CORPORATE FINANCE

Dr. Satish Kumar Matta

INTRODUCTION Finance is defined as the provision of money at the time it is

required. Every enterprise big or small, needs finance to carry on and expand its operations. Finance hold the key to all the business activities and a firm’s success and, in fact its survival dependent upon how efficiently it is able to acquire and utilize the funds.

Finance has become so important for the business enterprises that it has given birth to ‘Corporate Finance’ or ‘Financial Management’ as a separate subject. Corporate finance is that part of managerial process which is concerned with the planning and controlling of firm’s financial resources. It is concerned with the procurement of funds from most suitable sources and making the most efficient use of such funds. In the earlier stages, corporate finance was a branch of economics and a separate subject it is of recent origin. It is still developing and the subject is of immense importance to the managers because among the most crucial decisions of the firm are those which relate to finance.

The Financial Manager A striking feature of large corporations is that the owners (the

stockholders) are usually not directly involved in making business decisions, particularly on a day-to-day basis. Instead, the corporation employs managers to represent the owners’ interests and make decisions on their behalf. The financial management function is usually associated with a top officer of the firm, such as a vice president of finance or some other chief financial officer (CFO). The vice president of finance coordinates the activities of the treasurer and the controller. The controller’s office handles cost and financial accounting, tax payments, and management information systems. The treasurer’s office is responsible for managing the firm’s cash and credit, its financial planning, and its capital expenditures. These treasury activities are all related to the three general questions namely raising of finance through cheapest source, optimum utilization of raised funds and dividend decision and our study thus bears mostly on activities usually associated with the treasurer’s office.

Financial Management Decisions1. Capital Budgeting: The first question concerns the firm’s long-term

investments. The process of planning and managing a firm’s long-term investments is called capital budgeting. In capital budgeting, the financial manager tries to identify investment opportunities that are worth more to the firm than they cost to acquire. Loosely speaking, this means that the value of the cash flow generated by an asset exceeds the cost of that asset. The types of investment opportunities that would typically be considered depend in part on the nature of the firm’s business. For example, for a large retailer such as Wal-Mart, deciding whether or not to open another store would be an important capital budgeting decision. Similarly, for a software company such as Oracle or Microsoft, the decision to develop and market a new spreadsheet would be a major capital budgeting decision. Regardless of the specific nature of an opportunity under consideration, financial managers must be concerned not only with how much cash they expect to receive, but also with when they expect to receive it and how likely they are to receive it. Evaluating the size, timing, and risk of future cash flows is the essence of capital budgeting. In fact, whenever we evaluate a business decision, the size, timing, and risk of the cash flows will be, by far, the most important things we will consider

Continued:2. Capital Structure: The second question for the

financial manager concerns ways in which the firm obtains and manages the long-term financing it needs to support its long-term investments. A firm’s capital structure (or financial structure) is the specific mixture of long-term debt and equity the firm uses to finance its operations. The financial manager has two concerns in this area. First, how much should the firm borrow? That is, what mixture of debt and equity is best? The mixture chosen will affect both the risk and the value of the firm. Second, what are the least expensive sources of funds for the firm?

Continued:3. Working Capital Management: The third question concerns

working capital management. The term working capital refers to a firm’s short-term assets, such as inventory, and its short-term liabilities, such as money owed to suppliers. Managing the firm’s working capital is a day-to-day activity that ensures that the firm has sufficient resources to continue its operations and avoid costly interruptions. This involves a number of activities related to the firm’s receipt and disbursement of cash. Some questions about working capital that must be answered are the following: (1) How much cash and inventory should we keep on hand? (2) Should we sell on credit? If so, what terms will we offer, and to whom will we extend them? (3) How will we obtain any needed short-term financing? Will we purchase on credit or will we borrow in the short term and pay cash? If we borrow in the short term, how and where should we do it? These are just a small sample of the issues that arise in managing a firm’s working capital.

Forms of Business Organization1. Sole Proprietorship: A sole proprietorship is a business owned by one

person. This is the simplest type of /business to start and is the least regulated form of organization. Depending on where you live, you might be able to start up a proprietorship by doing little more than getting a business license and opening your doors. For this reason, there are more proprietorships than any other type of business, and many businesses that later become large corporations start out as small proprietorships.

The owner of a sole proprietorship keeps all the profits. That’s the good news. The bad news is that the owner has unlimited liability for business debts. This means that creditors can look beyond business assets to the proprietor’s personal assets for payments. Similarly, there is no distinction between personal and business income, so all business income is taxed as personal income. The life of a sole proprietorship is limited to the owner’s lifespan, and it is important to note, the amount of equity that can be raised is limited to the amount of the proprietor’s personal wealth. This limitation often means that the business is unable to exploit new opportunities because of insufficient capital. Ownership of a sole proprietorship may be difficult to transfer because this transfer requires the sale of the entire business to a new owner.

2. Partnership A partnership is similar to a proprietorship, except that there are

two or more owners (partners). In a general partnership, all the partners share in gains or losses, and all have unlimited liability for all partnership debts, not just some particular share. The way partnership gains (and losses) are divided is described in the partnership agreement. This agreement can be an informal oral agreement or a lengthy, formal written document. The advantages and disadvantages of a partnership are basically the same as those of a proprietorship. Partnerships based on a relatively informal agreement are easy and inexpensive to form. General partners have unlimited liability for partnership debts, and the partnership terminates when a general partner wishes to sell out or dies., All income is taxed as personal income to the partners, and the amount of equity that can be raised is limited to the partners’ combined wealth. Ownership of a general partnership is not easily transferred, because a transfer requires that a new partnership be formed. A limited partner’s interest can be sold without dissolving the partnership, but finding a buyer may be difficult.

3. Corporations or Companies The corporation is the most important form (in terms of size) of

business organization. A corporation is a legal “person” separate and distinct from its owners, and it has many of the rights, duties, and privileges of an actual person. Corporations can borrow money and own property, can sue and be sued, and can enter into contracts. A corporation can own stock in another corporation. Not surprisingly, starting a corporation is somewhat more complicated than starting the other forms of business organization. Forming a corporation involves preparing memorandum of association and articles of association (or a charter) and a set of by laws. The articles of association must contain a number of things, including the corporation’s name, its intended life (which can be forever), its business purpose, and the number of shares that can be issued. This information must normally be supplied to the state in which the firm will be incorporated.

Continued: For most legal purposes, the corporation is a “resident” of

that state. The by laws are rules describing how the corporation regulates its own existence. For example, the by laws describe how directors are elected. These bylaws may be a very simple statement of a few rules and procedures, or they may be quite extensive for a large corporation. The bylaws may be amended or extended from time to time by the stockholders. In a large corporation, the stockholders and the managers are usually separate groups. The stockholders elect the board of directors, who then select the managers. Management is charged with running the corporation’s affairs in the stockholders’ interests. In principle, stockholders control the corporation because they elect the directors.

Continued:

As a result of the separation of ownership and management, the corporate form has several advantages. Ownership (represented by shares of stock) can be readily transferred, and the life of the corporation is therefore not limited. The corporation borrows money in its own name. As a result, the stockholders in a corporation have limited liability for corporate debts. The most they can lose is what they have invested. The relative ease of transferring ownership, the limited liability for business debts, and the unlimited life of the business are the reasons why the corporate form is superior when it comes to raising cash. If a corporation needs new equity, for example, it can sell new shares of stock and attract new investors.

