Unit 3 Financial Management & Corporate Finance

Unit 3
MBA/BBA/B.com /UGC Net
By
Dr. Anand Vyas
Financial Decision: Capital Structure
capital structure of a company refers to the composition or make up of its capitalization and it includes
all long term capital resources viz., loans, reserves, shares and bonds’
i) Value Maximization
Capital structure maximizes the market value of a firm, i.e. in a firm having a properly designed capital
structure the aggregate value of the claims and ownership interests of the shareholders are maximized.
(ii) Cost Minimization

Capital structure minimizes the firm’s cost of capital or cost of financing. By determining a proper mix of
fund sources, a firm can keep the overall cost of capital to the lowest.
(iii) Increase in Share Price

Capital structure maximizes the company’s market price of share by increasing earnings per share of the
ordinary shareholders. It also increases dividend receipt of the shareholders.
(iv) Investment Opportunity

Capital structure increases the ability of the company to find new wealth- creating investment
opportunities. With proper capital gearing it also increases the confidence of suppliers of debt.
(v) Growth of the Country

Capital structure increases the country’s rate of investment and growth by increasing the firm’s
opportunity to engage in future wealth-creating investments.
Relevance and Irrelevancy theory
• Dividend is that portion of net profits which is distributed
among the shareholders. The dividend decision of the firm
is of crucial importance for the finance manager since it
determines the amount to be distributed among
shareholders and the amount of profit to be retained in the
business. Retained earnings are very important for the
growth of the firm. Shareholders may also expect the
company to pay more dividends. So both the growth of
company and higher dividend distribution are in conflict. So
the dividend decision has to be taken in the light of wealth
maximization objective. This requires a very good balance
between dividends and retention of earnings.
• Relevant Theory
• If the choice of the dividend policy affects the
value of a firm, it is considered as relevant. In
that case a change in the dividend payout
ratio will be followed by a change in the
market value of the firm. If the dividend is
relevant, there must be an optimum payout
ratio. Optimum payout ratio is that ratio which
gives highest market value per share.
Walter’s Model (Relevant Theory)
Prof. James E Walter argues that the choice of dividend payout ratio
almost always affects the value of the firm. Prof. J. E. Walter has very
scholarly studied the significance of the relationship between internal
rate of return (R) and cost of capital (K) in determining optimum
dividend policy which maximizes the wealth of shareholders.
Walter’s model is based on the following assumptions:
(i) The firm finances its entire investments by means of retained
earnings only.
(ii) Internal rate of return (R) and cost of capital (K) of the firm remains
constant.
(iii) The firms’ earnings are either distributed as dividends or
reinvested internally.
(iv) The earnings and dividends of the firm will never change.
(v) The firm has a very long or infinite life.
• Modigliani-Miller Model
• (Irrelevance Theory)
• According to MM, the dividend policy of a firm is
irrelevant, as it does not affect the wealth of
shareholders. The model which is based on certain
assumptions, sidelined the importance of the
dividend policy and its effect thereof on the share
price of the firm. According to the theory the value
of a firm depends solely on its earnings power
resulting from the investment policy and not
influenced by the manner in which its earnings are
split between dividends and retained earnings.
Leverage analysis – financial, operating and
combined leverage
• Financial Leverage is the degree to which a
company uses fixed-income securities such as
debt and preferred equity. The more debt
financing a company uses, the higher its
financial leverage. A high degree of financial
leverage means high interest payments, which
negatively affect the company’s bottom-line
earnings per share.
Operating leverage
• Operating leverage is defined as the ratio of fixed costs to variable
costs incurred by a company in a specific period. If the fixed costs
exceed the amount of variable costs, a company is considered to
have high operating leverage. Such a firm is sensitive to changes in
sales volume and the volatility may affect the firm’s EBIT and
returns on invested capital.
• High operating leverage is common in capital-intensive firms such
as manufacturing firms since they require a huge number of
machines to manufacture their products. Regardless of whether the
company makes sales or not, the company needs to pay fixed costs
such as depreciation on equipment, overhead on manufacturing
plants, and maintenance costs.
• Share this:
Combined Leverage
• Degree of Combined Leverage = %Change in EPS /
%Change in Sales.
• Degree of Combined Leverage = Degree of Operating
Leverage * Degree of Financial Leverage.
• Combined Leverage is the combination of the two
leverages. While operating leverage delineates the
effect of change in sales on the company's operating
earning, financial leverage reflects the change in EBIT
on EPS level.26
EBIT EPS Analysis
• The EBIT-EBT analysis is the method that studies the
leverage, i.e. comparing alternative methods of financing at
different levels of EBIT. Simply put, EBIT-EPS analysis
examines the effect of financial leverage on the EPS with
varying levels of EBIT or under alternative financial plans.
• It examines the effect of financial leverage on the behavior

of EPS under different financing alternatives and with vary-
ing levels of EBIT. EBIT-EPS analysis is used for making the
choice of the combination and of the various sources. It
helps select the alternative that yields the highest EPS.
Point of Indifference
• Another important tool that managers use to help them choose between
alternative cost structures is the indifference point. The indifference point
is the level of volume at which total costs, and hence profits, are the same
under both cost structures. If the company operated at that level of
volume, the alternative used would not matter because income would be
the same either way. At the cost indifference point, total costs (fixed cost
and variable cost) associated with the two alternatives are equal.
• Cost indifference point can be calculated as follows-
• Cost Indifference Point = Differential fixed cost/Differential variable cost

per unit

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Unit 3

MBA/BBA/B.com /UGC Net

(ii) Cost Minimization

(iii) Increase in Share Price

(iv) Investment Opportunity

(v) Growth of the Country

• It examines the effect of financial leverage on the behavior

• Cost indifference point can be calculated as follows-

• Cost Indifference Point = Differential fixed cost/Differential variable cost

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