FINANCIAL MANAGEMENT

MODULE – 1
NATURE & SCOPE OF FINANCIAL MANAGEMENT

Financial Management means planning, organizing, directing and controlling the financial
activities such as procurement and utilization of funds of the enterprise. It means applying
general management principles to financial resources of the enterprise.
Objectives of Financial Management

 To ensure regular and adequate supply of funds to the concern.

 To ensure adequate returns to the shareholders which will depend upon the earning
capacity, market price of the share, expectations of the shareholders.
 To ensure optimum funds utilization. Once the funds are procured, they should be
utilized in maximum possible way at least cost.
 To ensure safety on investment, i.e, funds should be invested in safe ventures so
that adequate rate of return can be achieved.
 To plan a sound capital structure-There should be sound and fair composition of
capital so that a balance is maintained between debt and equity capital.
Nature of financial management
The nature of financial management includes the following −
1. Estimates capital requirements: Financial management helps in anticipation of
funds by estimating working capital and fixed capital requirements for carrying
business activities.
2. Decides capital structure: Proper balance between debt and equity should be
attained, which minimizes the cost of capital.
3. Financial management decides proper portion of different securities (common
equity, preferred equity and debt).
4. Select source of fun: Source of fund is one crucial decision in every organization.
Every organization should properly analyze various source of funds (shares, bonds,
debentures etc.) and must select appropriate funds which involves minimal risk.
5. Selects investment pattern: Before investing the amount, the investment proposal
should be analyzed and properly evaluates its risk and returns.
6. Raises shareholders value: It aims to increase the amount of return to its
shareholders by decreasing its cost of operations and increase in profit. Finance
manager should focus on raising the funds from different sources and invest them in
profitable avenues.
7. Management of cash: Finance manager observes all cash movements (inflow and
outflow) and ensures they should face any deficiency or surplus of cash.
8. Apply financial controls: Implying financial controls helps in keeping the company
actual cost of operation within limits and earning the expected profits. There
different approaches involved like developing certain standards for business in
 advance, comparing the actual cost or performances with pre-established standards
and taking all require remedial measures.
Scope of financial management

1. Investment decision: Investment decision depicts investing in a fixed asset; it is also

referred to as capital budgeting. Investment decisions can be of either long-term or
short-term basis.
Long-term investment decisions allow committing funds towards resources like fixed
assets. Long-term investment decisions determine the performance of a business
and its ability to achieve financial goals over time.
Short-term investment decisions or working capital financing decisions mean
committing funds towards resources like current assets. It occupies funds for a
shorter period, including investments in inventory, liquid cash, etc. Short-term
investment decisions directly affect the liquidity and performance of an organization.

2. Financing decision: This scope of financial management indicates the possible

sources of raising finances from various resources. They are of 2 different types –
Financial planning decisions attempt to estimate the sources and possible
application of accumulated funds. A proper financial planning decision is crucial to
ensure the availability of funds whenever required.
3. Dividend decision: It involves decisions taken with regards to net profit distribution.
It is divided into two categories –Dividend for the shareholders.
Retained profits (usually depends on a particular company’s expansion and
diversification plans).
4. Working capital decision: it is concerned with investment in current asset and
current liabilities.
5. Ensures Liquidity
6. Profit Management

Corporate management works as a team to lead and direct the company's work toward the
executive-level goals. Managers are expected to understand the strategic goals of the
company and then work to allocate company resources to obtain those objectives.
The primary objective of the corporate management team is to maximize shareholder
wealth. The company's board of directors and the shareholders evaluate and review
managerial actions based on the growth in the value of the firm.
Primary objectives
1. Maximization of EBIT
 EBIT is an indicator of a company’s profitability. It is a company's net income before
income tax expense and interest expenses are deducted.
 EBIT is used to analyze the performance of a company's core operations without the
costs of the capital structure and tax expenses impacting profit.
 EBIT is also known as operating income since They both exclude interest expenses and
taxes from their calculations. However, there are cases when operating income can
differ from EBIT.
Formula and Calculation for EBIT
EBIT = Revenue − COGS − Operating Expenses
Or
 EBIT = Net Income + Interest + Taxes
Where :
COGS = Cost of goods sold

2. Maximization of Economic Value Added (EVA)

 Economic value added (EVA), also known as economic profit, aims to calculate the true
economic profit of a company.
 EVA is used to measure the value a company generates from funds invested in it.
 However, EVA relies heavily on invested capital and is best used for asset-rich
companies, where companies with intangible assets, such as technology businesses,
may not be good candidates.
The formula for calculating EVA is:
EVA = NOPAT - (Invested Capital * WACC)
Where:
NOPAT = Net operating profit after taxes
Invested capital = Debt + capital leases + shareholders' equity
WACC = Weighted average cost of capital
3. Maximization of Market Capitalization
4. Desired growth rate in EPS
Earnings Per Share (EPS)
 Earnings per share (EPS) is a company's net profit divided by the number of
common shares it has outstanding.
 EPS indicates how much money a company makes for each share of its stock
and is a widely used metric for estimating corporate value.
 A higher EPS indicates greater value because investors will pay more for a
company's shares if they think the company has higher profits relative to its
share price.
 EPS can be arrived at in several forms, such as excluding extraordinary items
or discontinued operations, or on a diluted basis.
 EPS = Net income available to shareholders by weighted average number of
shares outstanding.
Agency Problem
 An agency problem is a conflict of interest inherent in any relationship where one
party is expected to act in another's best interests.
 In corporate finance, an agency problem usually refers to a conflict of interest
between a company's management and the company's stockholders.
 The manager, acting as the agent for the shareholders, or principals, is supposed to
make decisions that will maximize shareholder wealth even though it is in the
manager’s best interest to maximize their own wealth.
 A principal-agent problem arises when there is a conflict of interest between the
agent and the principal, which typically occurs when the agent acts solely in his/her
own interests. In a principal-agent relationship, the principal is the party that legally
appoints the agent to make decisions and take actions on its behalf.
The main reasons for the principal-agent problem are conflicts of interests between two
parties and the asymmetric information between them (agents tend to possess more
information than principals).
The principal-agent problem generally results in agency costs that the principal should bear.
Because agents can act in their interests at the principals’ expense, the principal-agent
problem is an example of a moral hazard.
Examples of Principal-Agent Problem
The following cases are among the most common examples of the principal-agent problem:
 Shareholders (principal) vs. management (agent)
 Voters (principal) vs. politicians (agent)
 Financial institutions (principal) vs. rating agencies (agent)
Solutions to the Problem
Contract design- The main purpose of contract design is the creation of a contract framework
between the principal and the agent to address issues of information asymmetry, stimulate
the agent’s incentives to act in the best interests of the principal, and to determine
procedures for monitoring agents.
Performance evaluation and compensation- The agent’s compensation is the primary
method of aligning the interests of both parties. In order to address the principal-agent
problem, the compensation must be linked to the performance of the agent.
The performance of the agent is usually measured by subjective evaluation because it is a
more flexible and balanced assessment method for complex jobs. Common methods of agent
compensation include stock options, profit-sharing, and deferred compensation. Tying the
agent’s compensation closely to the benefits obtained for the principal helps to eliminate
conflicts of interest.

Organization of the finance function

In many organizations one can note different layers among the finance executives such as
Assistant Manager (Finance), Deputy Manager (Finance) and General Manager (Finance). The
designations given to the executives are different. They are
 Chief Finance Officer (CFO)
 Vice-President (Finance)
 Financial Controller
 General Manager (Finance)
  Finance Officers
Finance, being an important portfolio, the finance functions is entrusted to top management.
The Board of Directors, who are at the helm of affairs, normally constitutes a ‘Finance
Committee’ to review and formulate financial policies. Two more officers, namely ‘treasurer’
and ‘controller’ – may be appointed under the direct supervision of CFO to assist him/her. In
larger companies with modern management, there may be Vice-President or Director of
finance, usually with both controller and treasurer.

FINANCE MANAGER is a person who is responsible for taking care of all the essential financial
functions of an organization. Nowadays, Finance managers spend less time producing
financial reports and prefer to invest more time in conducting data analysis, planning and
strategizing or advising senior managers or top executives

RESPONSIBILITIES OF FINANCE MANAGERS

 Raising of Funds
 Allocation of Funds
 Profit Planning
 Understanding Capital Markets

ROLE OF A FINANCE MANAGER

 They analyze market trends to find opportunities for expansion or for acquiring
companies.
 They have to do some tasks that are specific to their organization or industry.
 They manage company credit.
 Make some dividend pay-out decisions.
 Keep in touch with the stock market if the company is listed.
 Appreciate the financial performance concerning return investments.
 They maximize the wealth for company shareholders.
 To handle financial negotiations with banks and financial institutions.
 MODULE 2
WORKING CAPITAL MANAGEMENT
WORKING CAPITAL:
 Working capital, also called net working capital (NWC), represents the difference
between a company’s current assets and current liabilities.
 NWC is a measure of a company’s liquidity and short-term financial health.
 Positive NWC indicates that a company can fund its current operations and invest in
future activities and growth.
 High NWC isn’t always a good thing. It might indicate that the business has too much
inventory or is not investing its excess cash.
 WC = CURRENT ASSETS – CURRENT LIABILITIES

WORKING CAPITAL MANAGEMENT

 Working capital management requires monitoring a company's assets and liabilities
to maintain sufficient cash flow to meet its short-term operating costs and short-term
debt obligations.
 Working capital management involves tracking various ratios including the working
capital ratio, the collection ratio, and the inventory ratio.
 Working capital management can improve a company's cash flow management and
earnings quality through efficient use of its resources.
CONCEPTS OF WORKING CAPITAL
1. Gross Working Capital: It is also called simply ‘working capital’. It refers to the total of
all the current assets of the firm. Current assets are the assets which are meant to be
converted into cash within a year or an operating cycle. Stock of raw materials, stock
of semi-finished goods, stock of finished goods, trade debtors, bills receivable, prepaid
expenses, cash at bank and cash in hand are examples of current assets.
2. Net Working Capital: For financing current assets, long-term funds as well as short
term funds are used. Short-term funds are provided by current liabilities i.e. claims of
outsiders which are expected to mature for payment within a year. Trade creditors,
bills payable and outstanding expenses are examples of current liabilities. Net working
capital refers to the excess of current assets over current liabilities.