Approaches to Finance Functionsor

Evolution or Scope of Corporate Finance

(1)Traditional Approach of Financial FunctionLimitations:(i) More emphasis on raising of funds.(ii)Ignores the financial problems of non-corporate

enterprises.(iii)More concerned to the problems of raising

financing on the occurrence of special events(iv) Special attention on long-term financing. (2) Modern Approach of Finance Function

Objectives or Goals of Corporate Finance

1. Profit maximization

Criticism of profit maximization on the following grounds:

(a) Profit is ambiguous/ not clear

(b)Ignores the time value of money

(c) Ignores risk factor

1. Wealth maximization.

MEANING AND DEFINITION “The finance function is the process of acquiring and

utilizing funds by a business”. – R.C. Osborn According to Ezra Solomon, “Financial management is

concerned with the management decisions that result in the acquisition and financing of long term and short term credits of a firm. As such it deals with the situations that require selection of specific assets as well as the problem of size and growth of an enterprise. The analysis of these decisions is based on the expected inflows and outflows of funds and their effects upon managerial objectives”.

According to Joseph L Massie, “Financial management is the operational activity of a business that is responsible for obtaining and effectively utilizing the funds necessary for efficient operations”.

Continued: In the words of Joseph F. Bradley, “Financial

management is that area of business management devoted to a judicious use of capital and careful selection of sources of capital in order to enable a spending unit to move in the direction of reaching its goals”.

According to James C. Van Horne, “Financial management is concerned with acquisition, financing and management of assets with some overall goal in mind”.

The most acceptable and popular definition of financial management as given by S.C. Kuchal is that, “Financial management deals with procurement of funds and their effective utilization in the business”.

FUNCTIONS OF FINANCIAL MANAGEMENT

There are three basic functions of financial management. These are (i) raising of finance, (ii) investing it in assets and (iii) distributing returns earned from assets to shareholders. These three functions are respectively known as financing decision, investing decision and dividend policy decision. While performing these functions, various other functions have also to be performed such as:

1. Determining the financial needs2. Financial control3. Routine functions(a)Supervision of cash receipts and payments and safeguarding of cash

balance.(b)Opening bank accounts and managing them.(c)Safeguarding of securities, insurance policies and other valuable

documents.(d)Maintaining record and preparation of reports.(e)Establishing a proper system of internal audit.

TIME VALUE OF MONEY Shareholders contribute their funds in the firm and in

considerations expect some future benefit either in the form of dividend or increased value of shares. Most of the financial decision, such as procurement of funds or acquisition of assets affects firm’s cash flow at different interval of time. If a firm raise fund through borrowings for present needs, these will have to be returned in future as interest and principal. Similarly funds can be raised through issue of share capital, but it will have to pay dividend on the share capital in future. On the other hand if a firm acquires an asset today, it will require immediate cash outflow, but the benefit of this asset will be received in future. While taking this type of decision, the firm will have to compare the total of cash inflows with the total cash outflows. For this the firm have to make appropriate adjustment for time otherwise it may take faulty decisions.

CONCEPT OF TIME VALUE OF MONEY “Time Value of Money’ is the value of a unit of money at different time intervals. The

value of money received today is different from the value of money received after some time in the future. In other words, the value of money changes over a period of time. An important financial principle is that the value of money is time dependent. Since a rupee received has more value, rational investors would prefer current receipts to future receipts. That is why this phenomenon is also referred to as “Time Preference of Money’. This principle is based on the following four reasons:

• Inflation: Under inflationary conditions the value of money, expressed in terms of its purchasing power over goods and services, declines.

Risk: Money received today is certain. However, money receivable at a future date is less certain and has some degree of risk attached to it. This factor reminds us the famous English saying “A bird in hand is worth two in the bush”.

• Personal Consumption Preference: Many individuals have a strong preference for immediate rather than delayed consumption. The promise of a bowl of rice next week counts for little to the starving man.

• Investment Opportunities: Money like any other desirable commodity has a price, given the choice of Rs.100 now or the same amount in one year’s time, it is always preferable to take the Rs.100 now because it could be invested over the next year at (say) 18% interest rate to produce Rs.118 at the end of one year. If 18% is the best risk-free return available, then you would be indifferent to receiving Rs.100 now or Rs.118 in one year’s time. Expressed another way, the present value of Rs.118 receivable one year hence is Rs.100.

Continued: After explaining various reasons for time preference

for money, let us take an example. For example, a firm wants to invest in a machine costing Rs. 10,00,000 now (cash out flow in zero period). The machine will give a cash inflow of Rs. 4,00,000 each, at the end of coming three years, hence making a total cash inflow of Rs.12,00,000 over three years. In this particular example cash inflows are occurring at different interval of time and hence are not comparable because of the time value of money principle. However, these cash flows can be made comparable by using discounting cash flow method.

SIMPLE INTEREST Simple interest is the interest calculated on the

original principal only for the time during which the money lent is being used. Simple interest is paid or earned on the principal amount lent or borrowed. Simple interest is ascertained with the help of the following formula:

Interest = PnrAmount = P(1 + nr)

Where, P = Principal r = Rate of Interest per annum (r being in decimal) n = Number of years

CONTINUED:Illustration What is the simple interest and amount of Rs.8,000

for 4 years at 12% p.a. Solution Interest = Pnr = 8,000 x 4 x 0.12 = Rs.3,840Amount (i.e. principal + Interest)

= P (1 + nr)= 8,000 [1+ (4 x 0.12)]= 8,000 (1+ 0.48)= 8,000 x 1.48= Rs.11,840

VALUATION TECHNIQUE• By compounding the various cash flows to a future date, or• By discounting the various cash flows to the present date. • Compound Value Concept• The compound value concept is used to find out the future value of

various cash flows. In case of this concept, the interest earned on the initial principal becomes a part of principal at the end of the compounding period. This interest earned on interest is known as compounding effect and hence compounding technique. The term compounded value is also referred to as terminal value i.e. value at the end of a period.

The importance of compound value concept can be understood by the famous statement given by Albert Einstein, “I do not know what the seven wonders of the world are, but I know the eighth ………compound interest”.

For example, if Rs. 1000 is invested at 10% compound interest for two years, the return for first year will be Rs. 100 and for the second year interest will received on Rs. 1100 (i.e. 1000 + 100) The total amount due at the end of second year will become Rs. 1210 (i.e. 1000+100+110). This can be understood better with the following illustration:

CONTINUED:Illustration: Rs. 10,000 is invested at 10% compounded annually

for three years. Calculate the compounded value after three years.

Solution:Amount at the end of 1st year will be:

10,000 + (10,000 × .10) = Rs. 11,000or 10,000 × (1.10) = Rs. 11,000Amount at the end of 2nd year will be:

10,000 + (11,000 × .10) = Rs. 12,100or 11,000 × (1.10) = Rs. 12,100Amount at the end of 3rd year will be:12,100 + (12,100 × .10) = Rs. 13,310or 12,100 × (1.10) = Rs. 13,310

This compounding procedure will continue for an indefinite time period.

APPLICATION OF COMPOUNDING TECHNIQUE

The above compounding technique can be used for calculating:

• The future value of single present cash flow.

• The future value of a series of unequal cash flows over a period of time.

• The future value of a series of equal cash flows over a period of time.

• The future value of a cash flow when compounding is done more than once in a year.

