the value of the firm One unrealistic assumption of

M–M‘s hypothesis is that, they assume no existence of taxes. When corporate

taxes are assumed, firms can increase earnings of all investors through

borrowing which results in interest tax shield.

Traditionalists argue that market imperfections make borrowing by individual

investors costly, risky and inconvenient. Thus the arbitrage envisaged by M–M

will not work, and investors may be willing to pay a premium for shares of

levered firms. But thousands of the levered firms would have already satisfied

the demand of investors who like their shares. Therefore, a firm changing its

debt policy is unlikely to influence the market value of the firm.

Miller Theory incorporating both Corporate and Personal Income

Taxes In practice, we do not find all firms using high amounts of debt. One

explanation for this behaviour could be personal income taxes. Miller has

propounded a theory incorporating both corporate and personal income taxes.

According to him, the advantage of interest tax shield is offset by the personal

taxes paid by debt-holders on interest income. Interest income is tax-exempt at

corporate level while dividend income is not. Interest income is taxed at personal

level while dividend income may largely escape personal taxes. Thus companies

can induce tax paying investors to buy debt securities if they are offered high

rate of interest. But after a stage it will not be possible to attract investors in the

high-tax brackets. This point establishes the optimum debt ratio for the

individual firms.

Financial Distress There is another factor which reduces the tax advantage of

borrowing. It is financial distress, which is costly. It includes cost of inflexibility,

inconvenience and insolvency. Thus the value of a levered firm is: Vl Vu TD PV of financial distress

The value will reach optimum value where marginal advantage of corporate

borrowing, TD, equals marginal present value of costs of financial distress

(PVFD).

Capital Structure Decision The advantage of debt is that it saves taxes since

interest is a deductible expense. On the other hand, its disadvantage is that it

can cause financial distress. Therefore, the capital structure decision of the firm

in practice should be governed by the trade-off between tax advantage and costs

of financial distress. Financial distress becomes costly when the firm finds it

difficult to pay interest and principal. From this point of view, both debt ratio

and EBIT–EPS analysis have their limitations. They do not reflect the debtservicing

ability of the firm.

Debt Capacity means the amount of debt which a firm should use given its

cash flows. Cash flow analysis indicates how much debt a firm can service

without any difficulty. A firm does not exhaust its debt capacity at once. It keeps

reserve debt capacity to meet financial emergencies. The actual amount of debt

also depends on flexibility, control and size of the firm in terms of its assets.

Other factors, which are important when capital is actually raised, include

timing (marketability) and flotation costs.

CHAPTER – XVI

Discount Rate We need estimate of the discount rate to determine the net

present value of a project. The discount rate depends on the project‘s business

risk and financial risk. Under CAPM, the equity beta captures both the business

risk and the financial risk. Financial risk arises when the firm uses debt.

Opportunity Cost of Capital Following the M–M proposition I, the

opportunity cost of capital can be calculated as the pre-tax weighted average cost

of capital.

Asset Beta a reflects the business risk of the firm or the project. Thus, under

CAPM the firm‘s or the project‘s opportunity cost of capital is given by the riskfree

rate plus the product of the risk premium and the asset beta.

You can estimate the equity beta and the debt beta from the market data and

then estimate the asset beta.

Equity Beta and the asset beta of an all-equity (unlevered) firm will be same.

In practice, the interest tax shields depend on the firm‘s profitability, which

fluctuates randomly. Therefore, the interest tax shields may not reduce the

systematic risk.

Free Cash Flows Approach The most popular method of the project

evaluation is to discount the free cash flows at the firm‘s weighted average cost

of capital (WACC)

The free cash flow approach adjusts the effect of the interest tax shields in the

discount rate (WACC) rather than the project‘s cash follows. This approach is

based on the assumption that the capital structure (debt ratio) is constant over

time. It also assumes that the project‘s and the firm‘s risk and capital structures

are the same. Hence, this approach will not work if the project‘s and the firm‘s

risk and capital structure are different, and where the project‘s capital structure

is not constant.

Equity Cash Flow (ECF) Approach is similar to the FCF approach and it is

based on the same assumptions. In the ECF approach the equity cash flows,

which are residual cash flows available to the equity shareholders, are

discounted by the levered cost of equity.

Capital Cash Flow (CCF) Approach is much easier to use when the project‘s

debt amount is fixed and the capital structure does not remain constant. CCFs

are calculated as the free cash flows plus the interest tax shields, and they are

discounted by the project‘s all-equity or opportunity cost of capital. The project‘s

opportunity cost of capital depends on its business risk and is not affected by the

capital structure. In the CCF approach the effect of the interest tax shields are

adjusted in the cash flows rather than the discount rate.

Adjusted Present Value (APV) Approach is an alternative approach for the

project‘s evaluation. It is a flexible approach that unbundled the project‘s value

into several parts. It separates the operational part from the financing effects.

The base-case NPV is calculated by discounting the free cash flows at the

project‘s opportunity cost of capital. The present values of the financing effects

are calculated separately using the discount rates appropriate to the risk of

these effects. For example, the interest tax shields are treated as risky as debt.

Hence, the interest tax shields are discounted at the cost of debt. APV is the sum

of the base-case NPV and the value of financing effects:

APV = Base – NPV + value of interest tax shields + value of other financing

effects

APV is a useful approach in the project financing where the debt is fixed and

there are several other financing effects like issue costs, investment incentives

and special tax benefits.

Adjusted Cost of Capital (or Discount Rate) Use it to discount the free cash

flows (perpetual):

The concept of the adjusted cost of capital is based on the M–M tax-corrected

hypothesis. Two critical assumptions are that the cash flows are perpetual and

the amount of debt is fixed. In case of the fixed debt ratio, which implies

rebalancing of debt, the adjusted cost of capital can be estimated using the

Value of the Firm The use of the DCF techniques can be extended to value a

business firm. In the valuation of a firm a financial analyst usually assumes a

constant debt ratio.

The firm can be valued using FCFs and WACC. Further, the analyst assumes a

horizon period for analysis and calculates the horizon value at the end of the

horizon period. Horizon value depends on the growth prospects of the firm after

the horizon period.