FACTORS AFFECTING COMPOSITION OF WORKING CAPITAL

1. Nature of Business: The requirement of working capital depends on the nature of

business. The nature of business is usually of two types: Manufacturing Business and
Trading Business. In the case of manufacturing business it takes a lot of time in
converting raw material into finished goods. Therefore, capital remains invested for a
long time in raw material, semi-finished goods and the stocking of the finished goods.
Consequently, more working capital is required. On the contrary, in case of trading
business the goods are sold immediately after purchasing or sometimes the sale is
affected even before the purchase itself. Therefore, very little working capital is
required. Moreover, in case of service businesses, the working capital is almost nil
since there is nothing in stock.
2. Scale of Operations: There is a direct link between the working capital and the scale
of operations. In other words, more working capital is required in case of big
organizations while less working capital is needed in case of small organizations.

3. Business Cycle: The need for the working capital is affected by various stages of the
business cycle. During the boom period, the demand of a product increases and sales
also increase. Therefore, more working capital is needed. On the contrary, during the
period of depression, the demand declines and it affects both the production and sales
of goods. Therefore, in such a situation less working capital is required.

4. Seasonal Factors: Some goods are demanded throughout the year while others have
seasonal demand. Goods which have uniform demand the whole year their
production and sale are continuous. Consequently, such enterprises need little
working capital.
On the other hand, some goods have seasonal demand but the same are produced
almost the whole year so that their supply is available readily when demanded.
Such enterprises have to maintain large stocks of raw material and finished products
and so they need large amount of working capital for this purpose. Woolen mills are a
good example of it.

5. Production Cycle: Production cycle means the time involved in converting raw
material into finished product. The longer this period, the more will be the time for
which the capital remains blocked in raw material and semi-manufactured products.
Thus, more working capital will be needed. On the contrary, where period of
production cycle is little, less working capital will be needed.

6. Credit Allowed: Those enterprises which sell goods on cash payment basis need little
working capital but those who provide credit facilities to the customers need more
working capital.

7. Credit Availed: If raw material and other inputs are easily available on credit, less
working capital is needed. On the contrary, if these things are not available on credit
then to make cash payment quickly large amount of working capital will be needed.

8. Operating Efficiency: Operating efficiency means efficiently completing the various

business operations. Operating efficiency of every organization happens to be
different.
Some such examples are: (i) converting raw material into finished goods at the
earliest, (ii) selling the finished goods quickly, and (iii) quickly getting payments from
the debtors. A company which has a better operating efficiency has to invest less in
stock and the debtors.
Therefore, it requires less working capital, while the case is different in respect of
companies with less operating efficiency.

9. Availability of Raw Material: Availability of raw material also influences the amount
of working capital. If the enterprise makes use of such raw material which is available
 easily throughout the year, then less working capital will be required, because there
will be no need to stock it in large quantity.
On the contrary, if the enterprise makes use of such raw material which is available
only in some particular months of the year whereas for continuous production it is
needed all the year round, then large quantity of it will be stocked. Under the
circumstances, more working capital will be required.

10. Growth Prospects: Growth means the development of the scale of business
operations (production, sales, etc.). The organizations which have sufficient
possibilities of growth require more working capital, while the case is different in
respect of companies with less growth prospects.

11. Level of Competition: High level of competition increases the need for more working
capital. In order to face competition, more stock is required for quick delivery and
credit facility for a long period has to be made available.

12. Inflation: Inflation means rise in prices. In such a situation more capital is required
than before in order to maintain the previous scale of production and sales. Therefore,
with the increasing rate of inflation, there is a corresponding increase in the working
capital.

Sources of short-term working capital-Trade credit, Instalment credit, Indigenous bank,

Advances, Factoring, Accrued expenses, commercial paper, commercial banks
Sources of long term, fixed, permanent working capital - Shares, debentures, public deposits,
ploughing back of profit, loans from financial institutions

Management of Cash
 Cash management is the process of managing cash inflows and outflows.
 There are many cash management considerations and solutions available in the
financial marketplace for both individuals and businesses.
 For businesses, the cash flow statement is a central component of cash flow
management.
 Cash management, also known as treasury management, is the process that involves
collecting and managing cash flows from the operating, investing, and financing
activities of a company. In business, it is a key aspect of an organization’s financial
stability.

Causes of Problems with Cash Management

1. Poor understanding of the cash flow cycle: Business management should clearly
understand the timing of cash inflows and outflows from the entity, such as when to
pay for accounts payable and purchase inventory. During rapid growth, a company can
end up running out of money because of over-purchasing inventory, yet not receiving
payment for it.
2. Lack of understanding of profit versus cash: A company can generate profits on its
income statement and be burning cash on the cash flow statement. When a company
generates revenue, it does not necessarily mean it already received cash payment for
 that revenue. So, a very fast-growing business that requires a lot of inventory may be
generating lots of revenue but not receiving positive cash flows on it.
3. Lack of cash management skills: It is crucial for managers to acquire the necessary
skills despite the understanding of the abovementioned issues. The skills involve the
ability to optimize and manage the working capital. It can include discipline and
putting the proper frameworks in place to ensure the receivables are collected on time
and that payables are not paid more quickly than is needed.
4. Bad capital investments: A company may allocate capital to projects that ultimately
do not generate sufficient return on investment or sufficient cash flows to justify the
investments. If such is the case, the investments will be a net drain on the cash flow
statement, and eventually, on the company’s cash balance.
Advantages-
 High productivity
 Help to improve credit worthiness, goodwill
 New business opportunities
 Create confidence on investors.
 It allows in speeding up the working capital cycle.
 It helps in rewarding such debtors that make quicker payments.
 It speeds up the operations of an organization.

Functions of cash management

 Cash planning and Control- Thus, cash planning is a technique to plan and control the
use of cash. This may be done on daily, weekly or monthly basis depending upon the
size of the firm and policies of management. Cash budget is the most significant tool
for cash planning and control.
Cash Budget: A firm should hold adequate cash balances but should avoid excessive
balances. The firms have therefore to assess its need for cash properly. “A cash budget
is a statement showing anticipated cash inflow, outflow and net cash balance for a
future period of time”.
 Management of Cash Inflows and Outflows
 Determination of Optimum Level of Cash- A business firm maintains the optimum cash
balance for transaction and precautionary motives.
 Optimum investment of surplus cash- Cash kept by the firm in excess of its normal
need is called the surplus cash. Due to changing working capital needs or
unpredictable requirements the finance manager is required to consider the minimum
cash balance that the firm should keep to avoid the cost of running out of funds. This
minimum level may be termed as ‘Safety level of Cash’.

Cash flow/cash forecasting

It is the process of estimating the flow of cash in and out of a business over a specific period
of time. An accurate cash flow forecast helps companies predict future cash positions, avoid
crippling cash shortages, and earn returns on any cash surpluses they may have in the most
efficient manner possible
It can be grouped as
1. Short term cash forecast
It is normally covered a period of 12 months. It can be further classified as
 a. Receipt and payment method (cash budget method)
Under this method, cash budget is prepared in columnar basis. There are two
parts. First part is receipts and second part is payments. The total receipts are
added with opening balance of cash and deducted the payments to get closing
balance of cash. If receipts are more than payments, there is a surplus of cash at
the end of the month and vice versa
b. Cash flow statement method
The cash flow statement is the least important financial statement but is also the
most transparent.
The cash flow statement is broken down into three categories
 Cash flow from operating activities: This category records a company's
operating cash movement, the net of which is where operating cash flow
is derived.
 Cash flow from investing activities: This category records changes in cash
from the purchase or sale of property, plants, equipment (PP&E), or long-
term investments.
 Cash flow from financing activities: This category reports cash level
changes from the purchase of a company’s own stock or issue of bonds and
payments of interest and dividends to shareholders
Cash flow is calculated using the direct (drawing on income statement data using
cash receipts and disbursements from operating activities) or the indirect method
(starts with net income, converting it to operating cash flow).
2. Long term Cash forecast
All the forecast beyond one year comes under this head
a. Fund flow statement analysis
and outflow of funds i.e. Sources and Applications of funds for a particular period.
In other words, a Funds Flow Statement is prepared to explain the changes in the
Working Capital Position of a Company. Funds Flow Statement is a statement
prepared to analyses the reasons for changes in the Financial Position of a
Company between two Balance Sheets. For preparing the Funds Flow Statement,
the first step is to prepare the Statement of Changes in Working Capital then the
fund from operation statement finally, Preparation of Funds Flow Statement or
Sources and Applications of Funds Statement
b. Balance sheet forecast method
A balance sheet forecast is a projection of assets, liabilities, and equity at a future
point in time. It is used to approximate what a business anticipates on owning in
the future and also what it expects to owe. Since the balance sheet represents a
business’s financial position at a certain point in time, it stands to reason that the
balance sheet forecast is an attempt to predict what the financial position of a
business will be in the future under a given set of circumstances.