1. The Future Value of Single Present Cash Flow

The future value of single present cash flow can be calculated with the help of following mathematical formula:

A = P (1 + i) n

Where,

A = Amount at the end of ‘n’ period

P = Principal amount at the beginning of the ‘n’period

i = Rate of interest per payment period (in decimal)

n = Number of payment periods

CONTINUED: What sum will amount to Rs.5,000 in 6 years time at 8 % per annum.SolutionA = P (1 + i) n

= 5,000 (1 + 0.08) 6

= 5,000 (1.08) 6

= 5,000 x 1587= Rs.7,935

Alternatively, this example can be solved by using future value interest factor table. Use of this table is quite useful as computation by this formula becomes difficult and time consuming if the number of years becomes large. This table gives the compounding value of future value of Re. 1 for various combinations of ‘i’ and ‘n’. The compounding value or future value from the table can be calculated by using the following fornula:

Compounding Value (future value) = P x FVIF i, n Where, P = Principal amountFVIF = Future value interest factor or compounding factor for given values of ‘i’

and ‘n’ taken from future

CONTINUED:Let us now solve the above example by using the compounding

value table:Future value to be received after 1st year:FV = 5,000 x 1.08 = 5400Future value to be received after 2nd year:FV = 5,000 x 1.166 = 5830Future value to be received after 3rd year:FV = 5,000 x 1.260 = 6,300Future value to be received after 4th year:FV = 5,000 x 1.360 = 6,800Future value to be received after 5th year:FV = 5,000 x 1.469 = 7,345Future value to be received after 6th year:FV = 5,000 x 1.587 = 7,935

2. The Future Value of a Series of Unequal Cash Flows over a Period of Time

When an investor has invested his money in installments over a period of time, he or she may want to know the value of his or her investments after a certain period. This can be calculated as illustrated below:

Illustration: Mrs. Meena Matta invested Rs. 20,000, Rs. 10,000 and Rs. 5,000 at the starting of 1st , 2nd and 3rd year. Calculate the compound value of her investment at the end of 3rd year when interest is provided at the rate of 10% compounded annually.

Solution:

Compounded value or FV of Rs. 20,000 invested for 3 years

FV = 20,000 (1 + 0.10) 3 = Rs. 26,620

Compounded value or FV of Rs. 10,000 invested for 2 years

FV = 10,000 (1 + 0.10) 2 = Rs. 12,100

Compounded value or FV of Rs. 5,000 invested for 1 years

FV = 5,000 (1 + 0.10) = Rs. 5,500

Hence, total compounded value of Mrs. Meena Matta investments will be:

= Rs. 26620 + Rs. 12,100 + Rs. 5,500 = Rs. 44,220

CONTINUED: Alternatively, this illustration can be solved by

using future value interest factor table as follows:

Amount of Mrs. Meena Matta at the end of 3 rd year will be:

= 20,000 x 1.331 + 10,000 x 1.210 + 5,000 x 1.10

= 26,620 + 12,100 + 5,500 = 44,220

Where, 1.331, 1.21 and 1.10 are the compounding values of Re 1 at 10% rate of interest after 3,2 and 1 year respectively.

The Future Value of a Series of Equal Cash Flows over a Period of Time (FV of an

Annuity): A series of equal cash flows (either inflow or

outflow) occurring over a period of equal time intervals is known as annuity. Suppose in the above illustration if Mrs. Meena Matta invests Rs. 20,000 an equal amount at the end of 1st year, 2nd year and 3rd year for 3 years at a certain rate of interest. This outflow of equal amount at equal time intervals can be termed as annuity.

CONTINUED:Illustration: Mrs. Geeta Damir invested Rs. 20,000, at the end of 1st, 2nd and

3rd year. Calculate the compound value of her investment at the end of 3rd year when interest is provided at the rate of 10% compounded annually.

Solution:Amount of Mrs. Geeta Damir at the end of 3rd year will be:= 20,000 x 1.210 + 20,000 x 1.110 + 20,000 x 1.00 = 24,200 + 22,000 + 20,000 = 66,200However, compounding value of this annuity can also be determined by

using the future value interest factor for an annuity of Re 1 Table.Compound value (Future Value) of an annuity = Annuity Amount x FVIFA

i, n Where FVIFA i, n = 20,000 x 3.310 = Rs. 66,200. Here, 3.310 is the compounding factor of an annuity of Re 1 at an

interest rate of 10% for 3 years taken from the future value interest factor for an annuity of Re. 1 Table.

4. The Future Value of a Cash Flow when Compounding is done More Than once in a Year

In all of the above illustrations, compounding of interest has been done on annual basis. However, in many cases interest is compounded more than once in a year, say semi-annually, quarterly or even monthly.

When interest is payable half - yearly I 2 * nFV = P 1 + ----- 2 When interest is payable quarterly I 4 * nFV = P 1 + ---- 4

Continued:

When interest is payable monthly

I 12 * n

FV = P 1 + ----

12

When interest is payable daily

I 365 * n

FV = P 1 + ------

365

Continued: Find the compound interest on Rs.2,500 for 15 months at 8%

compounded quarterly.Solution I 4 * n FV = P 1 + ------ 4 0.08 4 * 1.25 FV = 2500 1 + --------- 4 5 FV = 2500 1.02 FV = 2500 X 1.104 = 2,760 Compound Interest = 2,760 - 2,500 = Rs.260

Continued:Illustration: Mrs. Kanta Rani Damir has invested Rs. 1,00,000 for

3 years at the interest rate of 12% per annum compounded quarterly. Find the amount she will get after 3 years.

Solution We know, FV = (1 + i) n

Where, P = Principal = Rs. 1,00,000 12i = Effective rate of interest per quarter = ------ = 3%

4 n = No. of quarters = 3x4 = 12Hence,FV = 1,00,000 (1 + 0.03) 12 = 1,00,000 x 1.426 = 1,42,600Where, 1.426 is the compounding factor of Re. 1 at 3% per

quarter interest for 12 periods (quarters).

PRESENT VALUE OR DISCOUNTING CONCEPT

“Deposit Rs. 1,000 and take back Rs. 1,100 after one year”, stated in another way means that Rs. 1,000 is the present value of Rs. 1,100 to be received a year hence. The present value concept is exact opposite of the compounding technique concept. In case of compounding we calculate the future value of a sum of money or series of payments, while in case of Present Value Concept, we estimate the present worth of a future payment / installment or series of payments adjusted for the time value of money.

Concepts in Valuation The basis of Present Value approach is that

opportunity cost exists for money lying idle. This return is termed as ‘discounting rate’.Given a positive rate of interest, the present value of future rupee will always be lower. The technique for finding the present value is termed as ‘discounting’.

Discounting concept can be explained for calculating:1. Present value of a future sum.2.Present value of a series of unequal cash flows.3. Present value of a series of equal cash flows.

Present Value of Future Cash The present value of money received in future will be less than

the value of same money in hand today. This is because the money in hand can be invested and its absolute value can be increased at a future date. Whereas money received in future has to be discounted to find its present value. This can be calculated as per the following formula:

APV = ---------- (1 + i) n

Where, PV = Present ValueA = Amount or future cash flowsi = Rate of interest per annum or per periodn = No. of years or periods

Continued: Mrs. Rani Damir of Kota is supposed to get Rs. 1,00,000 after 3 years.

Let existing rate is 10%. Find the present value of this sum which Mrs. Rani will get after 3 years.

APV = ---------- (1 + i) n

Where,A = Rs. 1,00,000, i = 10 % p.a., n = 3 years 1,00,000 1,00,000PV = -------------- = -------------------- = Rs. 75,130 (1 + 0.10) 3 1.1 x 1.1 x 1.1

However, this problem can be solved with the help of readymade table showing the present value of one rupee for various values of i and n with help of Present Value Interest Factor Table.

Hence, PV = A x discounting factor or present value interest factor = 1,00,000 x 0.7513 = Rs. 75,130

Present Value of Series of Unequal Cash Flows In a business situation, it is very natural that returns received by a firm are

spread over a number of years. An investment made now may fetch returns for a period after some time. Any businessman will like to know whether it is worth to invest or forego a certain sum now, in anticipation of returns he will earn over a number of year(s). In order to take this decision he will need to equate the total anticipated future returns, to the present sum he is going to sacrifice. To estimate the present value of future series of returns, the present value of each expected inflows will be calculated. (In case of compounding, the expected future value of series of cash flows was calculated).