The value of equity is obtained by subtracting the outstanding amount of debt

from the value of the firm. The value of equity divided by the number of

outstanding shares gives the equity value per share.

CHAPTER – XVII – UNIT V:

Walter’s Model Price per share is the sum of the present value of the infinite

stream of constant dividends and present value of the infinite stream of

capital gains.

Gordon’s Model Market value of a share is equal to the present value of an

infinite stream of dividends to be received by shareholders.

Bird-in-the-hands Argument Investors are risk averters. They consider

distant dividends as less certain than near dividends. Rate at which an

investor discounts his dividend stream from a given firm increases with the

futurity of dividend stream and hence lowering share prices.

M–M Model According to M–M, under a perfect market situation, the

dividend policy of a firm is irrelevant as it does not affect the value of the firm.

They argue that the value of the firm depends on firm earnings which results

from its investment policy. Thus when investment decision of the firm is

given, dividend decision is of no significance.

Information Content In an uncertain world in which verbal statements can

be ignored or misinterpreted, dividend action does provide a clear cut means of

‗making a statement‘ that speaks louder than a thousand words.

Market Imperfections Tax Differential—Low Payout Clientele, Flotation

Cost, Transaction and Agency Cost, Information Asymmetry, Diversification,

Uncertainty—High Payout Clientele, Desire for Steady Income, and No or Low

Tax on Dividends:

CHAPTER – XVIII – UNIT V:

Forms of Dividends Dividends may take two forms: cash dividend and bonus

shares (stock dividend). In India, bonus shares cannot be issued in lieu of cash

dividends. They are paid with cash dividends. Bonus shares have a psychological

appeal. They do not increase the value of shares.

Target Payout Ratio Companies generally prefer to pay cash dividends. They

finance their expansion and growth by issuing new shares or borrowing. This

behaviour is based on the belief that shareholders are entitled to some return on

their investment. Most companies have long-term payment ratio targets. But

they do not apply target payout ratios to each year‘s earnings. They try to

stabilize dividend payments by moving slowly towards the target payout each

year. Also, they consider past dividends and current as well as future earnings

in determining dividend payment. Investors recognize this. Any extreme changes

are read as signals of management‘s expectations about the company‘s

performance in future. Thus dividends have information contents.

Stable Dividend Policy Companies like to follow a stable dividend policy since

investors generally prefer such a policy for the reason of certainty. A stable

dividend policy does not mean constant dividend per share. It means reasonably

predictable dividend policy. Companies determine dividend per share or

dividend rate keeping in mind their long-term payout ratio.

Firm’s Ability to Pay Dividend depends on its funds requirements for growth,

shareholders‘ desire and liquidity. A growth firm should set its dividend rate at a

low level (because of its high needs for funds) and move towards its target

slowly.

Practical consideration Financial Need of company, Shareholders

Expectations, Closely/Widely Held Company, Constraints on Paying Dividends,

Legal Restrictions, Liquidity, Borrowing Capacity, Access to the Capital Market,

Restrictions in Loan Agreements.

CHAPTER – XIX

Efficient Capital Markets Capital market deal with financial assets or

securities. Securities will be fairly priced in the capital markets if they are

efficient. Capital markets are considered to be efficient if the prices of securities

reflect the available information. Depending on the extent of the information

being impounded in the security prices, capital markets may be efficient in

weak, semi-strong or strong form.

India’s Capital Market includes primary, secondary, OTC and derivatives

segments. As a consequence of the growing economy and the government‘s policy

of liberalisation and deregulation, the various segments of capital market in

India have grown at phenomenal rates. The first stock exchange—the Bombay

Stock Exchange—was established in 1875. Now there are 23 stock exchanges in

India. The number of shareholders has increased to about 30–40 million. There

are about 9000 listed companies. Both the market capitalisation and volume of

trades have shown general growth, although they have fluctuated over years.

Stock exchanges in India have well-developed procedures for listing, trading,

settlement etc. The recent changes include shortening of the trading and

settlement period, rolling settlement, index-based price bands, dematerialised

share etc. A number of systems and rules exist for the regulation of the stock

exchanges. The Securities and Exchange Board of India (SEBI) is the central

regulatory authority regulating capital markets in India.

Primary Capital Market Companies raise new capital in the primary markets

either through public issues, rights issues or private placement. In India new

issues market has shown phenomenal growth after the eighties. A number of

companies are able to raise substantial amount from the capital market. The

corporate sector‘s dependence on the financial institutions for their funds

requirements is declining with the development of the new issues market. We

can also witness new financial instruments such as convertible securities, zerocoupon

debentures, warrants, special premium notes etc. being issued by

companies for raising capital. Yet another significant development is the free

pricing of the new issues by companies. Within the norms prescribed by SEBI, a

company can decide the issue price of its securities. Now companies are also

allowed book-building. In book-building investors make price bids for shares.

This leads to price discovery and the issuing company can assess the demand

based on different prices.

Secondary Capital Market Secondary market deals with securities that have

been previously issued. The over-the-counter market and the derivatives market

are other two forms of the secondary market.

OTC Market is an informal market where negotiated deals take place.

Derivatives Market deals in future and options; it is basically a market for

future delivery and payment. Options provide right, but not obligations to buy or

sell securities. Therefore, in option market delivery is conditional. In the

derivatives market options and future may include individual securities or

index.

Merchant Bankers play the role of intermediaries in the capital market in

India. They help companies in the total management of issues of securities.

Therefore, they are called issue managers. As members of stock exchange,

underwriters of new issues and book builders, the help to make market, and

hence, are known as market makers also. Merchant bankers cannot undertake

the pure fund-based activities.

Mutual Funds provide a mechanism for collective investment. Generally they

mobilise funds from individual investors and invest the collected funds in

portfolios of securities. There are two basic types of mutual funds: open-ended

and close-ended. An investor can buy and sell units or shares of open-ended

funds at the market price continuously. In close-ended funds, the net asset value

per share or unit is determined based on the total value of investment. Within

these two broad categories, mutual funds may offer income funds, growth funds,

balanced funds, tax-savings funds etc. Mutual funds companies also offer index

funds and hedged funds to investors. Index funds invest investors‘ money in

combination of securities in a general index like Sensex or in some sector index.

