Unit IV Financing And Dividend Decisions

• Introduction

• Cost of Capital – Meaning, Definition

• Basic assumptions of Cost of Capital

• Importance of Cost of Capital

• Classification of Cost of Capital

* Explicit cost and Implicit cost

* Future and Historical cost

* Specific cost and Combined cost

* Average cost and Marginal cost

• Factors affecting the cost of capital

Cost of Capital

• Cost of specific cost of capital* Cost of Debt Capital * Cost of Preference Capital* Cost of Equity share capital

* Dividend yield method* Dividend yield plus growth in dividend

method* Earning yield method and

* Realized yield method, etc• * Cost of retained earnings• * Weighted average cost of capital (WACC)

Capital Structure

• Capital structure is defined as the composition of all the securities the firm or hospital issues in order to finance its operations. These securities differ in various respects, with equity and debt as the underlying securities and incorporating several innovative instrument features such as – Leverage, Maturity, Fixed Vs Variable payments, Seniority, Currency, control, contingencies etc.

• Essential features of a sound Capital mix.

• Factors Influencing Capital Structure/Determinants of the Capital Structure

Capital Structure Theories

• Based on several diverse view points which underlines the role of capital structure on the wealth maximization of the share holders, there evolved four major theories/approaches which explain the relationship between capital structure, cost of capital and the value of the firm or hospital. They are –

• Net income ( NI) Approach,• Net Operating Income (NOI) Approach,• MM Approach and • Traditional Approach.

• Assumptions of the various capital structure theories • Basic equations in calculation of Cost of Capital

Net Income (NI) Approach • Concept: According to this approach the average cost of

capital (ko) declines as gearing increases. The cost of shareholders funds (ks) and the cost of debt (kd) are independent. Since kd is usually less than ks as debt is less risky than equity from the investor’s point of view, an increase in gearing should lead to a decrease in ko.

• Assumptions of NI approach

• Formula for calculating the value of a firm = V = S + B, Where,

V= Value of Firm or hospital

S= Market Value of Equity

B=Market Value of Debt

Net Operating Income (NOI) Approach • Concept: According to this approach, the market value of the

firm or hospital is not at all affected by changes in its capital structure. The market value of the firm or hospital is ascertained by capitalizing the net operating income at the overall cost of capital (Ko), which is considered to be constant. The market value of equity is ascertained by deducting the market value of the debt from the market value of the firm or hospital.

• Assumptions of NOI Approach

• Formula for calculating the value of a firm =V= EBIT

Where, Ko

V= Value of firm or hospital

Ko= Overall cost of capital

EBIT= Earnings before interest and tax

Concept of Optimum Capital Structure

• According to the Net Operating Income (NOI) Approach, the total value of the firm or hospital remains constant irrespective of the debt-equity mix or the degree of leverage. The market price of equity shares will not change on account of change in debt-equity mix. Hence, optimum capital structure doesn’t exist at all. Any Capital structure will be optimum according to this approach.

• In those cases where corporate taxes are presumed, theoretically there will be optimum capital structure when there is 100% debt. This is because with every increase in debt content ‘Ko’ declines and the value of the firm goes up. However, due to legal and other provisions, there has to be a minimum equity. This means that optimum capital structure will be at a level where there can be maximum possible debt content in the capital structure.

Modigliani – Miller Approach (MM Approach)

• According to this approach, the value of a firm or hospital is independent of its capital structure. The NOI approach is purely definitional or conceptual. MM approach maintains that the average cost of capital does not change with change in the debt weighed equity mix or capital structure of the firm or hospital. It also gives operational justification for this and not merely states only a proposition.

• Basic Propositions• Assumptions• Arbitrage process• Limitations of MM Hypothesis• Impact of taxes on MM Hypothesis

Traditional Approach

• Concept: The essence of the Traditional Approach lies in the fact that a firm or hospital, through judicious use of debt-equity mix can increase their total value and thereby reduce their overall cost of capital. This is because debt is relatively a cheaper source of funds as compared to issue of shares because of tax shield available on interest on debt. However, beyond a point, raising of funds through debt also may involve financial risk and might result in a higher equity capitalization rate. Thus, up to a point, the debt content in the capital structure will favorably affect the value of a firm or hospital. Beyond that point, use of debt will adversely affect the value of a firm or hospital. At this point of debt-equity mix, the capital structure will be at its optimum and the average or the composite cost of capital will be the least.

Capital Structure

• Features of an appropriate Capital Structure

• Leverages

• Operating Leverage – OL and Degree of Operating Leverage

• Financial Leverage – FL and Degree of Financial Leverage, and

• Combined leverages

• Indifference point

• EBIT – EPS Analysis

• Financial Break Even Point

• Pecking Order Theory

Dividend Policy

• Meaning, concept of Dividend

• Forms of Dividend – Cash dividend, Stock dividend, Stock split, Reverse split, Stock repurchase etc

• Types of Dividend Policies – Regular dividend policy, Stable dividend policy, Irregular dividend policy, no dividend policy

• Determinants of Dividend policies – Legal restrictions, Magnitude and trend of earnings, Desire and size of shareholders, Nature of industry, Age of company or hospital, Govt. policy, future financial requirements, Taxation policy, Inflation, Control aspects, Requirements of Institutional investors, Stability of dividends, Liquid resources etc.