The present value of series of cash flows can be represented by the following formula: A1 A 2 A 3 A n

PV = ---------- + ------------- + ------------- + …………… (1 + i) (1 + i) 2 (1 + i) 3 (1 + i) n Where: PV = Sum of present values of each future cash flow A1, A2, A3 = Cash flows after period 1, 2, 3, etc.

i = Discounting rate n = No. of years or periods

Continued: Given the time value money as 10% (i.e. the

discounting factor), you are required to find out the present value of future cash inflows that will be received over next four years.

Year Cash flows (Rs.) 1 10,000 2 20,000 3 30,000 4 40,000 Present value factors or discount rate at 10% is

0.909, 0.826, 0.751 and 0.683.

Present Value of an Annuity or Present Value of Equal Cash flow

In the above case there was a mixed stream of cash inflows. An individual or depositor may receive only constant returns over a number of years. For example returns on debentures / fixed deposits etc., is fixed in its nature. This implies that the cash flows are equal in amount. To find out the present value of annuity either we can find the present value of each cash flow or use the annuity table. The annuity table gives the present value for an annuity of Re. 1 for interest rate ‘r’ over number of years ‘n’.

Continued: Calculate the Present Value of Annuity of Rs. 5,000

received annually for four years, when discounting factor is 10%.

Alternatively, formula for calculation of the present value of an annuity can be derived from the formula for calculating the Present Value of a series of cash flows.

PV = A x PVIFA i, n

Where, PV = PVIFA i, n is the present value interest factor for an annuity of Re. 1 at the rate of interest for n periods or simply discounting factor for an annuity of Re. 1.

The PV in the above example can be calculated as:5000 × 3.170 = Rs. 15,850.

Present Value of a Perpetual Annuity A person may like to find out the present value of his

investment in case, he is going to get a constant return year after year. An annuity of this kind which goes on forever is called perpetuity. A practical example is the way in which scholarships are given to the students in schools / colleges. An individual invests a certain sum of money, on which a constant interest is received year after year. This return is given in the form of award, to students achieving academic excellence. This type of annuity continues forever.

Continued: The present value of perpetuity of an amount A can

be ascertained by simply dividing A by interest rate as discount i, symbolically represented as:

A

PVp = ------

i

Where,

PV p = Present value of perpetuity

A = amount of an equal cash flow

i = Rate of interest

Continued: Mr. Ramesh Naruala, principal wishes to institute a

scholarship of Rs. 5000 for an outstanding student every year. He wants to know the present value of investment which would yield Rs. 5,000 in perpetuity, discounted at 10%.

Solution: The present value can be simply calculated by:

A 5,000PVp = ------ = ---------- = Rs. 50,000 i 0.10 This is quite convincing since an initial sum of Rs.

50,000 would be invested at a rate of 10% and it would provide a constant return of Rs. 5,000 for ever without any loss of initial capital.

CALCULATION OF DOUBLING PERIOD

Generally, investor may be interested to know the period in which their investment becomes double. There is a thumb rule for this purpose which avoids the use of future value interest factor table. This rule is known as rule of 72. According to this rule the doubling period is obtained by dividing 72 by the interest rate. Hence,

72Doubling Period = ------ r

Continued: There is another more accurate rule of thumb (where r = rate of interest)

known as rule of 69 for calculating doubling period. According to this rule, doubling period can be calculated as follows:

69 Doubling Period = 0.35 + ------- r For example, if the rate of interest is 10 %, then doubling period

through these rules can be calculated as follows: 72 72Doubling Period = ------ = ---------- = 7 years and 2 months

r 10 69 69Doubling Period = 0.35 + ------- = 0.35 + -------- = 0.35 + 6.9 = r 107.25 = 7 Years and 3 Months.

SOURCES OF SHORT-TERM AND LONG-TERM FINANCE

One of the important constituents of financial system is the financial market instruments, popularly known as financial products. As on date, wide range of financial products are available in the Indian Financial Market. As more variety of financial products are available in the market, it suits the need of variety of investors, and as a consequence more and more investors are attracted towards the financial market.

The main criteria for the success of a financial product is that investor gets a reasonable return on his investment and issuer gets credit on reasonable terms.

KINDS OF FINANCIAL MARKET INSTRUMENTS

1. SHARES Section 2(46) of the Companies Act, 1956 defines the

term “share”. As per this share means share is the share capital of a company; and includes stock, except where a distinction between stock and share is expressed or implied.

By its nature, a share is not a sum of money but a bundle of rights and liabilities. From investor point of view a share is a right to participate in the profits of a company, while it is a going concern and declares dividend; and right to participate in the assets of the company, when it is wound up. On the other hand from company point of view, a share is a liability as it is to be returned at the time of winding up.

Continued:There are two types of shares:1. Preference shares2. Equity sharesPreference Shares: A preference share is a share

which fulfills the following two conditions:(a)It carries preferential right in respect of payment of

dividend; and (b)It also carries preferential right in regard to

repayment of capital. In simple words, preference share capital must

have priority both regards to dividend as well as capital.

TYPES OF PREFERENCE SHARES

1. Redeemable and Irredeemable Preference Shares (Sec. 80): Redeemable with in 20 years from the date of its issue. As per Companies (Amendment) Act, 1996, with effect from 1st March, 1997, a company cannot issue irredeemable preference shares.

2. Participating and Non-Participating Preference Shares: Preference shares are always non-participating, unless expressly stated to be participating.

Continued:3.Cumulative and Non-Cumulative Preference

Shares: Preference shares are always cumulative, unless expressly stated to be non-cumulative.

4. Convertible Preference Shares: This instrument is in two parts i.e., part A and part B. Part A is convertible into equity shares automatically and compulsory on the date of allotment without any application by the allottee. Part B is redeemed at par or converted into equity share after the lock-in-period, at the option of the investor, at a price 30% lower than average market price.

EQUITY SHARE Equity share means share which is not a preference share.

There are three kinds of equity shares: Equity shares with equal rights, Equity shares with differential rights and Sweat Equity share.

1. Equity Shares with Equal Rights: Here all the shareholders have equal rights in respect of dividend, voting or otherwise.

2. Equity Shares with Differential Rights: The Companies (Amendment) Act, 2000 has enabled the companies to issue equity share capital with differential rights as to dividend, voting or otherwise in accordance with such rules and conditions as may be prescribed. The Central Government has since notified the Companies (Issue of share capital with differential right) Rules, 2001.

Continued:3. Sweat Equity Shares: The concept of sweat

equity shares has been introduced to Companies (Amendment) Act, 1999 by inserting a new section 79 A in the Companies Act, 1956.

‘Sweat Equity Share’ means equity shares issued by the company to its employees or directors at a discount or for consideration other than cash, for providing know how, making available rights in the nature of intellectual property rights or value creation or by whatever name called.

2. DEBENTURES

Section 2 (12) of the Companies Act, 1956 defines debentures as: “ Debenture includes debenture stock, bonds and any other securities of a company, whether constituting a charge on the company’s or not”

In simple words, a debenture may be defined as an instrument acknowledging a debt to a company by some person or persons.

TYPES OF DEBENTURES

1. Redeemable and Perpetual or Irredeemable Debentures.

2. Registered and Bearer Debentures

3. Secured and Unsecured Debentures

4. Convertible and Non-Convertible Debentures

5. Third Party Convertible Debentures

6. Fully Convertible Debentures with Interest (optional).

PUBLIC DEPOSITS

Public deposits is a kind of borrowing made by companies. It may be noted that public deposits are always unsecured borrowings.