Hedged funds are broad based and may include foreign exchange market also.

They combine several investment strategies and try to maximise investors‘

returns. Mutual funds have several advantages to investors: simplicity,

diversification, professional expertise, affordability and flexibility. They do have

certain limitations: high brokerage, ownership risk, or no opportunity of making

extra-ordinary profit.

CHAPTER – XX

Securities Ordinary share, preference share and debentures are three

important securities used by the firms to raise funds to finance their activities.

Ordinary Shares provide ownership rights to ordinary shareholders. They are

the legal owners of the company. As a result, they have residual claims on

income and assets of the company. They have the right to elect the board of

directors and maintain their proportionate ownership in the company, called the

pre-emptive right.

Pre-Emptive Right of the ordinary shareholders is maintained by raising new

equity funds through rights offerings. Rights issue does not affect the wealth of a

shareholder. The price of the share with rights-on gets divided into ex-rights

price and the value of a right. So what the shareholder gains in terms of the

value of right he loses in terms of the low ex-rights price. However, he will lose if

he does not exercise his rights.

Debenture or Bond is a long-term promissory note. The debenture trust deed

or indenture defines the legal relationship between the issuing company and the

debenture trustee who represents the debenture holders. Debenture holders

have a prior claim on the company‘s income and assets. They will be paid before

shareholders are paid anything. Debentures could be secured and unsecured and

convertible and non-convertible. Debentures are issued with a maturity date. In

India, they are generally retired after 7 to 10 years by instalments.

Preference Share is a hybrid security as it includes some features of both an

ordinary share and a debenture. In regard to claims on income and assets, it

stands before an ordinary share but after a debenture. Most preference shares in

India have a cumulative feature, requiring that all past outstanding preference

dividends be paid before any dividend to ordinary shareholders is announced.

Preference shares could be redeemable, i.e., with a maturity date or

irredeemable, i.e., perpetual, without maturity date. Like debentures, a firm can

issue convertible or non-convertible preference shares.

Term Loans are loans for more than a year maturity. Generally, in India, they

are available for a period of 6 to 10 years. In some cases, the maturity could be

as long as 25 years. Interest on term loans is tax deductible. Mostly, term loans

are secured through an equitable mortgage on immovable assets. To protect

their interest, lending institutions impose a number of restrictions on the

borrowing firm.

CHAPTER – XXI

Convertible Security is either a debenture or a preference share that can be

exchanged for a stated number of ordinary shares at the option of the investor.

Companies offer convertible securities to sweeten debt and thereby make it

attractive. It is a form of deferred equity financing, and provides low cost funds

during the early stage of investment project. The valuation of convertible

securities depends on its value as a straight, non-convertible security

(investment value) and its value if converted into ordinary shares. It generally

sells for a premium; that is, its market price exceeds the higher of its investment

or conversion value.

Warrant is an option to buy a specified number of ordinary shares at an

indicated price during a specified period. A detachable warrant is bought and

sold independent of the debenture to which it is associated. Warrants are

generally used to sweeten a debt to make it marketable and lower the interest

costs. When warrants are exercised, the firm obtains additional cash. The

market value of warrants depends primarily on the ordinary share price.

Warrants generally sell above their minimum, theoretical value. The difference

between the market price and theoretical value of warrants is the premium.

Zero-Interest or Deep-Discount Bonds or Debentures with Option Such

debentures are issued at a price much lower than their face value. Thus, there is

an implicit rate of interest. A company may also issue debentures redeemable at

premium and/or with warrants‘ attached. These features are added to make the

issue of debentures attractive to the investors.

CHAPTER – XXII

Lease is an agreement for the use of the asset for a specified rental. The owner

of the asset is called the lessor and the user the lessee. Two important categories

of leases are: operating leases and financial leases. The most compelling reason

for leasing equipment rather than buying it is the tax advantage of depreciation

that can mutually benefit both the lessee and the lessor. Other advantages

include convenience and flexibility as well as specialised services to the lessee.

In India, lease proves handy to those firms, which cannot obtain loan capital

from normal sources.

Operating Leases are short-term, cancellable leases where the risk of

obsolescence is borne by the lessor.

Financial Leases are long-term non-cancellable leases where any risk in the

use of the asset is borne by the lessee and he enjoys the returns too.

Equivalent Loan Financial lease involves fixed obligations in the form of lease

rentals. Thus it is like a debt and can be evaluated that way. Given the lease

rentals and tax shields, one can find the amount of debt which these cash flows

can service. This is equivalent loan. If equivalent loan is more than the cost of

the asset, it is not worth leasing the equipment.

Net Advantage of Lease You can also approach lease evaluation by calculating

the net advantage of lease (NAL).

Hire Purchase Arrangement like in a lease, the hire purchaser is able to

avoid the payment for the purchase of the asset now, and instead pays hire

purchase instalments (either monthly or quarterly or any other agreed period)

over a specified period and time. The hire purchaser becomes the owner of the

asset once he had paid all instalments. Unlike the leasee, he is entitled to claim

depreciation as well as the salvage value of the acquired asset. Hire purchase

arrangement differs from instalment sale arrangement in terms of the

ownership. Under hire purchase, ownership passes to the hire purchaser on the

payment of the last instalment, while under instalment sale ownership is

transferred once the agreement has been made between the buyer and the seller.

Project Financing is yet another asset-based financing arrangement. It is the

financing of a project as an independent economic unit, where the project itself

forms a direct security, and its cash flows are used to service the debt or equity

provided by the project sponsor. Project financing is the most common method of

financing large infrastructure projects. Project financing involves considerable

risk in the form of completion risk, market risk, foreign exchange risk, political

risk etc. Therefore, generally the project sponsors seek guarantees from the host

governments and use various risk mitigation arrangements. Usually, the risk

will be distributed among owners, contractors, suppliers of inputs, customers,

government etc. Project finance may take the form of a simple loan, or may

involve a more complex arrangement like BOOT , BOO etc.

Build-Own-Operate-Transfer In a BOOT arrangement, the project sponsor

builds a project, operates it for a long period of time to earn a reasonable return,

and then transfers it to the host government or its agency.