Marketable Securities
 Marketable securities are assets that can be liquidated to cash quickly.
 These short-term liquid securities can be bought or sold on a public stock exchange or
a public bond exchange.
 These securities tend to mature in a year or less and can be either debt or equity.
  Marketable securities include common stock, Treasury bills, and money market
instruments, among others.
 Marketable securities are defined as any unrestricted financial instrument that can be
bought or sold on a public stock exchange or a public bond exchange. Therefore,
marketable securities are classified as either marketable equity security or
marketable debt security.
Marketable debt securities are government bonds and corporate bonds. One can trade these
on the public exchange and their market price is also readily available.
Marketable equity securities are common stock and most preferred stock as well. One can
also easily trade them on the public exchanges and their market price information is easily
available.
There is also a third type of marketable securities classified further into three categories –
money market instruments, derivatives, and indirect investments. Indirect investments
include money put into hedge funds and unit trusts. Derivatives are the investments that are
dependent on another security for their value, like futures, options, and warrants. Money
market securities are short-term bonds, like Treasury bills (T-bills), banker’s acceptances and
commercial paper. Big financial entities purchase these in massive quantities.

Features of Marketable securities

 These are highly liquid, meaning one can easily buy and sell these securities.
 Are easily transferable on a stock exchange or otherwise.
 Offer a lower rate of return.
 These are highly marketable as there are active marketplaces where they can be
bought or sold.

Receivables Management
 Receivable is defined as ‘debt owed to the firm by customers arising from sale of goods
or services in the ordinary course of business.’
 A firm requires to allow credit to its customers for expansion of sales. Receivables
contribute a significance portion of current assets.
 When we sell any services, products or solutions to our clients or customers, they owe
us the money, collecting that money is called receivables management.

Objectives of Receivables Management

 Maximizing value of the firm
 Optimum investment in debtors
 Initiate collection procedure on overdue accounts

Benefits of Receivables Management

 Increase in market share
 Better cash flow
 Lower working capital requirements
 Lowered interest cost
 Better bargaining with sellers
 Increased sales
 Increase in profits
INVENTORY MANAGEMENT
 Inventory management is the entire process of managing inventories from raw
materials to finished products.
 Inventory management tries to efficiently streamline inventories to avoid both gluts
and shortages.
 Two major methods for inventory management are just-in-time (JIT) and materials
requirement planning (MRP).

Inventory Management Methods

1. Just-in-Time Management (JIT): This manufacturing model originated in Japan in the
1960s and 1970s. Toyota Motor (TM) contributed the most to its development.1 the
method allows companies to save significant amounts of money and reduce waste
by keeping only the inventory they need to produce and sell products. This approach
reduces storage and insurance costs, as well as the cost of liquidating or discarding
excess inventory. JIT inventory management can be risky. If demand unexpectedly
spikes, the manufacturer may not be able to source the inventory it needs to meet
that demand, damaging its reputation with customers and driving business toward
competitors. Even the smallest delays can be problematic; if a key input does not
arrive "just in time," a bottleneck can result.
2. Materials requirement planning (MRP): This inventory management method is
sales-forecast dependent, meaning that manufacturers must have accurate sales
records to enable accurate planning of inventory needs and to communicate those
needs with materials suppliers in a timely manner. For example, a ski manufacturer
using an MRP inventory system might ensure that materials such as plastic,
fiberglass, wood, and aluminum are in stock based on forecasted orders. Inability to
accurately forecast sales and plan inventory acquisitions results in a manufacturer's
inability to fulfill orders.
3. Economic Order Quantity (EOQ): This model is used in inventory management by
calculating the number of units a company should add to its inventory with each
batch order to reduce the total costs of its inventory while assuming constant
consumer demand. The costs of inventory in the model include holding and setup
costs. The EOQ model seeks to ensure that the right amount of inventory is ordered
per batch so a company does not have to make orders too frequently and there is
not an excess of inventory sitting on hand. It assumes that there is a trade-off
between inventory holding costs and inventory setup costs, and total inventory costs
are minimized when both setup costs and holding costs are minimized.
4. Days sales of inventory (DSI): is a financial ratio that indicates the average time in
days that a company takes to turn its inventory, including goods that are a work in
progress, into sales. DSI is also known as the average age of inventory, days
inventory outstanding (DIO), days in inventory (DII), days sales in inventory or days
inventory and is interpreted in multiple ways. Indicating the liquidity of the
inventory, the figure represents how many days a company’s current stock of
inventory will last. Generally, a lower DSI is preferred as it indicates a shorter
duration to clear off the inventory, though the average DSI varies from one industry
to another.
Objectives of inventory management
 Material Availability
 Better Level of Customer Service
 Keeping Wastage and Losses to a Minimum
 Maintaining Sufficient Stock
 Cost-Effective Storage
 Cost Value of Inventories Can Be Reduced
 Optimizing Product Sales.
Advantages:
 Delivery in time
 Possibility of discount on bulk purchase
 Efficiency handle unforeseen circumstances
 No idling of workers and machineries
Disadvantages
 Working capital tied up: can’t utilize the amount for other purposes nor it yield any
interest.
 More space required: more inventories more is the space needed and space accounts
for rent.
 Increased insurance charges
 Increased overhead expenses
 Chances of damages

FLOAT MANAGEMENT
Float management involves keeping a large number of shares available for trading. A large
float creates a significant level of liquidity, which means that investors can easily buy and sell
shares without any undue delays to find counterparties.

Float management activities:

 Issue more shares. When a company has the option of raising funds through a debt
or equity issuance, the finance staff favors obtaining a loan, since it is (usually) quicker
and less expensive to obtain than funds raised through a stock offering. However, if
the company has a small float, it could make quite a difference from a stock liquidity
perspective to obtain funds through selling stock, and then registering those shares as
soon as possible. Going to the trouble of issuing new shares may be less worthwhile if
the company already has a sufficient float.

 Register stock (company initiative). If a company has a large amount of unregistered

stock, consider having the company’s securities attorneys file with the SEC for a stock
registration. This will take a number of months to accomplish, as well as a significant
amount of legal fees, but can be worthwhile if the result is a large amount of registered
shares. Indeed, some shareholders may have required the company to register their
shares as part of a private placement of the company’s stock. Since these investors
are likely to sell their shares immediately following registration, it increases the
amount of readily available stock, and therefore the size of the float.
  Register stock (employee initiative). If employees hold unregistered stock and the
company has no plans to register the shares for them, then inform the employees of
their right under the SEC’s Rule 144 to have their shares automatically registered after
a six month holding period. This can include the recommendation of brokerages to
employees who can sell the shares for the employees once the holding period has
been completed. Selling these shares into the market can be a lengthy process.

 Only issue common stock. When a company issues a wide range of securities, only
some may be registered for trading. Alternatively, each type may be registered, but
the volume of securities of each class represents too small a float to create an active
market. Accordingly, consider simplifying the capital structure of the business, so that
it is only comprised of a large pool of common stock. At a minimum, keep an offer
open to the holders of all other types of securities to swap them for whatever number
of common shares appears appropriate, so that the common stock float gradually
increases over time.

 Minimize stock repurchases. When a company has an excess amount of cash, a

common use is to repurchase some of the outstanding stock. Doing so tends to prop
up the stock price, and also increases the earnings per share for the remaining shares.
However, a stock repurchasing initiative also reduces the float. This is a minor issue
when a company already has a large float. Nonetheless, if the amount of the
repurchase is expected to be large, or if the existing float is small, it may not be a good
idea to repurchase shares.

 Break up stock blocks. A company may have a large number of registered shares
outstanding and yet have a relatively small float, if some investors have accumulated
large positions in the company’s stock. These large holdings have effectively
withdrawn stock from circulation, leaving a vastly smaller effective float. It may be
worthwhile to contact these investors about selling off at least a portion of their
holdings, which may represent a substantial increase in the size of the available float.

 Conduct road shows. The company should regularly engage in non-deal road shows
to create interest among investors to own the company’s stock. From a float
perspective, road shows are particularly effective if the presentation team visits
entirely new geographic regions on regular basis, thereby accessing new pools of
potential investors.