‘Deposit’ means any deposit of money with, and includes any amount borrowed by a company but shall not include such categories of amount as may be prescribed in consultation with the Reserve Bank of India.

BONDS Bond is a negotiable certificate evidencing indebtedness. It is normally

secured. A debt is generally issued by a company, municipality or Government. A bond investor lends money to the issuer and in exchange, the issuer promises to repay the bond amount on a specified date. The issuer usually pays the bond holder periodic payments over the life of the bond.

TYPES OF BONDS

1. Zero Coupon Bond 2.Deep Discount Bond3. Convertible Bond 4. Dual Convertible Bond5. Stepped Coupon Bond 6. Floating Rate Bonds and Notes7. Commodity Bonds 8. Capital Index Bonds9.. Disaster Bonds 10. Easy Exit Bonds11. Clip and Strip Bonds 12.Industrial Revenue Bonds13. Carrot and Stick Bonds

Continued:1. Zero Coupon Bond : This bond is issued at a discount

and repaid at a face value. No periodic interest is paid. The difference between the issue price and redemption price represents the return to holder. The buyer of these bonds receives only one payment at the time of maturity of the bond.

2. Deep Discount Bond: This bond is issued at a very high discount on its face value and face value is paid at the time of maturity. IDBI (Industrial Development Bank of India) and SIDBI (Small Industries Development Bank of India) had issued this instrument. IDBI had issued deep discount bond of face value of Rs. 1,00,000 at a price of Rs. 2,700, with a maturity period of 25 years. Alternatively investor can withdraw from the investment periodically after five years.

Continued:3. Convertible Bond: A bond giving the investor the

option to convert the bond into equity at a fixed conversion price.

4. Dual Convertible Bond: A dual convertible bond is convertible into either equity share or debentures/preference shares, at the option of the investor.

5. Stepped Coupon Bond: Under stepped coupon bonds, the interest rate is stepped up or down during the tenure of the bond. The main advantage to the investor is the attraction of higher rate of interest in case of general rise in interest.

Continued6. Floating Rate Bonds or Notes: In this case, interest is not

fixed and is allowed to float depending upon market conditions. The instrument is used by the issuer to hedge themselves against the volatility in interest rates.

7. Commodity Bonds: commodity bonds are bonds issued to share the risk and profitability of future commodity prices with the investors. For example, Petro bonds, Silver Bonds, Gold Bonds, Coal bonds etc.

8. Capital Index Bonds: Capital Index bonds are inflation protection securities. Such bonds, therefore provide good hedge against inflation risk. The return to the investors in these bonds is connected with the wholesale price index.

9. Disaster Bonds: These are issued by companies and institutions to share the risk and expand the capital to link investor returns with the size of insurer losses. The bigger the losses, the smaller the return and vice-versa.

Continued10. Easy Exit Bonds: Easy exit bonds are bonds

which provides liquidity and easy exit route to the investor by way of redemption where investor can get ready encashment in case of need to withdraw before maturity.

11. Clip and Strip Bonds: In clip and strip bonds, two separate coupon instrument are sold to the investors. The streams of coupon payments are stripped away and the principal amount of the bond is sold as a deep discount bond. The gain to investor is difference between the purchase price and the par value.

Continued12. Industrial Revenue Bonds: Industrial revenue

bonds are issued by financial institutions in connection with the development of the industrial facilities. These may become attractive if certain income tax and wealth tax concessions are offered.

13. Carrot and Stick Bonds: Carrot and Stick bonds are the variations of convertible debentures redeemable at premium. The carrot (incentive) is the lower than the normal conversion premium. The stick is the issuer’s right to call the issue at a specified premium if the price of equity shares is traded above a specified percentage of the conversion price.

MONEY MARKET Money market refers to the market where borrowers

and lenders exchange short-term funds to solve their liquidity needs.

The money market is a market which uses overnight or short-term funds. It also uses financial assets that are close substitute for money i.e., those which can easily be converted into money with minimum transaction cost and without a loss in value. It refers to the segment of financial system which enables the raising of short-term funds for meeting the temporary shortages of cash and obligations as well as temporary deployment of excess funds for earnings returns.

Continued: The money market operates as a whole sale market

and has a number of inter-related sub-markets such as the call market, the bill market, the treasury bill market, the commercial paper market, the certificate of deposit market etc. The volume of transaction in money market is very large and varied and skilled professional operators are required to ensure successful operations. Due to its flexibility, money market trading is mostly done on telephone with written confirmation from both borrowers and lenders being sent immediately thereafter. The transaction are required to be on ‘same day settlement’ basis.

CHARACTERSTICS OF MONEY MARKET

• Short duration i.e., intra-day to one year.

• Large size of instruments.

• High liquidity due to existence of secondary market.

• High safety because only persons of high standing are selectively permitted by the RBI to enter this market.

• Market determined interest rates.

OBJECTIVES OF MONEY MARKET

The broad objectives of money market are to provide the following:

• A balancing mechanism for short-term surpluses and deficiencies.

• A focal point of RBI intervention for influencing liquidity in the economy.

• A reasonable access to the users of short-term funds to meet their requirements at realistic / reasonable price or cost.

CONSTITUENTS OF MONEY MARKET

Commercial banks, financial institutions, large companies and the Reserve Bank of India are the major constituents of Indian money market. RBI as the residual source of funds in the country plays a key role and holds a strategic importance in the money market. RBI is able to expand or contract the liquidity in the market through different instruments as Statutory Liquidity Ratio (SLR), Current Liquidity Ratio (CLR), etc. Thus, RBI policy controls the availability and the cost of credit in the economy.

MONEY MARKET INSTRUMENTS 1. MONEY AT CALL AND MONEY AT SHORT

NOTICE: Money at call is outright money. Money at short notice is for a maturity of or upto 14 days. The participants are bank and All India Financial Institutions as permitted by RBI. Corporate with minimum lendable resources of Rs. 20 crores for transaction have also been permitted to lend in the market through Discount and Finance House of India Limited (DFHI). DFHI is an organization which was set up to develop an active secondary market for money market instruments and integrate various segments of the market in order to facilitate the smoothening of short-term liquidity imbalances.

The market is over the telephone market. Non-bank participants act as lenders only. Banks borrow for a variety of reasons to maintain their Cash Reserve Ratio, to meet heavy withdrawals, to adjust their maturity mismatch etc.

Continued:2. Commercial Bills: Commercial bills are

basically negotiable instruments accepted by buyers for goods or services obtained by them on credit. Such bills, being bills of exchange, can be kept up to due date and encashed by seller or may be endorsed to a third party in payment of dues to the latter. But the most common method is that the seller who gets the accepted bills of exchange discounts it with the banks or Financial Institutions or Bill Discounting Houses and collects money, less the interest charged for the discounting.

Continued3. Certificate of Deposits: Certificate of Deposits

are similar to the traditional term deposit but are negotiable and can be traded in the secondary market. A Certificate of deposit is a document of title at a time of deposit.

Certificate of deposit are issued in multiple of Rs. 1 lakh, subject to minimum investment of Rs. 1 lakh per investor. The maturity of certificate of deposit varies between 15 days and 1 year.

Continued4. Commercial Paper: The Commercial Papers refers to the unsecured

promissory notes issued by credit worthy companies to borrow funds on a short-term basis. In India, this instrument has been introduced to enable high rate borrowers to have new avenues for short-term borrowing and also providing an additional instrument to investors.

Commercial paper can be issued in multiples of Rs. 5 lakhs but the amount to be invested should not be less than Rs. 5 lakhs face value. The commercial papers are issued for maturities between 7 days and 365 days from the date of issue.