Build-Own-Operate In BOO arrangement, the project is not transferred to the

host government, rather the owner divests its stake in the capital markets. In a

build-lease-transfer arrangement, the owner transfers the project to a lessee for

operational purposes, but keeping ownership intact.

CHAPTER – XXIII

Venture Capital is risk financing available in the form of equity or quasiequity.

A venture capitalist also provides management support and acts as a

partner and adviser to the entrepreneur. Thus, he is different from a banker

and an investor of the shares of an enterprise. Venture capital is available as

early stage financing, expansion financing and acquisition financing.

Venture capital activity in developed countries has been encouraged because

of a large number of tax incentives available to venture capital firms and

investors, well-developed avenues for buying and selling shares of the small

scale enterprises and favourable social climate and government policy for

encouraging entrepreneurial activities.

Venture Capital in India There are about a dozen venture capital

organisations in India, mainly started by central and state-level financial

institutions and commercial banks. A few private sector venture capital funds

have also been established. Venture capital is available in three forms in

India: equity, conditional loans and income notes. Conventional loans are also

made available by venture capital firms. Income notes are hybrid securities,

combining the features of both conventional and conditional loans. Overall, in

India the focus in venture capital is still on debt financing. India has yet to

develop reasonable mechanisms of disinvestment. The OTC market has

started functioning, and hopefully, it would provide an impetus to venture

capital activity. India lacks sufficient tax incentives to encourage venture

capital activity. There is need for separate tax concessions for developing

venture capital in India

CHAPTER – XXIV

Balance Sheet is a statement of a firm‘s assets, liabilities and equity on a

specific date.

Assets are economic resources that help generating revenues.

Liabilities are the firm‘s obligations to creditors.

Equity is the investment made by owners in the firm.

Statement of Changes in Financial Position Both the balance sheet and the

profit and loss statement do not explain the changes in assets, liabilities and

owner‘s equity. The statement of changes in financial position is prepared to

show these changes. Two common forms of such statement are: (a) the funds

flow statement, and (b) the cash flow statement.

Fund can be defined at least in three ways: It may mean (i) cash, (ii) working

capital (the difference between current assets and current liabilities), or

(iii) financial resources (arising from both current and non-current items).

Funds Flow Statement provides an analysis of changes in the firm‘s working

capital position.

Cash Flow Statement is prepared to analyse changes in the firm‘s cash

position. Both these statements can be recast to incorporate additional financial

information that does not affect cash or working capital but influences the

financing and asset mix of the firm. Funds flow and cash flow statement are

important managerial tools for financial analysis. They help the firm to know its

liquidity position, capital expenditures incurred, dividend paid and extent of

external financing.

Projected Funds or Cash Flow Statement plan the matching of inflow and

outflow of funds or cash.

Funds/Cash from Operations The main source of funds—working capital or

cash—is the firm‘s operations. Funds from operations are calculated by

adjusting the figure of net profit for non-fund or non-cash items such as

depreciation. Depreciation is added to net profits to arrive at funds from

operation. To determine cash from operations, changes in current assets and

current liabilities are also adjusted in net profits. Increase in current assets and

decrease in current liabilities reduce cash while decrease in current assets and

increase in current liabilities increase cash. Other sources of working capital or

cash include sale of fixed assets, issue of share capital and borrowings. The

typical examples of uses of funds are: acquisition of fixed assets, repayment of

debt and payment of cash dividend.

CHAPTER – XXV

Financial Ratio is a relationship between two financial variables. It helps to

ascertain the financial condition of a firm.

Ratio analysis is a process of identifying the financial strengths and

weaknesses of the firm. This may be accomplished either through a trend

analysis of the firm‘s ratios over a period of time or through a comparison of the

firm‘s ratios with its nearest competitors and with the industry averages. The

four most important financial dimensions, which a firm would like to analyse,

are: liquidity, leverage, activity and profitability.

Liquidity Ratios measure the firm‘s ability to meet current obligations, and

are, calculated by establishing relationships between current assets and current

liabilities.

Leverage Ratios measure the proportion of outsiders‘ capital in financing the

firm‘s assets, and are calculated by establishing relationships between borrowed

capital and equity capital.

Activity Ratios reflect the firm‘s efficiency in utilising its assets in generating

sales, and are calculated by establishing relationships between sales and assets.

Profitability Ratios measure the overall performance of the firm by

determining the effectiveness of the firm in generating profit, and are calculated

by establishing relationships between profit figures on the one hand, and sales

and assets on the other.

Ratio analysis is a very useful tool to raise relevant questions on a number of

managerial issues. It provides clues to investigate those issues in detail. However,

caution needs to be applied while interpreting ratios as they are calculated from the

accounting numbers. Accounting numbers suffer from accounting policy changes,

arbitrary allocation procedures and inflation.

CHAPTER – XXVI

Strategic Planning Company‘s strategy establishes an effective and efficient

match between its resources, opportunities and risks. It provides a mechanism of

integrating goals of multiple stakeholders.

Financial Planning of a company has close links with strategic planning.

Financial plan should be developed within the overall context of the strategic

planning. It is a process of identifying a firm‘s investments and financing needs,

given its growth objectives. It involves trade-off between various investment and

financing options. A financial plan may be prepared for a period of three or five

years.

Steps in Financial Planning:

Past performance Analysis of the firm‘s past performance to ascertain the

relationships between financial variables, and the firm‘s financial strengths

and weaknesses.

Operating characteristics Analysis of the firm‘s operating

characteristics—product, market, competition, production and marketing

policies, control systems, operating risk etc. to decide about its growth

objective.

Co rporate strategy and investment needs Determining the firm‘s

investment needs and choices, given its growth objective and overall strategy.

Cash flow from operations Forecasting the firm‘s revenues and expenses

and need for funds based on its investment and dividend policies.

Financing alternatives Analysing financial alternatives within its

financial policy and deciding the appropriate means of raising funds.

Consequences of financial plans Analysing the consequences of its

financial plans for the long-term health and survival to firm.

Consistency Evaluating the consistency of financial policies with each other

and with the corporate strategy.