The Indian Money Market

• Money market is a market for financial assets which are close substitutes for money. It is an overnight market for procuring short-term funds and instruments having a maturity period of one or less than one year. It does not refer to a physical location, but refers to an activity that is conducted over telephone. Money market constitutes a very important segment of the Indian financial system.

• Features of Indian Money Market• Functions of Money Market• Benefits of an efficient Money Market• Money Market Instruments ( TBs, CDs, CP, Call Money, CBs,

CBLO etc)

The Indian Capital Market

• The Indian Capital Market is an important constituent of the Indian Financial System. It is a market for long term funds – both equity and debt raised within and outside the country.

• The Capital Market aids economic growth by mobilizing the savings of the economic sectors and directing them towards channels of productive use.

• Functions of Capital Market

• Structural Framework of Indian Capital Market

• Primary Capital Market and Secondary Capital Market

Various sources of Finance for Hospitals

• The Corporate Sector (including hospitals) draws its capital needs from the following sources:

– Promoters Contribution,

– Equity & Preference Capital raised from the shareholders (generally referred to as equity capital),

– Bonds/Debentures raised from the Public (generally referred to as Debt Capital),

– Term Loans from Banks & Financial Institutions,

– Short-term Working Capital from Banks,

– Unsecured Loans & Deposits, and

– Internal generation of Funds (Profits/surpluses re-ploughed).

Methods of floating securities in the market

• Corporate may raise capital in the primary market by way of an initial public offer(IPO), rights issue or private placement. An IPO is the selling of securities to the public in the primary market. This Initial Public Offering can be made through the fixed price method, book building method or a combination of both.

• The methods by which new issues are made are – (i) Public issue through prospectus(ii) Tender/Book building(iii) Offer for sale(iv) Private placement and (v) Rights issue.

Raising Foreign funds

• Apart from raising funds from domestic primary market or secondary market, a firm or a hospital can raise funds from international markets also. Indian companies or hospitals have raised resources from international capital markets through –

• Global Depository Receipts (GDRs)

• American Depository Receipts (ADRs)

• Foreign Currency Convertible Bonds (FCCBs) and

• External Commercial Borrowings (ECBs).

Debt finance through term loans

• A term loan is a loan made by a bank / financial institution to a business having an initial maturity of more than 1 year. The primary source of this mode of finance is financial institutions. Term loans or project finance is provided by financial institutions for new projects and also for expansion / diversification and modernization whereas the bulk of term loans extended by banks are in the form of working capital term loan to finance the working capital gap. Though they are permitted to finance infrastructure projects on a long-term basis, the quantum of such financing is only marginal.

Loan financing

• A firm or hospital may meet its financial requirements by taking both short-term loans or credits and long term loans.

• The short term loans or credits are obtained for working

capital requirements. Some of the popular sources of short term loans or credits are – trade credit, loans from commercial banks in the form of loans, cash credits, hypothecation, pledge, overdrafts, bills discounted and purchased, public deposits, loans from finance companies in the form of leasing and hire purchasing, merchant banking, equity research and investment counseling, accrual accounts, loans from indigenous bankers, advances from customers and other miscellaneous sources.

Foreign Currency Loan Guidelines

• A foreign currency loan is a loan denominated in a currency other than that of the borrower’s home country that must be repaid also in this currency. The majority of foreign currency loans are granted with a maturity of up to 25 years, but are rolled over every three or six months. The interest rate is linked to the London Inter bank Offered Rate (LIBOR) of the relevant currency. The bank charges an additional 1.5% to 2%, depending on the size of the loan, the nature of customer relations, the collateral provided, etc.2) Interest (and principal) payments are due retroactively upon maturity and have to be made in the currency in which the loan is denominated. In many cases, the borrower may repay the loan before it is due or switch to another currency (including euro) at the rollover dates.

SEBI and government guidelines

• In 1988 the Securities and Exchange Board of India (SEBI) was established by the Government of India through an executive resolution, and was subsequently upgraded as a fully autonomous body (a statutory Board) in the year 1992 with the passing of the Securities and Exchange Board of India Act (SEBI Act) on 30th January 1992. In place of Government Control, a statutory and autonomous regulatory board with defined responsibilities, to cover both development & regulation of the market, and independent powers has been set up. Paradoxically this is a positive outcome of the Securities Scam of 1990-91.

SEBI and government guidelines

• In 1988 the Securities and Exchange Board of India (SEBI) was established by the Government of India through an executive resolution, and was subsequently upgraded as a fully autonomous body (a statutory Board) in the year 1992 with the passing of the Securities and Exchange Board of India Act (SEBI Act) on 30th January 1992. In place of Government Control, a statutory and autonomous regulatory board with defined responsibilities, to cover both development & regulation of the market, and independent powers has been set up. Paradoxically this is a positive outcome of the Securities Scam of 1990-91.

SEBI

• Basic objectives 0f SEBI

• Functions of SEBI

• SEBI in India’s Capital Market

• Recent amendments of SEBI

• RBI – Functions of RBI

• FIPB