Operating cycle: The time gap between purchase of inventory and converting the material
into cash.
Working capital Financing: working capital financing is used to fund company’s investment
in short-term assets such as accounts receivable and inventory and to provide liquidity so
that company can fund its day-to-day operations including payroll, overhead and other
expenses. There are many types of WC financing:
 Trade credit: This is simply the credit period which is extended by the creditor of the
business. Trade credit is extended based on the creditworthiness of the firm which is
reflected by its earning records, liquidity position, and records of payment.
 Cash credit or bank overdraft: cash credit or bank overdraft is the most useful and
appropriate type of working capital financing extensively used by all small and big
businesses. It is a facility offered by commercial banks where by the borrower is
sanctioned a particular amount which can be utilized for making his business
payments. The borrower has to make sure that he does not cross the sanctioned limit.
Without a doubt this is a cost-effective working capital financing.
 Working capital loans: WC loans are as good as term loan for a short period. These
loans may be repaid in installments or a lump sum at the end. The borrower should
take such loans or financing permanent WC needs the cost of interest would not allow
using such loans for temporary WC.
 Purchase or discount of bills: For a business it is another good service provided by
commercial banks for WC financing. Every firm generates bills in the normal course of
business while selling goods to debtors. Ultimately that bill acts as a document to
receive payment from the debtor. The seller who requires money will approach the
bank with that bill and bank will apply the discount on the total amount of the bill
based on the prevailing interest rates and pay the remaining amount to the seller. On
the date of maturity of that bill the bank approach the debtor and collect money from
him.
 Bank guarantee: it is primarily known as non-fund based WC financing. Bank
guarantee acquired by a buyer or seller to reduce the risk of loss to the opposite party
due to non-performance of the agreed task which may be repaying the money or
providing of some services etc.
 Letter of credit: it is also known as non-fund based WC financing. Letter of credit and
bank guarantee has a very thin line of difference. Bank guarantee is revoked and the
bank makes payment to the holder In case of non-performance of the opposite party
whereas in the case of a letter of credit the bank will pay the opposite party as soon
as the party performs as per agreed terms. So a buyer would buy a letter of credit and
sent it to the seller. Once the seller sends the goods as per the agreement the bank
would pay the seller and collects that money from the buyer.
 Factoring: factoring is an arrangement were by a business sells all over selected
accounts payables to a third party at a price lower than the realizable value of those
accounts. The third party here is known as the factor who provides factoring services
to business. The factor would not only provide financing by purchasing the accounts
but also collects the amount from the debtors.
 MODULE – 3
FINANCE & INVESTMENT DECISIONS

Time value of money

 The time value of money is a basic financial concept that holds that money in the
present is worth more than the same sum of money to be received in the future. This
is true because money that you have right now can be invested and earn a return, thus
creating a larger amount of money in the future
 Time value of money means that a sum of money is worth more now than the same
sum of money in the future. This is because money can grow only through investing.
An investment delayed is an opportunity lost.
 FV=PV×(1+i) ^n or PV= FV/(1+i) ^n
where:
FV=Future value
PV=Present value (original amount of money)
i=Interest rate per period
n=Number of periods

Techniques of Time Value of Money

A. Compounding Technique: Compounding future value at particular rate

1. Compounding single cash flow

2. Compounding series of unequal cash flows
3. Compounding series of equal cash flows or Annuity

1. Compounding single cash flows- (Invest only once in a time and calculate the future
value of cash flow)
A = P (1+r)n
A = Amount at the end of the period
P = Principal amount or base amount
R = Rate of interest or return
N = Number of years in which compounding is made
2. Compounding of series of unequal cash flows- Invest different amount at different
periods or consecutive years. For example: Invest in mutual funds
A=[P1(1+r)1]+[P2(1+r)2]+[P3(1+r)3]….+[Pn(1+r)n]
 3. Compounding of series of equal cash flows or Annuity- Investing equal amounts in
different periods or consecutive years.
Future Value FV = Annuity (1+r)n-1/r
Annuity= Amount that repeating
N= Duration of Annuity
R= Rate of Interest
(By using annuity table method is more better than using formula method)
B. Discounting or Present Value Technique- Compounding present value of future
cash flows
Present value or discounting techniques shows what the value is today of some future some
of money.
Discounting Techniques

1. Discounting of single cash flow

2. Discounting of series of unequal cash flows
3. Discounting of series of equal cash flows or Annuity

1. Discounting of single cash flows

Present value of a single cash flow refers to how much a single cash flow in the future will
be worth today. The present value is calculated by discounting the future cash flow for the
given time period at a specified discount rate.

2. Discounting series of unequal cash flows

This means a cash flow of one year would not be the same as of other years and can vary
month on month, year on year, and so on. This variation or fluctuation in regular cash flow is
referred to as uneven cash flows.

3. Discounting series of equal cash flows or Annuity

1- 1
PV = A x (1+r)n/r

The present value of an annuity is the current value of future payments from an annuity,
given a specified rate of return, or discount rate. The higher the discount rate, the lower
the present value of the annuity.

Conceptual framework of RISK and RETURN

Concept of RISK:
A person making an investment expects to get some returns from the investment in the
future. However, as future is uncertain, the future expected returns too are uncertain. It is
the uncertainty associated with the returns from an investment that introduces a risk into
a project. The expected return is the uncertain future return that a firm expects to get from
its project. The realized return, on the contrary, is the certain return that a firm has actually
earned.
It is the variability of actual return from the expected return associated with a given asset.
There are broadly two groups of elements classified as systematic risk and unsystematic risk.
1. Systematic Risk: The systematic risk cannot be avoided. It relates to economic trends
which affect the whole market. It refers to that portion of variation in return caused
by factors that affect the price of all securities.
Types of systematic risk
 Market risk: It arises out of changes in demand and supply
 Interest rate risk: Price of securities tend to move inversely with changes in the rate
of interest
 Purchasing power risk: It arises due to inflation. Inflation leads to increase in cost of
production due to wage rise, rise in prices of raw materials etc.

2. Unsystematic Risk: The returns of a company may vary due to certain factors that
affect only that company. Examples of such factors are raw material scarcity, labor
strike, management ineffi-ciency, etc. When the variability in returns occurs due to
such firm-specific factors it is known as unsystematic risk.
Types of Unsystematic Risk
 Business risk: Internal and external business risk. Internal risk is caused due to
improper product mix, non-availability of raw materials etc. External business risk
arises due to change operating conditions caused by conditions thrust up on it.
 Financial risk: It associated with capital structure of the company. A company with
no debt financing has no risk.
 Credit or default risk: The credit risk deals with the probability of meeting with a
default. It is primarily the probability that a buyer will default.
Measurement of Risk
A. Mean-variance approach
Mean-variance approach: Mean-variance approach is used to measure the total risk, i.e.
sum of systematic and unsystematic risks. Under this approach the variance and standard
deviation measure the extent of variability of possible returns from the expected return and
is calculated as:

Where, Xi = Possible return,

P = Probability of return, and
n = Number of possible returns

B. Correlation or regression approach

Correlation or regression approach: Correlation or regression method is used to measure
the systematic risk. Systematic risk is expressed by β and is calculated by the following
formula:

Where, rim = Correlation coefficient between the returns of stock i and the return of the
market index,
σm = Standard deviation of returns of the market index, and
σi = Standard deviation of returns of stock i.
Using regression method, we may measure the systematic risk.
The form of the regression equation is as follows:

Where, n = Number of items,

Y = Mean value of the company’s return,

X = Mean value of return of the market index,
α = Estimated return of the security when the market is stationary, and
β = Change in the return of the individual security in response to unit change in the return of
the market index.

Concept of return
Return can be defined as the actual income from a project as well as appreciation in the
value of capital. Thus there are two components in return—the basic component or the
periodic cash flows from the investment, either in the form of interest or dividends; and the
change in the price of the asset, com-monly called as the capital gain or loss.
Total Return = Cash payments received + Price change in assets over the period /Purchase
price of the asset.
COST OF CAPITAL
 Cost of capital represents the return a company needs to achieve in order to justify
the cost of a capital project, such as purchasing new equipment or constructing a
new building.
 Cost of capital encompasses the cost of both equity and debt, weighted according to
the company's preferred or existing capital structure. This is known as the weighted
average cost of capital (WACC).
 A company's investment decisions for new projects should always generate a return
that exceeds the firm's cost of the capital used to finance the project. Otherwise, the
project will not generate a return for investors.

Weighted Average Cost of Capital (WACC)- A firm's cost of capital is typically calculated
using the weighted average cost of capital formula that considers the cost of both debt and
equity capital.