Financial Forecasting is an integral part of financial planning. Forecasting

uses past data to estimate the future financial requirements. A simple approach

to financial forecasting is to relate the items of profit and loss account and

balance sheet to sales.

Financial Modelling facilitates financial forecasting. It makes forecasting

easy. A financial model has three components: input — current financial

statement and growth forecasts; model — a system of equations based on the

relations between financial variables; output — projected financial statements.

Financial models a large company can be very complicated when more details

are considered. In practice, companies focus on the most crucial decisions and

variables and keep the model simple.

Sustainable Growth Sometimes companies will like to achieve growth that

their current financial policies could sustain. Sustainable growth is the annual

percentage growth in sales that is consistent with the firm‘s financial policies

(assuming no issue of fresh equity).

CHAPTER – XXVII

Gross Working Capital refers to the firm‘s investment in current assets.

Net Working Capital means the difference between current assets and current

liabilities, and therefore, represents that position of current assets which the

firm has to finance either from long-term funds or bank borrowings.

Operating Cycle is defined as the time duration which the firm requires to

manufacture and sell the product and collect cash. Thus operating cycle refers to

the acquisition of resources, conversion of raw materials into work-in-process

into finished goods, conversion of finished goods into sales and collection of sales.

Larger is the operating cycle, larger will be the investment in current assets. In

practice, firms are acquire resources on credit. To that extent, firm‘s need to

raise working finance is reduced.

Net Operating Cycle is used for the difference between operating cycle (or

gross operating cycle) and the payment deferral period (or the period for which

creditors remain outstanding).

The Manufacturing Cycle is conversion of raw material into work-in-process

into finished goods, is a component of operating cycle, and therefore, it is a major

determinant of working capital requirement. Manufacturing cycle depends on

the firm‘s choice of technology and production policy.

Credit Policy of the firm is another factor which influences the working capital

requirement. It depends on the nature and norms of business, competition and

the firm‘s desire to use it as a marketing tool.

Investment in Current Assets involves a trade-off between risk and return.

When the firm invests more in current assets it reduces the risk of illiquidity,

but loses in terms of profitability since the opportunity of earning from the

excess investment in current assets is lost. The firm therefore is required to

strike a right balance.

Financing of Current Assets also involves a trade-off between risk and

return. A firm can choose from short- or long-term sources of finance. If the firm

uses more of short-term funds for financing both current and fixed assets, its

financing policy is considered aggressive and risky. Its financing policy will be

considered conservative if it makes relatively more use long term funds in

financing its assets. A balanced approach is to finance permanent current assets

by long-term sources and ‗temporary‘ current assets by short-term sources of

finance. Theoretically, short-term debt is considered to be risky and costly to

finance permanent current assets.

CHAPTER – XXVIII

Trade Credit creates debtors (book debts) or accounts receivable. It is used as a

marketing tool to maintain or expand the firm‘s sales. A firm‘s investment in

accounts receivable depends on volume of credit sales and collection period.

Credit Policy The financial manager can influence volume of credit sales and

collection period through credit policy. Credit policy includes credit standards,

credit terms, and collection efforts. The incremental return that a firm may gain

by changing its credit policy should be compared with the cost of funds invested

in receivables. The firm‘s credit policy will be considered optimum at the point

where incremental rate of return equals the cost of funds. The cost of funds is

related to risk; it increases with risk. Thus, the goal of credit policy is to

maximise the shareholders wealth; it is neither maximisation of sales nor

minimisation of bad-debt losses.

Credit Standards are criteria to decide to whom credit sales can be made and

how much. If the firm has soft standards and sells to almost all customers, its

sales may increase but its costs in the form of bad-debt losses and credit

administration will also increase. Therefore, the firm will have to consider the

impact in terms of increase in profits and increase in costs of a change in credit

standards or any other policy variable.

Credit Terms The conditions for extending credit sales are called credit terms

and they include the credit period and cash discount.

Cash Discounts are given for receiving payments before than the normal credit

period. All customers do not pay within the credit period. Therefore, a firm has

to make efforts to collect payments from customers.

Collection Efforts of the firm aim at accelerating collections from slow-payers

and reducing bad-debt losses. The firm should in fact thoroughly investigate

each account before extending credit. It should gather information about each

customer, analyse it and then determine the credit limit. Depending on the

financial condition and past experience with a customer, the firm should decide

about its collection tactics and procedures.

Average Collection Period and Aging Schedule are methods to monitor

receivables. They are based on aggregate data for showing the payment

patterns, and therefore, do not provide meaningful information for controlling

receivables.

Collection Experience Matrix Receivables outstanding for a period are

related to credit sales of the same period. This approach is better than the two

traditional methods of monitoring receivables.

Factoring involves sale of receivables to specialised firms, called factors.

Factors collect receivables and also advance cash against receivables to solve the

client firms‘ liquidity problem. For providing their services, they charge interest

on advance and commission for other services..

CHAPTER – XXIX

Inventories Companies hold inventories in the form of raw materials, work-inprocess

and finished goods. Inventories represent investment of a firm‘s funds.

The objective of the inventory management should be the maximisation of the

value of the firm. The firm should therefore consider: (a) costs, (b) return, and (c)

risk factors in establishing its inventory policy.

Transaction Motive to Hold Inventory for facilitating smooth production

and sales operation.

Precautionary Motive to Hold Inventory to guard against the risk of

unpredictable changes–in usage rate and delivery time.

Speculative Motive to Hold Inventory to take advantage of price

fluctuations.

Ordering Costs requisition, placing of order, transportation, receiving,

inspecting and storing and clerical and staff services. Ordering costs are fixed

per order. Therefore, they decline as the order size increases.

Carrying Costs warehousing, handling, clerical and staff services, insurance

and taxes. Carrying costs vary with inventory holding. As order size increases,

average inventory holding increases and therefore, the carrying costs increase.

Economic Order Quantity (EOQ) The firm should minimise the total cost

(ordering plus carrying). The economic order quantity (EOQ) of inventory will

occur at a point where the total cost is minimum.