All India Financial Institutions and Corporates can raise the funds by issue of commercial papers. However corporates can raise the funds subject to the satisfaction of the following conditions:

1. It should have a tangible net-worth of at-least Rs. 4 crore. 2. It must have availed the working capital facility from some banks or financial institutions. 3. Commercial papers proposed to be issued should have minimum specified credit rating from any of the approved credit rating agency.

Continued5. Term Money: The term money will be for 14 days to 90 days,

with highly elastic interest rates fixed by market farces on demand and supply. The short-term money market in the formal market (consisting of RBI. SBI, Banks, LIC, UTI, GIC) relate to term money market, commercial bill market and inter-deposit market.

6. Bills Rediscounting: Bill-financing seller drawing a bill of exchange and the buyer accepting it, thereafter seller discounting it with, say a bank, is an important device for fund raising in advanced countries. The bills are liquidated on maturities. Hundies (an indigenous form of bill of exchange) have been popular in India, too. But there is a general reluctance on the part of buyers to commit themselves to payments on maturity. In addition, banks have a facility to rediscount the bills with the RBI and other approved institutions like LIC, GIC, UTI, IFCI, DFHI etc.

Continued6. Bills Rediscounting: Bill-financing seller drawing

a bill of exchange and the buyer accepting it, thereafter seller discounting it with, say a bank, is an important device for fund raising in advanced countries. The bills are liquidated on maturities. Hundies (an indigenous form of bill of exchange) have been popular in India, too. But there is a general reluctance on the part of buyers to commit themselves to payments on maturity. In addition, banks have a facility to rediscount the bills with the RBI and other approved institutions like LIC, GIC, UTI, IFCI, DFHI etc.

Continued7. Government Securities / Gilt – Edged Securities:

Government Securities (G-Sec) are sovereign securities which are issued by the Reserve Bank of India on behalf of the Government. The term ‘Government Securities’ includes Central Government Securities, State Government Securities and Treasury Bills. The Central Government borrows funds to finance it fiscal deficit.

Benefits of Investing in Government Securities1. No tax deducted at source.2. Additional Income Tax Benefit u/s 80L.3. Zero default risk.4. Highly liquid.5. Qualifies for Statutory Liquidity Ratio (SLR) purpose.

Continued8. Treasury Bills: Treasury bills are claims against

the government. They are negotiable securities and since they can be rediscounted with the RBI. They are highly liquid. As a result, RBI holds the major portion of outstanding treasury bills. The other feature of treasury bills are absence of default risk, easy availability, assured yield, low transaction cost, etc.

The treasury bills are issued are for 14 days, 91 days, 182 days and 364 days. Bids for Treasury Bills are to be made for a minimum amount of Rs. 25,000 only and in multiple therof.

Internal Source of Finance An existing company earning a good amount of

profit has the option of not distributing dividend to it its shareholders. The company realizing profitable investment opportunities can plough back its undistributed profit to pursue its growth expansion strategies. This way company is financing its investment from the internal sources.

1.Depreciation as a source of internal financing.

2.Retained earnings as a source of internal financing.

FOREIGN CAPITAL AS A SOURCE OF FINANCE

Foreign capital has become an important source of finance for Indian industries in different ways. It refers to the funds provided by foreign investors. These investors may be foreign governments, institutions, banks, business corporations or individual investors. Till 1990, quantum of foreign capital investment was quite low. However, with the introduction of economic reforms in 1991 and starting of the process of liberalization and globalization, government has encouraged the inflow of foreign investments in India. Government has taken a number of policy initiatives since then to attract foreign investment in various sectors of economy. There have been different ways in which the foreign investment is coming to the India namely (i) Foreign direct investment (FDI) (ii) Foreign portfolio investment (iii) Foreign commercial borrowings.

FOREIGN DIRECT INVESTMENT Foreign Direct Investment refers to the investment made by foreign

companies by setting up their branches, subsidiaries in another country. FDI, helps the foreign companies by setting up their companies to invest heavily in establishing their manufacturing branches, setting up marketing facilities, service centers etc. The foreign companies not only invest their funds but also bring scarce materials, professional know-how and superior technologies. Under the FDI mechanism, foreign companies are allowed to take back the profits earned on such investments, to their respective home countries. Indian government after the post reforms era, has been encouraging flow of FDI from Non-Resident Indians (NRIs) and Overseas Corporate Bodies (OCB). Government has created an institutional set-up like setting up of Foreign Investment Promotion Board (FIBB) in 1996, Foreign Investment Implementations Authority (FIIA), Secretariat for Industrial Assistance (SIA), Investment Promotion and Infrastructure Development cell to encourage FDI in India in a big way. Various tax concessions have been allowed to 100% Export oriented units or units set up in various economic zones or backward areas by overseas bodies. India has now become one of the favourite countries for such investment by foreign corporate bodies.

FOREIGN PORTFOILIO INVESTMENT Besides FDI, the Reserve Bank of India and the government

have allowed Indian companies with a proven track record to raise long term finance in foreign currencies through the issue of debt investments and ordinary shares from foreign capital markets. In 1993, government allowed Indian companies through a scheme known as “Issue of Foreign Currency Convertible Bonds and ordinary shares (through Depository Mechanism) scheme, 1993” to raise foreign capital. The scheme since then has been amended from time to time to encourage more and more foreign capital. Through this scheme Indian companies are allowed to raise long term loans or capital in foreign currency by way of issuing (a) Foreign currency convertible bonds, and (b) Ordinary shares through depository mechanism.

EURO ISSUES After the announcement of the above mentioned scheme in 1993, the Indian companies have started

raising long term finance from foreign investors and NRIs by way of Euro Issues. Euro Issue refers to the issue of a security listed in European Stock Exchanges, though the subscription from such issue can come from any country in the world. Indian companies have raised foreign currency funds by issuing various financial instruments like:

Foreign Currency Convertible Bonds (FCCBS): FCCBS are bonds issued according to the relevant scheme and subscribed by a non-resident investors in foreign currency and convertible into depository receipts or ordinary shares of the issuing company at a specified fixed price. Important features of these bonds are as follows:

• These bonds are unsecure in nature.

• They carry a fixed rate of interest which is quite low from Indian standard.

• Have a definite maturity date.

• An option for conversion into fixed number of ordinary shares of issuing company at a specified price.

• Denominated in a freely convertible foreign currency like U.S. dollars, Euros etc. Interest and redemption value is also paid in foreign currency.

• Can be freely traded in listed foreign stock exchanges. For example, Euro convertible bonds can befreely traded on European stock exchanges like London Stock Exchange, Luxemburg StockExchange.

Many Indian companies like Essar Gujrat, Jindal Strips, Reliance Industries, ICICI, TISCO etc. have raised foreign currency capital by issuing FCCBS.

Continued: European Deposit Receipts (EDRs): An EDR is a

depository receipt/certificate issued by an overseas depository bank outside India and issued to non-resident investors represented by the ordinary shares of the issuing company. Hence, like depository receipt, an EDR is also a negotiable instrument representing fixed number of ordinary shares of issuing company. EDR is tradable again in European stock exchanges.

Global Depository Receipts (GDRs): A GDR is a depository receipt which is listed on stock exchanges in U.S.A or Europe or in both. A GDR represents a certain number of ordinary shares of the issuing company. These ordinary shares are denominated in Indian currency i.e. rupee, though GDR is traded in dollars. Indian companies issue these shares to an overseas depository who in term issues these GDRs to the investors.