The cost of capital becomes a factor in deciding which financing track to follow: debt, equity,
or a combination of the two.
The cost of debt is merely the interest rate paid by the company on its debt. However, since
interest expense is tax-deductible, the debt is calculated on an after-tax basis as follows:
Cost of debt= interest expense/ total debt *(1-T)
Where :
Interest expense= Int. paid on the firm’s current debt
T= The company’s marginal tax rate
The cost of debt can also be estimated by adding a credit spread to the risk-free rate and
multiplying the result by (1 - T).
Features of cost of capital

 It is not a cost, but it is a required rate of hurdle rate

 Minimum rate of return needed to maintain market value
 Rate of return is the reward for business and financial risk
It consist three elements
Risk less cost: cost of risk free instruments
Business risk premium: Assuming business risk
Financial risk premium: Assuming risk of using debts
Classification of cost of capital
1. Historical cost and Future cost
Historical costs are the costs which are incurred for the procurement of funds based
upon the existing capital structure of the firm. It is a book cost.
Future cost is the cost which is relate to estimated for the future. Simply it is the cost
to be incurred for raising new funds.
2. Specific cost and Composite cost
Specific cost refers to the cost which is associated with the particular sources of
capital. E.g. Cost of Equity
Composite cost is the combined cost of different sources of capital taken together.
E.g. Cost of debt, cost of equity & Cost of preference shares.
3. Average cost and Marginal cost
Average cost is the combined cost of various sources of capital such as equity shares,
debentures, preference shares.
Marginal cost of capital is the average cost of capital which has to be incurred due to
new funds raised by the company for their financial requirements.
4. Explicit cost and Implicit cost
Explicit cost is the cut-off rate or internal rate of return.
Implicit cost is the rate of return related to the best investment opportunity of the
firm and its shareholders that will be foregone in order to take up a particular project.
Factors Affecting Cost of Capital

 Current Economic Conditions: If there is no money in the public, we can depend on

debt instruments rather than equity for raising funds. That may leads to increase bank
rate.
 Current Dividend Policy: Every company has to make dividend policy. What amount
of total earning, company is interested to pay as dividend. For this, we have to study
Price-earning Ratio (Dividend/EPS). If Price earning ratio will increase, cost of retained
earning will decrease because we will less money which have retained and use for
promoting of business as source of fund.
 Getting of New Fund: Company's new fund's requirement will also affect the cost of
capital. If company needs 1 crore immediately for business promotion, company will
have to pay high rate of interest because with this, risk of financial institution will
increase. Every loan provider works with patience, he needs to analyze the company
before providing big loan. If he will give big loan immediately, it is sure, he will get
more return from company and company has to pay more cost of this.
 Current Income Tax Rates: We know, we charge the interest before tax charges.
When we earn money, we deduct our interest charges, then we deduct tax charges.
So, if tax rate will high, it will effect the cost of share capital because with high tax
charges, our net earn will decrease and it will decrease earning per share. So, we will
give less dividend to our shareholders.
Importance

 Usual in investment decisions

 Useful in designing capital structure
 Useful in deciding method of finance
 Useful in evaluation of the performance of management
 Useful in evaluation of expansion project
 Optimum mobilization of resources
LEVERAGE

 Leverage refers to the use of debt (borrowed funds) to amplify returns from an
investment or project.
 Investors use leverage to multiply their buying power in the market.
 Companies use leverage to finance their assets—instead of issuing stock to raise
capital, companies can use debt to invest in business operations in an attempt to
increase shareholder value.
Classification of Leverage

 Operating Leverage
Operating Leverage: Operating leverage can be defined as the degree of change in the level
of EBIT due to a change in sales Operating leverage occurs due to presence of fixed
operating cost in the business. It can also be calculated by an alternate formula:
Contribution /EBIT
The higher the fixed cost, the higher will be the DOL and therefore higher the operating risk
Degree of Operating Leverage
• Operating leverage affects a firm’s operating profit (EBIT).
• The degree of operating leverage (DOL) is defined as the percentage change in the
earnings before interest and taxes relative to a given percentage change in sales.
DOL = % Change in EBIT/ % Change in Sales
Operating leverage: by using fixed operating costs, a small change in sales revenue is
magnified into a larger change in operating income. This “multiplier effect” is called the
degree of operating leverage.

 Financial Leverage- The use of the fixed-charges sources of funds, such as debt and
preference capital along with the owners’ equity in the capital structure, is described
as financial leverage or gearing or trading on equity.
The financial leverage employed by a company is intended to earn more return on the fixed-
charge funds than their costs. The surplus (or deficit) will increase (or decrease) the return on
the owners’ equity. The rate of return on the owners’ equity is levered above or below the
rate of return on total assets. Degree of Financial Leverage: The degree of financial leverage
(DFL) is defined as the percentage change in EPS due to a given percentage change in EBIT.

 Combined Leverage: by using operating leverage and financial leverage, a small

change in sales is magnified into a larger change in earnings per share. This “multiplier
effect” is called the degree of combined leverage.
The degree of combined leverage (DCL) is given by the
following equation:
= % Change in EBIT/ % Change in EPS * % Change in EPS/ % Change in Sales * % Change in EBIT
/ % Change in Sales

Capital Budgeting Decisions and Techniques

Capital budgeting is the process of evaluating and selecting long term investments that are
consistent with the goal of shareholders (owners) wealth maximization
1. Non-Discounted Or traditional techniques
a) Payback period
Payback is the no. of years required to recover the original cash outlay invested in a project.
If the project generates constant annual cash inflows, the payback period can be computed
by dividing cash outlay by the annual cash inflow.
Payback = Initial Investment /Annual Cash Inflow
Advantages of payback

 Simplicity
 Cost Effective
 Short-term effects
 Risk shields
Limitations

 Cash flows after payback

 Cash flows ignored
 Cash flow patterns
 Administrative Difficulties
 Inconsistent with shareholder value

b) Accounting Rate of Return (ARR)

The accounting rate of return (ARR), also known as the return on investment (ROI), uses the
accounting information, as revealed by the financial statements, to measure the profitability
of an investment
ARR = Average Income/ Average Investment
2. Discounted techniques
a) Net Present Value (NPV)
 The NPV Method is a discounted cash flow technique
 This method compares cash inflows and cash outflows occurring at different time
period
 The major characteristic of this method is that it takes into account the time value of
money and all cash inflows and outflows are converted to present value.
Calculation of NPV involves following steps

 Cash inflows and outflows are determined

 A discount rate or cut-off rate is determined. This rate is also called as cost of capital,
required rate of return, the target rate of return, hurdle rate etc.
 With the help of this rate of return, present value of cash inflows are calculated. For
this purpose, Present Value Factor should be calculated at a given rate with the help
of this formula PVF = 𝟏/(𝟏+𝒓)𝒏
 or it could be taken from the PVF Table.
 Cash inflows of each year is then multiplied with Present Value Factor (P.V.F.)

b) Internal Rate of Return (IRR)
 IRR is also known as Time-adjusted rate of return.
 IRR is the rate at which NPV of a project becomes zero.
 In other words, we could say that IRR is the rate at which present value of cash
inflows and present value of cash outflows will be equal.
  In this technique, unlike net present value, we are not given a discount rate. The
discount rate is to be ascertained by trial and error procedure.
Calculation of IRR

 Calculate PV Factor by using the below formula ( by co-incidence, it is payback

period)
 PVF = 𝑰𝒏𝒕𝒊𝒂𝒍 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 /𝑨𝒏𝒏𝒖𝒂𝒍 𝑪𝒂𝒔𝒉 𝑰𝒏𝒇𝒍𝒐𝒘
 Search for a value nearest to PVF from PVAF table for given number of years.
 One value should be higher and one value should be lower to PVF.
 Take discount rates of those higher and lower PVF.
 Calculate present values of cash inflows with the help of these discount rates
 Apply the following formula
IRR =L+ P1-Q/ P1-P2 x H-L
L= Low Discount rate
H= High Discount rate
P1= Present value at lower rate, P2= Present value at high rate
Q= Initial Investment
(c) Profitability Index
This method is also known as Cost Benefit Ratio Method. It is based on Net Present Value
method and calculates the benefit on per rupee investment.
Profitability Index = 𝑷𝑽 𝒐𝒇 𝑪𝒂𝒔𝒉 𝑰𝒏𝒇𝒍𝒐𝒘 /𝑷𝑽 𝒐𝒇 𝑪𝒂𝒔𝒉 𝑶𝒖𝒕𝒇𝒍𝒐𝒘
 MODULE-4
CAPITAL STRUCTURE AND DIVIDEND DECISIONS

Capital Asset Pricing Model (CAPM)

 The Capital Asset Pricing Model (CAPM) describes the relationship between
systematic risk and expected return for assets, particularly stocks.
 CAPM is widely used throughout finance for pricing risky securities and generating
expected returns for assets given the risk of those assets and cost of capital.
 The general idea behind CAPM is that investors need to be compensated in two
ways: time value of money and risk
 Beta is used in the capital asset pricing model (CAPM), a model that calculates the
expected return of an asset based on its beta and expected market returns.
 Also known as "beta coefficient.“
 The formula for calculating the expected return of an asset given its risk is as follows:
ERi =Rf+Rp
where:
ERi =expected return of investment
Rf =risk-free rate
Rp- risk premium

Advantages of the CAPM Model

 Ease-of-use: CAPM is a simplistic calculation that can be easily tested to derive a

range of possible outcomes to provide confidence around the required rates of
return.
 Diversified Portfolio: The assumption that investors hold a diversified portfolio,
similar to the market portfolio, eliminates the unsystematic risk.
 Systematic risk: CAPM takes into account systematic risk, which is left out of other
return models.
 Business and Financial Risk Variability: When businesses investigate opportunities,
if the business mix and financing differ from the current business, then other
required return calculations.
Disadvantages of the CAPM Model

 Risk-Free Rate (Rf): The commonly accepted rate used as the Rf is the yield on short-
term government securities. The issue with using this input is that the yield changes
daily, creating volatility.
 Return on the Market (Rm): The return on the market can be described as the sum
of the capital gains and dividends for the market. A problem arises when, at any
given time, the market return can be negative. As a result, a long-term market return
is utilized to smooth the return. Another issue is that these returns are backward-
looking and may not be representative of future market returns.
 Ability to Borrow at a Risk-Free Rate: CAPM is built on four major assumptions,
including one that reflects an unrealistic real-world picture. This assumption—that
investors can borrow and lend at a risk-free rate—is unattainable in reality.
Determination of Project Proxy Beta: Businesses that use the CAPM to assess an
investment need to find a beta reflective of the project or investment. Often, a proxy beta is
necessary. However, accurately determining one to properly assess the project is difficult
and can affect the reliability of the outcome.