Optimum Inventory Policy The value of the firm will be maximised when the

marginal rate of return of investment in inventory is equal to the marginal cost

of funds. The marginal rate of return (r) is calculated by dividing the

incremental operating profit by the incremental investment in inventories, and

the cost of funds is the required rate of return of suppliers of funds.

Reorder Point The inventory level at which the firm places order to replenish

inventory is called the reorder point. It depends on (a) the lead time and (b) the

usage rate. Under perfect certainty about the usage rate, and instantaneous

delivery (i.e., zero lead time), the reorder point will be equal to: Lead time

Usage rate.

Safety Stock In practice, there is uncertainty about the lead time and/or usage

rate. Therefore, firms maintain safety stock which serves as a buffer or cushion

to meet contingencies. In that case, the reorder point will be equal to: Lead time

Usage rate + Safety stock. The firm should strike a trade-off between the

marginal rate of return and marginal cost of funds to determine the level of

safety stock.

Selective Control System – A-B-C Analysis A firm, which carries a number

of items in inventory that differ in value, can follow a selective control system. A

selective control system, such as the A-B-C analysis, classifies inventories into

three categories according to the value of items: A-category consists of highest

value items, B-category consists of high value items and C-category consists of

lowest value items. More categories of inventories can also be created. Tight

control may be applied for high-value items and relatively loose control for lowvalue

items.

Total Quality Management (TQM) System Large numbers of companies

these days follow the total quality management (TQM) system which requires

companies to adopt JIT and computerised system of inventory management.

CHAPTER – XXX

Transaction Motive for Holding Cash A firm needs cash to make payments

for acquisition of resources and services for the normal conduct of business.

Precautionary Motive for Holding Cash A firm keeps additional funds to

meet any emergency situation.

Speculative Motive for Holding Cash Some firms may also maintain cash

for taking advantages of speculative changes in prices of input and output.

Optimum Balance of Cash A firm should hold an optimum balance of cash,

and invest any temporary excess amount in short-term (marketable) securities.

In choosing these securities, the firm must keep in mind safety, maturity and

marketability of its investment.

Management of Cash involves three things: (a) managing cash flows into and

out of the firm, (b) managing cash flows within the firm, and (c) financing deficit

or investing surplus cash and thus, controlling cash balance at a point of time. It

is an important function in practice because it is difficult to predict cash flows

and there is hardly any synchronisation between inflows and outflows.

Cash Budget Firms prepare cash budget to plan for and control cash flows.

Cash budget is generally prepared for short periods such as weekly, monthly,

quarterly, half-yearly or yearly. Cash budget will serve its purpose only if the

firm can accelerate its collections and postpone its payments within allowed

limits. The main concerns in collections are: (a) to obtain payment from

customers within the credit period, and (b) to minimise the lag between the time

a customer pays the bill and the time cheques etc. are collected. The financial

manager should be aware of the instruments of payments, and choose the most

convenient and least costly mode of receiving payment. Disbursements or

payments can be delayed to solve a firm‘s working capital problem. But this

involves cost that, in the long run, may prove to be highly detrimental.

Therefore, a firm should follow the norms of the business.

Receipts and Disbursements Method is employed to forecast for shorter

periods. The individual items of receipts and payments are identified and

analysed. Cash inflows could be categorised as: (i) operating, (ii) non-operating,

and (iii) financial. Cash outflows could be categorised as: (i) operating,

(ii) capital expenditure, (iii) contractual, and (iv) discretionary. Such

categorisation helps in determining avoidable or postponable expenditures.

Adjusted Income Method uses proforma income statement (profit and loss

statement) and balance sheet to work out cash flows (by deriving proforma cash

flow statement). As cash flows are difficult to predict, a financial manager does

not base his forecasts only on one set of assumptions. He or she considers

possible scenarios and performs a sensitivity analysis. At least, forecasts under

optimistic, most probable and pessimistic scenarios can be worked out.

Concentration Banking and Lock-Box System methods followed to expedite

conversion of an instrument (e.g., cheque, draft, bills, etc.) into cash.

Marketable Securities The excess amount of cash held by the firm to meet its

variable cash requirements and future contingencies should be temporarily

invested in marketable securities, which can be regarded as near moneys. A

number of marketable securities may be available in the market. The financial

manager must decide about the portfolio of marketable securities in which the

firm‘s surplus cash should be invested.

Baumol Model of Cash Management considers cash management similar to

an inventory management problem.

where C* is the optimum cash balance, c is the cost per transaction, T is the

total cash needed during the year and k is the opportunity cost of holding cash

balance. The optimum cash balance will increase with increase in the per

transaction cost and total funds required and decrease with the opportunity cost.

Miller-Orr Model If the firm‘s cash flows fluctuate randomly and hit the upper

limit, then it buys sufficient marketable securities to come back to a normal level

of cash balance (the return point). Similarly, when the firm‘s cash flows wander

and hit the lower limit, it sells sufficient marketable securities to bring the cash

balance back to the normal level (the return point).

CHAPTER – XXXI – UNIT II:

Short-Term Sources of Financing Trade Credit, Deferred Income and

Accrued Expenses, and Bank Finance. Two alternative ways of raising shortterm

finances in India are: factoring and commercial paper.

Spontaneous Sources of Working Capital Finance Trade Credit and

Deferred Income and Accrued Expenses are available in the normal course of

business, and therefore, they are called spontaneous sources of working capital

finance. They do not involve any explicit costs.

Non-Spontaneous or Negotiated Sources of Working Capital Finance

Bank Finances have to be negotiated and involve explicit costs. They are called

non-spontaneous or negotiated sources of working capital finance

Trade Credit refers to the credit that a buyer obtains from the suppliers of

goods and services. Payment is required to be made within a specified period.

Suppliers sometimes offer cash discount to buyers for making prompt payment.

Buyer should calculate the cost of foregoing cash discount to decide whether or

not cash discount should be availed.

A buyer should also consider the implicit costs of trade credit, and particularly,

that of stretching accounts payable. These implicit costs may be built into the

prices of goods and services. Buyer can negotiate for lower prices for making

payment in cash.

Accrued Expenses and Deferred Income also provide some funds for

financing working capital. However, it is a limited source as payment of accrued

expenses cannot be postponed for a long period. Similarly, advance income will

be received only when there is a demand-supply gap or the firm is a monopoly.