Continued: American Depository Receipts (ADRs): ADRs are used when funds are to be raised

through retail investors in U.S.A. ADR is again a depository receipt denominated in U.S. dollars issuing by a depository bank representing ordinary shares in non-U.S. companies. Through ADRs, an American investor can invest his funds in the ordinary shares of a non-U.S. company. This investment will be in the form of depository receipts offered for issue by a foreign company either is U.S. A or in international market. Advantages of raising long term finance through FCCBS, DRS (EDRs, GDRS. ADRs) are as follows:

• The cost of funds raised from foreign market is lower than the cost in the domestic market.

• Through the issue of FCCBs, EDRs, GDRs, and ADRs Indian companies collect the issue proceeds in the foreign currency. The foreign currency can be utilized for imports, repayment of foreign currency loans, acquisitions in foreign country etc.

• The issue of depository receipts does not involve any foreign exchange risk to the issuing company because shares are represented in rupees.

• There is no dilution of management control of the company as these issues do not give any voting rights to the holders.

• Depository receipts give their holders an option to convert them into ordinary shares of the company.

• The issue of these instruments in the international market enhances the reputation and goodwill of the issuing company worldwide. This gives strategic advantages to the company in dealing with bankers, customers, authorities etc.

• Because of the enhancement in the reputation of the company worldwide, its products find easy acceptability internationally.

LEVERAGE ANALYSIS A general dictionary meaning of the term ‘Leverage’ refers to “an

increased means of accomplishing some purpose”. Leverage allows us to accomplish certain things which are otherwise not possible, viz; lifting of heavy objects with the help of lever. This concept of leverage is valid in business also. In financial management, the term ‘leverage’ is used to describe the firm’s ability to use fixed cost assets or funds to increase the return to its owners; i.e. equity shareholders. James Horne has defined leverage as “the employment of an asset or sources of funds for which the firm has to pay a fixed cost or fixed return”. Thefixed cost (also called fixed operating cost) and fixed return (called financial cost) remains constant irrespective of the change in volume of output or sales. Thus, the employment of an asset or source of funds for which the firm has to pay a fixed cost or return has a considerable influence on the earnings available for equity shareholders. The fixed cost/return acts as the fulcrum and the leverage magnifies the influence. It must, however, be noted that higher is the degree of leverage, higher is the risk as well as return to the owners. It should also be remembered that leverage can have negative or reversible effect also. It may be favourable or unfavourable.

Continued: There are basically two types of leverages, (i)

operating leverage, and (ii) financial leverage. The leverage associated with the employment of fixed cost assets is referred to as operating leverage, while the leverage resulting from the use of fixed cost/return source of funds is known as financial leverage. In addition to these two kinds of leverages, one could always compute 'composite leverage' to determine the combined effect of the leverages. In the present days, the term leverage is also used in relation to working capital so as to measure the sensitivity of return on investment to changes in the level of current assets.

1. FINANCIAL LEVERAGE OR TRADING ON EQUITY

A firm needs funds so run and manage its activities. The funds are first needed to set up an enterprise and then to implement expansion, diversification and other plans. A decision has to be made regarding the composition of funds. The funds may be raised through two sources : owners, called owners equity, and outsiders, called creditors’ equity . When a firm issues capital these are owners' funds, when it raises, funds by raising long-term and short-term loans it is called creditors’ or outsiders’ equity. Various means used to raise funds represent the financial structure of a firm. So the financial structure is represented by the left side of the balance sheet i.e. liabilities side.

Continued: Traditionally, the short-term finances are excluded from the

methods of financing capital budgeting decisions, so, only long term sources are taken as a part of capital structure. The term capital structure refers to the relationship between various long-term forms of financing such as debentures, preference share capital, equity share capital, etc. Financing the firm’s assets is a very crucial problem in very business and as a general rule there should be proper-mix of debt and equity capital. The use of long-term fixed interest bearing debt and preference share capital along with equity share capital is called financial leverage or trading on equity. The long-term fixed interest bearing debt is employed by a firm to earn more from the use of these resources than their cost so as to increase the return on owner’s equity. It is true that the capital structure cannot affect the total earnings of a firm but it can affect the share of earnings for equity shareholders.

Continued: The fixed cost funds are employed in such a way that the

earnings available for common stockholders (equity shareholders) are increased. A fixed rate of interest is paid on such long-term debts (debentures, etc.). The interest is a liability and must be paid irrespective of revenue earnings. The preference share capital also bears a fixed rate of dividend. But, the dividend is paid only when the company has surplus profits. The equity shareholders are entitled to residual income after paying interest and preference dividend. The aim of financial leverage is to increase the revenue available for equity shareholders using the fixed cost funds. If the revenue earned by employing fixed cost funds is more than their cost (interest and/or preference dividend) then it will be to the benefit of equity shareholders to use such a capital structure. A firm is known to have a favorable leverage if its earnings are more than what debt would cost. On the contrary, if it does not earn as much as the debt costs then it will be known as an unfavorable leverage.

Continued: Every firms has to make its own decision

regarding the quantum of funds to be borrowed. When the amount of debt is relatively large in relation to capital stock, a company is said to be trading on their equity. On the other hand if the amount of debt is comparatively low in relation to capital stock, the company is said to be trading on thick equity.

IMPACT OF FINANCIAL LEVERAGE

The financial leverage is used to expand the shareholders earnings. It is based on the assumption that the fixed charges/costs funds can be obtained at a cost lower than the firm’s rate of return on its assets. When the difference between the earnings from assets financed by fixed cost funds and the costs of these funds are distributed to the equity stockholders, they will get additional earnings without increasing their own investment. Consequently, the earnings per share and the rate of return on equity share capital will go up. On the contrary, if the firm acquires fixed cost funds at a higher cost than the earnings from those assets then the earnings per share and return on equity capital will decrease. The impact of financial leverage can be analyzed while looking at earnings per share and return on equity capital.

Continued: A firm is considering two financial plans with a

view to examining their impact on Earnings per Share (EPS). The total funds required for investment in assets are Rs. 5,00,000.

Plan 1 Plan 2Debt (Interest @ 10% p.a.) 4,00,000 1,00,000Equity shares (Rs. 10 each) 1,00,000 4,00,000Total Funds required 5,00,000 5,00,000 The earnings before interest and tax are assumed

to Rs. 50,000, Rs. 75,000 and Rs. 1,25,000. the rate of tax be taken 50%. Comment.

Comments (1) Plan I is a leveraged financial plan because it has 80% debt financing

and has only 20% equity financing. Plan II is a conservative financial plan or thick trading on equity where fixed cost funds are only 20% of total funds and the rest is financed through equity capital.

(2) The EPS is increasing in Plan I with the increase in profits (EBIT). In situation (1) the earnings per share is same in both the plans i.e., Re. 0.50. As the EBIT has increased from Rs. 50,000 to Rs. 75,000 (situation 2) the EPS in plan I is Rs. 1.75 while it is Rs. 0.81 in plan II. EPS is Rs. 4.25 in Plan I and Rs. 1.438 in Plan II when EBIT increases to Rs. 1,25,000

(3) It is a clear from the analysis that EPS is increasing with the increase in profits in Plan I as compared to that of Plan II. This is possible with the use of more fixed cost funds in plan I as compared to Plan II.

(4) The increase in EPS in Plan I is due to the financial leverage because earnings before interest and tax are same in all the situation.

Illustration 2 G & H Ltd. Company has equity share capital of Rs. 5,00,000

divided into shares of Rs. 100 each. It wishes to raise further Rs. 3,00,000 for expansion cum modernization plans. The company plans the following financing schemes.

(a) All common stock(b)Rs. one lakh in common stock and Rs. two lakh in 10%

debentures.(c)All debt at 10% p.a.(d) Rs. one lakh in common stock and Rs. two lakhs in preference

capital with the rate of dividend at 8%. The company's existing earnings before interest and tax (EBIT)

are Rs. 1,50,000. The corporate rate of tax is 50%. . . You are required to determine the earnings per share (EPS) in

each plan and comment on the implications of financial leverage.