Limitations of CAPM
 It is based on unrealistic assumptions.
 It is difficult to test the strength of CAPM.
 Betas do not remain stable over time.

Capital Structure
 Capital structure is how a company funds its overall operations and growth.
 Debt consists of borrowed money that is due back to the lender, commonly with
interest expense.
 Equity consists of ownership rights in the company, without the need to pay back
any investment.
 The debt-to-equity (D/E) ratio is useful in determining the riskiness of a company's
borrowing practices.
FACTORS AFFECTING CAPITAL STRUCTURE

 Nature of Business: The nature of business can have strong effect on the pattern of
capital structure. A business with fixed and regular income can safely rely on
debentures and preference share s which necessitate regular payment of fixed
interest & dividends.
 Money Market Conditions: During boom period the investors will go in for equity
shares with the expectations of high dividends. But in times of depression, they will
look more to safety than income and will be willing to invest in debentures rather than
in equity share .
 Stability of Earning: The decision about the type of securities to be issued should be
taken in the contest of earning of the company. If earnings are regular and steady,
preference shares and debentures can be issued
 Capital Requirement: If a small amount of capital is needed, only one type of security
such as equity shares can be issued. But if a large amount of capital is required, it will
be necessary to issued different types of securities.
 Retaining Control: Preference share and debentures have no voting rights, more
funds can be raised through their issue and at the same time control of the company
can be retained by the existing management.
 Long Term Interest of the company: Sometimes it happens that the type of security
which seems appropriate from the viewpoint of money market conditions, is not
appropriate from the viewpoint of Long Term Interest of the company.
 Legal Restrictions: The companies have to comply with legal provisions regarding the
issue of different.
 Nature of Assets the Company: If a value of company’s asset is subject to wide
fluctuations, is will not be advisable to issue debentures The company will have to rely
on equity shares.
Theories of Capital Structure
In financial management, capital structure theory refers to a systematic approach to financing
business activities through a combination of equities and liabilities.
1. Net Income (NI) Theory
According to this theory a firm can increase the value of the firm and reduce the overall cost
of capital by increasing the proportion of debt in its capital structure to the maximum possible
extent.
It is due to the fact that debt is, generally a cheaper source of funds because: (i) Interest rates
are lower than dividend rates due to element of risk, (ii) The benefit of tax as the interest is
deductible expense for income tax purpose.
2. Net Operating Income (NOI) Theory
According to this theory, the total market value of the firm is not affected by the change in
the capital structure and the overall cost of capital remains fixed irrespective of the debt-
equity mix.
Assumptions;
 The split of total capitalization between debt and equity is not essential or relevant.
 The equity shareholders and other investors i.e. the market capitalizes the value of
the firm as a whole.
 The business risk at each level of debt-equity mix remains constant. Therefore, overall
cost of capital also remains constant.
 The corporate income tax does not exist.

3. Traditional Theory
According to this theory, a firm can reduce the overall cost of capital or increase the total
value of the firm by increasing the debt proportion in its capital structure to a certain limit.
Because debt is a cheap source of raising funds as compared to equity capital.
Assumptions:
 First Stage: The use of debt in capital structure increases the total value of the firm
and decreases the cost of capital.
Because cost of equity remains constant or rises slightly with debt, but it does not rise
fast enough to offset the advantages of low cost debt.
Cost of debt remains constant or rises very negligibly.
 Second Stage: During this Stage, there is a range in which the total value of the firm
will be maximum and the cost of capital will be minimum.
Because the increase in the cost of equity, due to increase in financial risk, offset the
advantage of using low cost of debt.
 Third Stage: The value of the firm will decrease and the cost of capital will increase.
Because further increase of debt in the capital structure, beyond the acceptable limit
increases the financial risk.
4. Modigliani-Miller (M-M) Theory
This theory was propounded by Franco Modigliani and Merton Miller.
They have given two approaches
A. In the Absence of Corporate Taxes
B. When Corporate Taxes Exist
Assumptions of M-M Approach
 Perfect Capital Market
 No Transaction Cost
  Homogeneous Risk Class: Expected EBIT of all the firms have identical risk
characteristics.
 Risk in terms of expected EBIT should also be identical for determination of market
value of the shares
 No Corporate Taxes: But later on in 1969 they removed this assumption.

A. In the Absence of Corporate Taxes

According to this approach the total value of the firm and its cost of capital are
independent of its capital structure.
The debt-equity mix of the firm is irrelevant in determining the total value of the firm.
Because with increased use of debt as a source of finance, cost of equity increases and
the advantage of low cost debt is offset equally by the increased cost of equity.
In the opinion of them, two identical firms in all respect, except their capital structure,
cannot have different market value or cost of capital due to Arbitrage Process.

B. When Corporate Taxes are Exist

M-M’s original argument that the total value of the firm and cost of capital remain
constant with the increase of debt in capital structure, does not hold good when corporate
taxes are assumed to exist.
They recognized that the total value of the firm will increase and cost of capital will
decrease with the increase of debt in capital structure. They accepted that the value of
levered firm will be greater than the value of unlevered firm.

DIVIDEND DECISION
 Dividend is defined as the distribution of a portion of a company’s earnings, decided
by the board of directors, to a class of its shareholders.
 Dividend is a taxable payment declared by a company’s board of directors and given
to its shareholders out of the company’s current or retained earnings, usually
quarterly. Dividends are usually given as cash (cash dividend), but they can also take
the form of stock (stock dividend) or other property.
 A company has to decide how much profit to distribute as dividend and how much to
retain for investment in the business.
 The dividend policy of the company should be to maximize market value per share.
The dividend decision should be made keeping in mind the overall objective of
maximizing shareholders wealth.
Factors affecting Dividend Decisions

 Amount of Earnings: Dividend can be paid out of current and past earnings so it is
the main determining factor of dividend policy.
 Stability earnings: A company having stable earnings is in a position to declare
higher dividend, otherwise strict dividend policy is followed.
 Stability of dividend: Companies generally follow a stable dividend policy. They
follow increasing dividend policy when there is confidence that their earning
capacity has gone up
 Growth opportunities: Companies having good growth opportunities retain more
money. Out of their earnings so as to finance the required investment
  Shareholder’s preference: Desire of shareholders for dividends depends upon their
economic status. While declaring dividend management must keep in mind the
preference of shareholders
 Taxation policy: The taxation rate affects the net earnings of a company and thereby
its dividend policy also. If tax on dividend is higher, it is better to pay less by way of
dividends
 Stock market reactions: An increase in dividend policy has a positive impact on the
share price. It is good news for the investors and hence stock price increase.
Decrease in dividend has a negative impact on the share price.
 Access to capital market: Large and reputed companies depend less on retained
earnings and tend to pay higher dividends than the smaller companies which have
relatively low access to the market
 Legal constraints: As per the provisions of companies Act dividend can be paid only
out of current or past profit after providing for depreciation. No dividend can be paid
out of capital. Such provisions must be adhered to while declaring the dividend.
 Contractual constraints: Sometimes the lenders may impose certain restrictions on
the payment of dividends in future. The companies are required to ensure that the
dividend doesn’t violate the terms of the loan agreement.
Dividend Policy:

 Dividends are often part of a company's strategy. However, they are under no
obligation to repay shareholders using dividends.
 Stable, constant, and residual are the three types of dividend policy.
 Even though investors know companies are not required to pay dividends, many
consider it a bellwether of that specific company's financial health.
Types of Dividend Policies

 Stable Dividend Policy: A stable dividend policy is the easiest and most commonly
used. The goal of the policy is a steady and predictable dividend payout each year,
which is what most investors seek. Whether earnings are up or down, investors
receive a dividend.
 Constant Dividend Policy: The primary drawback of the stable dividend policy is that
investors may not see a dividend increase in boom years. Under the constant
dividend policy, a company pays a percentage of its earnings as dividends every year.
In this way, investors experience the full volatility of company earnings.
 Residual Dividend Policy: Residual dividend policy is also highly volatile, but some
investors see it as the only acceptable dividend policy. With a residual dividend
policy, the company pays out what dividends remain after the company has paid for
capital expenditures (CAPEX) and working capital.
Factors affecting Dividend Policy

 Legal restriction
 Magnitude and trend of exchange
  Desire and type of shareholder
 Nature of industry
 Age of the company
 Future financial requirement
 Control objective
 Stability of dividends
 Liquid resources
 Inflation
Objectives of Dividend Policy

 It established the profitable record of the company

 It creates the confidence amongst the shareholders.
 It aids in long-term financing and renders financing easier.
 It stabilizes the market value of shares.
 It is sign of continued normal operations of the company.
 It creates confidence among the investors.
 It provides a source of livelihood to those investors who view dividends as a source
of funds to meet day to day expenses.
 It meets the requirements of institutional investors who prefer companies with
stable dividends.
Definition of Dividend: A dividend is a distribution of part of the earnings of the company to
its equity shareholders. The board of directors of the company decides the dividend amount
to be paid out to the shareholders.
Different Forms / Types of Dividends