Bank Finance is the most commonly negotiated source of the working capital

finance. It can be availed in the forms of overdraft, cash credit,

purchase/discount of bills and loan. Each company‘s working capital need is

determined as per the norms. These norms are based on the recommendation of

the Tandon Committee and later on, the Chore Committee. The policy is to

require firms to finance more and more of their capital needs from sources other

than bank. Banks are the largest providers of working capital finance to firms.

Commercial Paper is an important money market instrument for raising

short-term finances. Firms, banks, insurance companies, individuals etc. with

short-term surplus funds invest in commercial papers. Investors would generally

invest in commercial paper of a financially sound and creditworthy firm. In

India, commercial papers of 91 to 180 days maturity are being floated. The

interest rate will be determined in the market. The yield on commercial paper

can be calculated as follows:

CP yield = [Face value – Sale price/Sale price] [360/Days to maturity]

CHAPTER – XXXII

Merger is the combination of two or more firms into one of the firms. Merger

could be horizontal, vertical or conglomerate. A merger results into an economic

advantage when the combined firms are worth more together than as separate

entities. Merger benefits may result from economies of scale, economies of

vertical integration, increased efficiency, tax shields or shared resources. Merger

should be undertaken when the acquiring company‘s gain exceeds the cost. Cost

is the premium that the buyer (acquiring company) pays for the selling company

(Target Company) over its value as a separate entity. Discounted cash flow

technique can be used to determine the value of the target company to the

acquiring company. Merger and acquisition activities are regulated under

various laws in India. The objective of the laws as well as the stock exchange

requirements is to make merger deals transparent and protect the interest of all

shareholders.

Horizontal Merger is the combination of two or more firms in the same stage

of production/distribution/area of business.

Vertical Merger is combination of two or more firms involved in different

stages of production or distribution.

Conglomerate Merger is the combination of firms engaged in unrelated lines

of business. Acquisition or takeover means a combination in which the acquiring

company acquires all or part of assets (shares) of the target company. In

acquisition, there exists willingness of the management of the target company to

be acquired while this may not be so under takeover.

Leveraged Buy-Out (LBO) In a leveraged buy out a company is bought by

raising most funds through borrowings. When the company is boughtout by its

own managers, it is called management buyout (MBO). After acquisition, the

LBO generates lot of profits and creates high value. Lenders get high return by

converting their loans into equity or using warrants buying the company‘s

shares..

Pooling of Interest Method In the pooling of interest method, assets and

liabilities are combined at book values.

Purchase Method In the purchase method, the assets and liabilities are

revalue and then combined. The difference between book values of assets and

liabilities and their revaluation is shown as goodwill or capital reserve.

CHAPTER – XXXIII

Derivatives are instruments that derive their value and payoff from another

asset, called underlying asset. Derivatives include options, forward contracts,

futures contracts and swaps. Investors, including firms, are risk averse. They

aim at reducing risk by hedging through derivatives.

Hedging helps to (i) reduce costs of financial distress, (ii) isolate the effects of

changes in external factor like interest rates and foreign exchange rates on

profitability, and (iii) allow managers to focus on improving operating efficiency

rather worrying about changes in factors on which they have no control.

Forward Contract is an agreement between two parties, called counterparties,

to buy and sell an asset at a future date at a price agreed upon today. There is

no immediate flow of cash. Cash is paid or received on the due date. Forward

contracts are obligations. They are not traded on organised exchanges.

Futures Contract is like a forward contract. But, unlike forward contracts,

futures contracts are traded on organised exchanges. Thus, they are liquid. Yet

another feature of futures contract is that they are marked to market. Prices

differences every day are settled through the exchange clearing house. The

clearinghouse pays to the buyer if the price of a futures contract increases on a

particular day. The seller pays money to the clearing house. The reverse will

happen if the prices decrease.

Swaps are arrangements to exchange cash flows over time.

Currency Swap The agreement provides for exchanging payments

denominated in one currency for payments in another currency over a period of

time.

Interest Rate Swap one type of interest payments, say, fixed-rate payments, is

exchanged for another, interest payments, say, floating-rate payments. The

floating interest rates may be tied to LIBOR.

CHAPTER – XXXIV

International Financial Management The guiding principle for international

financial management, like domestic financial management, is the shareholder

wealth maximisation. International financial management, however, differs

from domestic financial management, as it has to deal with multiple currencies,

interest rates, inflation rates and foreign exchange and political risks. There are

a number of ways in which an international company can finance its foreign

operations. It should strive to reduce its risk and minimise cost. It should take

advantages of government subsidies and tax asymmetries.

Foreign Exchange Rate is the price of one currency in terms of the other

currency.

Spot Rate is the current exchange rate, and is used for immediate delivery of

currency (which is two business days).

Forward Rate is the price determined today for delivery in the future.

International Parity Conditions There exists a definite relationship between

interest rates, inflation rates and exchange rates. These relationships are called

international parity conditions.

Interest Rate Parity The difference between the current exchange rate and the

forward rate results from the differences in the interest rates of two countries.

This is referred to as the interest rate parity.

where rF is interest rate of country F (say, the foreign country), rD is interest rate

of country D (say, domestic country), sF/D is the spot exchange rate between the

countries F and D and fF/D is the forward rate between the countries F and D.

Expectation Theory of Exchange Rates A forward exchange rate should be

what the foreign exchange market participants expect the future spot rate to be.

This is the expectation theory of exchange rates.

Purchasing Power Parity The expected future spot rate deviates from the

current spot rate because of the difference in the expected inflation rates in two

countries. This notion is based on the law of one price. The price of similar goods

should be same in foreign currency equivalent. This is known as purchasing

power parity. Nominal interest rates reflect the expected inflation rates.

International Fisher Effect In a perfect capital market, real rates will be

same in all countries. This is the international Fisher effect.

Foreign Exchange Risk An international company expecting to receive or pay

cash flows in future in foreign currency is exposed to foreign exchange risk. To

avoid the foreign exchange risk of borrowing, a company can borrow a mix of

currencies — local as well as foreign. It can hedge against the risk of its

liabilities if it creates assets in those currencies. We can distinguish between

three types of foreign exchange risk: transaction exposure; economic exposure

and translation exposure. There are three alternatives available to hedge the

foreign exchange risk: forward contract; currency options; money market

operations.

Transaction Exposure Risk involves the possible exchange loss (or gain) on

existing foreign currency-denominated transactions due to change in the

exchange rate.

Economic Exposure Risk refers to change in the value of the firm caused by

the unexpected changes in the exchange rate.

Translation Exposure Risk is caused when for translating the assets and

liabilities of subsidiaries of a multinational company, the exchange rate at the

end of the accounting period is different from the exchange rate at the beginning.

Forward Contract A company can take a forward contract. It can either buy or

sell a currency forward at a known forward rate.

Currency Option The company can buy a currency option. A call option is the

right to buy and a put option is the right to sell currency at a predetermined

exchange rate. The company will exercise its option only when it is

advantageous to do so. Currency options allow the company to hedge against

risk and gain from favourable change in the exchange rate.

Money Market Operations The company can also hedge its foreign exchange

exposure through money market operations; that is, borrowing and investing in

the money markets.

International Capital Budgeting Decisions like domestic capital budgeting

decisions, require estimates of cash flows and an appropriate discount rate. The

cash flows can be estimated either in the domestic currency or in the foreign

currency. The financial managers should forecast the foreign exchange rates

assuming the parity conditions. The opportunity costs should be appropriately

modified, reflecting the interest rate of the country in whose currency cash flows

are estimated.

Eurocurrency Loans or Eurobonds A number of companies access funds in

the Eurocurrency markets either through borrowing from banks or by issuing

Eurobonds. Eurocurrency loans or Eurobonds are issued in countries other than

the country in whose currency they are denominated. Eurocurrency markets are

free from government regulations. Some companies also issue foreign bonds in

foreign domestic capital markets.

Depository Receipts A number of companies, particularly developing

countries, also raise funds through depository receipts. Depository receipts,

representing claims on the shares of a company, are issued by a depository,

usually an international finance firm to investors in developed countries.

Depository is an intermediary between the company and depository receipt

holders. He receives dividends from the company and then converts it into

receipt holders‘ currency and distributes to them.

American Depository Receipts (ADRs) Depository receipts issued to

investors in the US are called American Depository Receipts (ADRs).

Global Depository Receipts (GDRs) Depository receipts issued to investors in

many countries are called Global Depository Receipts (GDRs).

CHAPTER – XXXV

Corporate Strategy A firm‘s strategy establishes an effective and efficient

match between its competences and opportunities and environmental risks. It

provides a mechanism integrating the goals of its multiple consistencies.

Financial Policy In practice, financial policy of a company is closely linked

with its corporate strategy. Financial policies of the firms should be developed in

context of its corporate strategy. Within the overall framework of the firm‘s

strategy, there should be consistency between financial policies—investment,

debt and dividend. For example, a firm can sustain a high-growth strategy only

when its investment projects generate high profits and it follows a policy of low

payout and high debt.

Economic Profit Growth should lead to the enhancement of the shareholder

value. This will happen when the firm is economically profitable; that is, when

the firm‘s return on equity (ROE) is higher than its cost of equity (ke). Value is

created when ROE > ke; value is maintained when ROE = ke; and value id

destroyed when ROE < ke. Alternatively, ROCE can be compared with WACC.

Value is created when ROCE > WACC.

Economic Value Added The amount of EVA is the difference between aftertax

PBIT and the charges for capital employed or invested capital: EVA = PBIT (1 – T ) – WACC × CE

CHAPTER – XXXVI

Performance of Government Companies Like the private sector companies,

the government companies also aim at profitability and value creation. But they

focus much more on non-financial and social objectives A very few government

companies make profits and declare dividend. In 2002–03, 81 companies, out of

118 profit making companies paid about 36 percent of their net profits as

dividends.

Finance Function in Government Companies The organization of finance

function of the government companies is evolving over the years, and it has

become now a specialized function with a decentralized structure in case of

multi-divisional and multi-product companies. The scope of finance function in

the government companies is as extended as in the case of the private sector

companies. It includes the funds management, budgeting, cost control, assets

management and security etc.

Investment Decisions of Government Companies The basic principle of

value creation governs the investment decisions of the government companies.

But these companies also use economic return and the social impact criteria in

choosing projects. The authority for investment expenditure goes beyond the

management of the company. Government departments and ministries play

important role in authorizing investment expenditures beyond certain specified

limits. Most government companies are dependent on the government funding

for financing their expansion and growth. The government funding is available

either as equity or debt. Hence, the issue of capital structure is considered

redundant as the source of the debt and equity is the same, that is, the tax

payer‘s money allocated by the government.

Current Assets in Government Companies Government companies have

huge investment in current assets. Hence, working capital management

assumes for greater importance. A number of companies (e.g., BHEL, NTPC)

have well-established policies and practices of managing working capital.

However, a large number of companies have inadequate working capital

management. The Boards of the companies hardly discuss the working capital

management issues and lay down policies and procedures.

Financial Controls in Government Companies are more stringent then in

the private sector companies. They are subjected to internal audit, statutory

audit and audit by controller and Auditor General. An additional feature of

performance evaluation and control in government companies is Memorandum

of Understanding (MoU). Performance budgeting and zero-base-budgeting (ZBB)

are special budgeting control tools used by government companies.

Memorandum of Understanding (MoU) is a performance contract between

the government and the company management. It specifies the performance

targets as well as explicitly states the autonomy and accountability of

management in meeting financial and non-financial objectives and targets. The

emphasis is only reducing the close control of the government and the day-to-day

interference in the management of companies.

Performance Budgeting is a flexible system of aligning organizational

mission, goals and objectives with budgeted funds and expected results. It takes

a comprehensive, policy oriented approach, rather than a short term mechanical

approach of preparing budgets.

Programme Budgeting Performance budgeting may be extended to each

specific programmes, and it is referred to Programme budgeting.

Zero-base budgeting is based on the notion that each activity or Programme

and its funding must be justified each time afresh.

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