 Cash Dividend: A Cash dividend is the most common form of the dividend. The
shareholders are paid in cash per share. The board of directors announces the
dividend payment on the date of declaration. The dividends are assigned to the
shareholders on the date of record. The dividends are issued on the date of payment.
But for distributing cash dividend, the company needs to have positive retained
earnings and enough cash for the payment of dividends.
 Bonus Share: Bonus share is also called as the stock dividend. These are issued by the
company when they have low operating cash, but still want to keep the investors
happy. Each equity shareholder receives a certain number of additional shares
depending on the number of shares originally owned by the shareholder.
 Share Repurchase: Share repurchase occurs when a company buys back its own
shares from the market and reduces the number of shares outstanding. This is
considered as an alternative to the dividend payment as cash is returned to the
investors through another way.
 Property Dividend: The company makes the payment in the form of assets in the
property dividend. The asset could be any of this equipment, inventory, vehicle or any
 other asset. The value of the asset has to be restated at the fair value while issuing a
property dividend.
 Scrip Dividend: Scrip dividend is a promissory note to pay the shareholders later. This
type of dividend is used when the company does not have sufficient funds for the
issuance of dividends.
 Liquidating dividend: When the company returns the original capital contributed by
the equity shareholders as a dividend, it is termed as liquidating dividend. It is often
seen as a sign of closing down the company.
Dividend payout ratio: The dividend payout ratio shows how much of a company's earnings
after tax (EAT) are paid to shareholders. It is calculated by dividing dividends paid by earnings
after tax and multiplying the result by 100.
Dividend Payout Ratio= Dividends Paid/ Net Income
Alternatively, the dividend payout ratio can also be calculated as:
Dividend Payout Ratio=1−Retention Ratio
On a per-share basis, the retention ratio can be expressed as:
Retention Ratio= EPS−DPS/EPS
Where:
EPS=Earnings per share
DPS=Dividends per share
Dividend Yield:

 The dividend yield—displayed as a percentage—is the amount of money a company

pays shareholders for owning a share of its stock divided by its current stock price.
 Mature companies are the most likely to pay dividends.
 Companies in the utility and consumer staple industries often having higher dividend
yields.
 Real estate investment trusts (REITs), master limited partnerships (MLPs), and
business development companies (BDCs) pay higher than average dividends;
however, the dividends from these companies are taxed at a higher rate.
 It's important for investors to keep in mind that higher dividend yields do not always
indicate attractive investment opportunities because the dividend yield of a stock
may be elevated as the result of a declining stock price.
Stock split: A stock split or stock divide increases the number of shares in a company. A
stock split causes a decrease of market price of individual shares, not causing a change of
total market capitalization of the company.
Reverse split: A reverse stock split consolidates the number of existing shares of stock held
by shareholders into fewer shares.
A reverse stock split does not directly impact a company's value (only its stock price).
Buyback of shares: The repurchase of outstanding shares by a company in order to reduce
the number of shares on the market. Companies will
Buy-back shares either to increase the value of shares still available, or to eliminate any
threats by shareholders who may be looking for a controlling stake.
Objectives
 To increase promoters holding.
 Increase earning per share(EPS).
 To pay surplus cash not required by business.
 Tax Gains: Since dividends are taxed at higher rate than capital gains, companies
prefer buyback to reward their Investors instead of distributing cash dividends, as
capital gains tax is generally lower. At present, short-term capital gains are taxed at
10% and long-term capital gains are not taxed while DDT is 15%.
 MODULE-5
CORPORATE FINANCE

Business Valuation
 Business valuation determines the economic value of a business or business unit.
 Business valuation can be used to determine the fair value of a business for a variety
of reasons, including sale value, establishing partner ownership, taxation, and even
divorce proceedings.
 Several methods of valuing a business exist, such as looking at its market cap, earnings
multipliers, or book value, among others.
Business Valuation Methods
 Asset Valuation- Your company’s assets include tangible and intangible items. Use the
book or market value of those assets to determine your business’s worth. Count all
the cash, equipment, inventory, real estate, stocks, options, patents, trademarks, and
customer relationships as you calculate the asset valuation for your business.
 Historical Earnings Valuation- A business’s gross income, ability to repay debt, and
capitalization of cash flow or earnings determines its current value. If your business
struggles to bring in enough income to pay bills, its value drops. Conversely, repaying
debt quickly and maintaining a positive cash flow improves your business’s value. Use
all of these factors as you determine your business’s historical earnings valuation.
 Relative Valuation- With the relative valuation method, you determine how much a
similar business would bring if they were sold. It compares the value of your business’s
assets to the value of similar assets and gives you a reasonable asking price.
 Future Maintainable Earnings Valuation- The profitability of your business in the
future determines its value today, and you can use the future maintainable earnings
valuation method for business valuation when profits are expected to remain stable.
To calculate your business’s future maintainable earnings valuation, evaluate its sales,
expenses, profits, and gross profits from the past three years. These figures help you
predict the future and give your business a value today.
 Discount Cash Flow Valuation- If profits are not expected to remain stable in the
future, use the discount cash flow valuation method. It takes your business’s future
net cash flows and discounts them to present day values. With those figures, you know
the discounted cash flow valuation of your business and how much money your
business assets are expected to make in the future.

Approaches to Valuing a Business

Cost Approach- Measure the value of an intangible asset by taking into account all relevant
occurring costs and investments related to the appraised asset.
The cost approach to real estate valuation considers the value should equal the total cost to
build an equivalent structure. The cost approach considers the cost of land, plus costs of
construction, less depreciation. The cost approach is considered less reliable than other real
estate valuation methods, but can be useful in certain cases such as when evaluating new
construction or a unique home with few comparable. The methods are,

 Historic costs:- accounting all costs directly related to the appraised asset
  Replacement costs:- valuing the costs for buying an asset bringing the same utility than
the appraised one
 Reproduction cost:- valuing the costs induced in creating, at the time of the appraisal,
a similar asset based on actual knowledge Cost approach is generally used in situations
of high uncertainty and limited information exist
2. Market Approach

 The market approach is a method of determining the value of an asset based on the
selling price of similar assets. It is one of three popular valuation methods, along with
the cost approach and discounted cash-flow analysis (DCF).
 Regardless of the type of asset being valued, the market approach studies recent sales
of similar assets, making adjustments for the differences between them. For example,
when appraising real estate, adjustments might be made for factors such as the square
footage of the unit, the age and location of the building, and its amenities
 The market approach bases the value of the subject business on sales of comparable
businesses or business interests. It’s especially useful when valuing public companies
(or private companies large enough to consider going public) because data on
comparable public businesses is readily available.
3. Income Approach

 The income approach is a real estate valuation method that uses the income the
property generates to estimate fair value.
 It's calculated by dividing the net operating income by the capitalization rate.
 A buyer should pay special attention to the condition of the property, operating
efficiency, and vacancy when using the income approach.
 For example, when valuing a four-unit apartment building in a specific county, the
investor looks at the recent selling prices of similar properties in the same county.
After calculating the capitalization rate, the investor can divide the rental property’s
NOI by that rate. For example, a property with a net operating income (NOI) of
$700,000 and a chosen capitalization rate of 8% is worth $8.75 million.
Bond:

 A bond is defined as a long-term debt tool that pays the bondholder a specified
amount of periodic interest over a specified period of time.
 In financial area, a bond is an instrument of obligation of the bond issuer to the
holders.
 It is a debt security, under which the issuer owes the holders a debt and, depending
on the terms of the bond, is obliged to pay them interest and/or to recompense the
principal at a later date, called the maturity date.
 Interest is generally payable at fixed intervals such as semi-annual, annual, and
monthly. Sometimes, the bond is negotiable, i.e. the ownership of the instrument can
be relocated in the secondary market. This means that once the transfer agents at the
bank medallion stamp the bond, it is highly liquid on the second market.
Bond valuation:

 Bond valuation is a way to determine the theoretical fair value (or par value) of a
particular bond.
 It involves calculating the present value of a bond's expected future coupon payments,
or cash flow, and the bond's value upon maturity, or face value.
 As a bond's par value and interest payments are set, bond valuation helps investors
figure out what rate of return would make a bond investment worth the cost.
Bond valuation, in effect, is calculating the present value of a bond’s expected future coupon
payments. The theoretical fair value of a bond is calculated by discounting the future value of
its coupon payments by an appropriate discount rate. The discount rate used is the yield to
maturity, which is the rate of return that an investor will get if they reinvested every coupon
payment from the bond at a fixed interest rate until the bond matures. It takes into account
the price of a bond, par value, coupon rate, and time to maturity.
Share:
In financial markets, a share is described as a unit of account for different investments. It is
also explained as the stock of a company, but is also used for collective investments such as
mutual funds, limited partnerships, and real estate investment trusts.
Share valuation:

 There are several methods for valuing a company or its stock, each with its own
strengths and weaknesses.
 Some models try to pin down a company's intrinsic value based on its own financial
statements and projects, while others look to relative valuation against peers.
 For companies that pay dividends, a discount model like the Gordon growth model is
often simple and fairly reliable—but many companies do not pay dividends.
 Often, a multiples approach may be employed to make comparative evaluations of a
company's value in the market against its competitors or broader market.
 When choosing a valuation method, make sure it is appropriate for the firm you're
analyzing, and if more than one is suitable use both to arrive at a better estimate.
Values of shares:

 Face Value: A Company may divide its capital into shares of @10 or @50 or @100 etc.
Company’s share capital is presented as per Face Value of Shares. Face Value of Share
= Share Capital / Total No of Share. This Face Value is printed on the share certificate.
Share may be issued at less (or discount) or more (or premium) of face value.
 Book Value: Book value is the value of an asset according to its balance sheet account
balance. For assets, the value is based on the original cost of the asset less any
devaluation, amortization or impairment costs made against the asset.
 Cost Value: Cost value is represented as price on which the shares are purchased with
purchase expenses such as brokerage, commission.
  Market Value: This values is signified as price on which the shares are purchased or
sold. This value may be more or less or equal than face value.
 Fair Value: This value is the price of a share which agreed in an open and unrestricted
market between well-informed and willing parties dealing at arm’s length who are
fully informed and are not under any compulsion to transact.
 Yield Value: This value of a share is also called Capitalized value of Earning Capacity.
Normal rate of return in the industry and actual or expected rate of return of the firm
are taken into consideration to find out yield value of a share.
Need for Valuation:

 When two or more companies merge

 When absorption of a company takes place.
 When some shareholders do not give their approval for reconstruction of the
company, there shares are valued for the purpose of acquisition.
 When shares are held by the associates jointly in a company and dissolution takes
place, it becomes essential to value the shares for proper distribution of partnership
property among the partners.
 When a loan is advanced on the security of shares.
 When shares of one type are converted in to shares of another type.
 When some company is taken over by the government, compensation is paid to the
shareholders of such company and in such circumstances, valuation of shares is made.
 When a portion of shares is to be given by a member of proprietary company to
another member, fair price of these shares has to be made by an auditor or
accountant.
Corporate Restructuring

Corporate restructuring refers to the changes in ownership, business mix, assets mix and
alliances with a view to enhance the shareholder value.
Hence, corporate restructuring may involve ownership restructuring, business restructuring
and assets restructuring.

Forms of Corporate Restructuring

A. Merger
B. Amalgamation
C. Acquisition
D. MOU
E. Disinvestment

A. Merger
A merger is where two or more business entities combine to create a new entity or existing
company.
A merger is an agreement that unites two existing companies. Mergers are commonly done
to expand a company's reach, expand into new segments, or gain market share.
Forms of Merger:
  Horizontal Merger: Acquisition of a company in the same industry in which the
acquiring firm competes increases a firm’s market power by exploiting
 Vertical Merger: Acquisition of a supplier or distributor of one or more of the firm’s
goods or services
 Conglomerate Merger: Acquisition by any company of unrelated industry
Takeover: The term takeover is understood to connote hostility. When an acquisition is a
‘forced’ or ‘unwilling’ acquisition, it is called a takeover. A holding company is a company
that holds more than half of the nominal value of the equity capital of another company,
called a subsidiary company, or controls the composition of its Board of Directors. Both
holding and subsidiary companies retain their separate legal entities and maintain their
separate books of accounts.
Legal Procedures for merger

 Permission for merger

 Information to the stock exchange
 Approval of board of directors
 Application in the High Court
 Shareholders’ and creditors’ meetings
 Sanction by the High Court
 Filing of the Court order
 Transfer of assets and liabilities Payment by cash or securities

B. Amalgamation:
An amalgamation is where one business entity acquires one or more business entities. It is a
type of merger process in which two or more companies combine their businesses to form an
entirely new entity/company. Amalgamation is an appropriate arrangement wherein two or
more companies operate in the same business; thus, Amalgamation helps in reduction in
operational cost due to operational synergy.
ABC Corp and XYZ Corp will cease to exist after the Amalgamation process resulting in a new
entity, JKL Corporation.

Legal Procedures:

1. Any Company, creditors of the Company, any class of them, members or any class of
them can file an application under Section 391 seeking sanction of any scheme of
compromise or arrangement. While filing an application under section 391 or 394, the
applicant is supposed to disclose all material particulars in accordance with the
provisions of the Act.
2. Upon satisfying that the scheme is prima facie workable and fair, the Tribunal order
for the meeting of the members, class of members, creditors or the class of creditors
as the case may be. Rather, passing an order calling for meeting, if the requirements
of holding meetings with class of shareholders or the members, are specifically dealt
with in the order calling meeting, then, there won’t be any subsequent litigation.
3. The scheme must get approved by the majority of the stake holders viz., the members,
class of members, creditors or such class of creditors. The scope of conduct of meeting
 with the members, class of members, creditors or such class of creditors will be
restrictive somewhat in an application seeking compromise or arrangement.
4. There should be due notice disclosing all material particulars and annexing the copy
of the scheme as the case may be while calling the meeting.
5. In a case where amalgamation of two companies is sought for, before approving the
scheme of amalgamation, a report is to be received from the registrar of companies
that the approval of scheme will not prejudice the interests of the shareholders.
6. The Central Government is also required to file its report in an application seeking
approval of compromise, arrangement or the amalgamation as the case may be under
section 394A.
7. After complying with all the requirements, if the scheme is approved, then, the
certified copy of the order is to be filed with the concerned authorities.

C. Acquisition
When one company takes over another and clearly established itself as a new owner, the
purchase is called an acquisition
 An acquisition occurs when one company buys most or all of another company's
shares.
 If a firm buys more than 50% of a target company's shares, it effectively gains control
of that company.
 An acquisition is often friendly, while a takeover can be hostile; a merger creates a
brand new entity from two separate companies.

Types of Acquisition

 Friendly acquisition: Both the companies approve the acquisition under friendly
terms.
 Reverse acquisition: A private company takes over a public company.
 Back flip acquisition: The purchasing company becomes a subsidiary of the
purchased company.
 Hostile acquisition: Here, the entire process is done by force.

Benefits of Acquisitions
 Reduced entry barriers
 Market power.
 New competencies and resources
 Access to experts
 Access to capital
 Fresh ideas and perspective

 In an acquisition, both companies continue to exist as separate legal entities. One

of the companies becomes the parent company of the other.

 In a merger, both entities combine and only one continues to survive while the
other company ceases to exist.

 Another type of transaction is an amalgamation, where neither legal entity

continues to survive. Instead, an entirely new company is created.
 D. Memorandum of Understanding
A memorandum of understanding is an agreement between two or more parties outlined in
a formal document. It is not legally binding but signals the willingness of the parties to move
forward with a contract.
Objectives
 The statement that the parties are currently negotiating.
 Clarifying the key points of an operation for the convenience of the parties.
 Assess the interest of the other party to carry out the business.
 Collect the advances that occur in each of the negotiations.
 Provides guarantees if the deal collapses during negotiation.
Advantages:
 An MOU allows for the establishment of a mutual intention. It enables each party’s
goals and objectives to be clear.
 The finalization of an MOU allows for having a paper trail or records of the terms
that have been in the negotiations leading towards finalization.
 MOUs reduce the levels of uncertainty between the involved parties because the
document usually highlights the expectations and objectives and prevents possible
future disagreements.
 An MOU provides ease of exit, as any party that finds the objectives and goals not
being met can easily end the agreement.
 Because the MOU already outlines objectives and terms, the document can serve as
the foundation for a possible future contract.
Contents:
 Name of the Project
 Name of the parties and their responsibilities
 Length of the agreement
Elements
 An Offer
 Acceptance of the Offer
 Legally binding intention
 Consideration

E. Disinvestment:
 Disinvestment is the action of an organization or government selling or liquidating an
asset or subsidiary. Absent the sale of an asset, disinvestment also refers to capital
expenditure reductions, which can facilitate the re-allocation of resources to more
productive areas within an organization or government-funded project.
 Disinvestment is when governments or organizations sell or liquidate assets or
subsidiaries.
 Disinvestments can take the form of divestment or a reduction of capital expenditures
(CapEx).
  Disinvestment is carried out for a variety of reasons, such as strategic, political, or
environmental.
Types of Disinvestment:

 Commoditization and Segmentation: Within the target market for commoditized

goods, a company may identify product segments delivering higher profitability than
others, while expenditures, resources, and infrastructure required for manufacturing
remain the same for both products.
 Ill-Fitting Assets: A company may opt for the disinvestment of certain assets of a
company it has acquired, particularly if those assets do not fit with its overall strategy.
 Political and Legal: Organizations may decide on the disinvestment of holdings that
no longer fit with their social, environmental, or philosophical positions.
Objectives:

 To reduce the financial burden on the Government

 To improve public finances
 To introduce, competition and market discipline
 To fund growth
 To encourage wider share of ownership
 To depoliticize non-essential services
Importance of Disinvestment

 Financing the increasing fiscal deficit

 Financing large-scale infrastructure development
 For investing in the economy to encourage spending
 For retiring Government debt- Almost 40-45% of the Centre’s revenue receipts go
towards repaying public
 debt/interest
 For social programs like health and education