Comments In the four plans of fresh financing, Plan III is the most

leveraged of all. In this case additional financing is done by raising loans @ 10% interest. Plan II has fresh capital stock of Rs. one lakh while Rs. two lakhs are raised from loans. Plan IV does not have fresh loans but preference capital has been raised for Rs. two lakhs.

The earnings per share is highest in Plan III i.e. Rs. 12. This plan depends upon fixed cost funds and thus has benefited the common stockholders by increasing their share in profits. Plan II is next best scheme where EPS is Rs. 10.83. In this case too Rs. 2 lakhs are raised through fixed cost funds. Even in Plan IV, where preference capital of Rs. 2 lakhs is issued, it is better than Plan I where common stock of Rs. 3 lakh is raised.

The analysis of this information shows that financial leverage has helped in improving earnings per share for equity shareholders. It helps to conclude that higher the ratio of debt to equity the greater the return for equity stockholders.

Impact of Leverage on loss If a firm suffers losses then the highly leveraged

scheme will increase the losses per share. This impact is clear from the following illustration.

Illustration 3. Taking the figures in Illustration 2, a concern suffers a loss of Rs. 70,000. Discuss the impact of leverage under all the four plans.

Comments The loss per share is highest in Plan III because it has

the higher debt-equity ratio while it is lowest in Plan I because all additional funds are raised through equity capital. The leverage will have an adverse impact on earnings if the firm suffers losses because fixed cost securities will enlarge the losses.

Continued: Illustration 4. Calculate EPS (earning per share) of

SKM Ltd. and G & H Ltd. assuming (a) 20% before tax rate of return on assets (b) 10% before tax rate of return on assets based on the following data :

SKM Ltd. G & H Ltd.

Rs. Rs.

Assets 2,00,00,000 2,00,00,000

Debt (12%) ---- 1,00,00,000

Equity (Rs. 10 each) 2,00,00,000 1,00,00,000

Assume a 50% income tax in both cases. Also give your comments on the financial leverage.

Comments G & H Ltd. has used debt in its financing, as such

when the rate of return is 20% (higher than the cost of debt), its EPS is higher than that of SKM Ltd. which does not use any debt. But when the financial leverage is unfavorable at 10% rate of return (the cost of debt is higher), there is a negative impact of leverage and the EPS has decreased.

DEGREE OF FINANCIAL LEVERAGE

The degree of financial leverage measures the impact of a change in operating income (EBIT) on change in earning on equity capital or on equity share. Degree of financial leverage DFL can be calculated as:

Percentage change in EPSDFL = ------------------------------------- Percentage change in EBIT

or EBITDFL= --------------------- EBT (or, EBIT-I)

Illustration 5 XYZ Company has currently an equity share capital of Rs. 40

lakhs consisting of 40,000 equity shares of Rs. 100 each. The management is planning to raise another Rs. 30 lakhs to finance a major program of expansion through one of the four possible financing plans. The options are :

(i) Entirely through equity shares. (ii) Rs. 15 lakhs in equity shares of Rs. 100 each and the

balance in 8% Debentures. (iii) Rs. 10 lakhs in equity shares of Rs. 100 each and the balance

through long-term borrowing at 9% interest p.a. (iv) Rs. 15 lakhs in equity shares of Rs. 100 each and the balance

through preference shares with 5% dividend. The company’s expected EBIT will be Rs. 15,00,000. Assuming

corporate rate of tax 50%, you are required to determine the EPS and comment on the financial leverage that will be authorized under each of the above scheme of financing.

SIGNIFICANCE OF FINANCIAL LEVERAGE Financial leverage is employed to plan the ratio between debt and

equity so that earning per share is improved. Following is the significance of financial leverage :

(1) Planning of Capital Structure: The capital structure is concerned with the raising of long-term funds, both from shareholders and long-term creditors. A financial manager has to decide about the ratio between fixed cost funds and equity share capital.

(2)Profit Planning: The earning per share is affected by the degree of financial leverage. If the profitability of the concern is increasing then fixed cost funds will help in increasing the availability of profits for equity stockholders. Therefore, financial leverage is important for profit planning. The level of sales and resultant profitability is helpful in profit planning. An important tool of profit planning is break-even analysis. The concept of break-even analysis is used to understand financial leverage. So, financial leverage is very important for profit planning.

LIMITATIONS OF FINANCIAL LEVERAGE/TRADING ON EQUITY

The financial leverage or trading on equity suffers from the following limitations :1. Double-edged weapon: Trading on equity is a double-edged weapon. It can be

successfully employed to increase the earnings of the shareholders only when the rate of earnings of the company is more than the fixed rate of interest/dividend on debentures/preference shares. On the other hand, if it does not earn as much as the cost of interest bearing securities, then it will work adversely and hence cannot be employed.

2. Beneficial only to companies having stability of earnings: Trading on equity is beneficial only to the companies having stable and regular earnings. This is so because interest on debentures is a recurring burden on the company and a company having irregular income cannot pay interest on its borrowings during lean years.

3. Increases risk and rate of interest: Another limitation of trading on equity is on account of the fact that every rupee of extra debt increases the risk and hence the rate of interest on subsequent loans also goes on increasing. It becomes difficult for the company to obtain further debts without offering extra securities and higher rates of interest reducing their earnings.

4. Restrictions from financial institutions: The financial institutions also impose restrictions on companies which resort to excessive trading on equity because of the risk factor and to maintain a balance in the capital structure of the company.

2. OPERATING LEVERAGEOperating leverage arises due to the presence of fixed

operating expenses in the firm’s income flow. A company’s operating costs can be categorized into three main sections:

• Fixed Costs;• Variable Costs;• Semi-variable Costs. The operating leverage is the firm’s ability to use fixed

operating costs to increase the effects of changes in sales on its earnings before interest and taxes. Operating leverage occurs any time a firm has fixed costs. The percentage change in profits with a change in volume of sales is more than the percentage change in volume.The degree of leverage will be calculated as :

Continued: Contribution

Operating Leverage = ---------------------- Operating Profit (EBIT)

Contribution = Sales – Variable Costor

= Fixed Cost + ProfitOperating Profit = Sales – Variable Cost – Fixed Cost

or = Contribution – Fixed Cost

ContributionProfit Volume (P/V) Ratio = -----------------

Sales Fixed Cost

Break Even Point = ---------------- P/V Ratio

% Change in ProfitsDegree of Operating Leverage = ---------------------------

% Change in Sales

Continued: When production and sales move above the break

even point, the firm enters highly profitable range of activities. At break even point the fixed costs are fully recovered, any increase in sales beyond this level will increase profits equal to contribution. A firm operating with a high degree of leverage and above break even point earns good amount of profits.

If a firm does not have fixed costs then there will be no operating leverage. The percentage change in sales will be equal to the percentage change in profits. When fixed costs are there, the percentage change in profits will be more than percentage change in sales volume.

Continued: Illustration 6: Following is the cost information of

Kanchan Enterprises:Fixed Cost = Rs. 50,000Variable Cost = 70% of SalesSales = Rs. 2,00,000 in the previous year and

Rs. 2,50,000 in the current year. Find out percentage change in Sales and

Operating profits when:(i)Fixed costs are not there (no leverage).(ii)Fixed costs are there (leverage situation).

Solution (i) P.Y. C.Y. % Change

Sales 2,00,000 2,50,000 25Less: Variable Cost 1,40,000 1,75,000 25Profit from operations 60,000 75,000 25(ii) Sales 2,00,000 2,50,000 25Less: Var. cost 1,40,000 1,75,000 25Contribution 60,000 75,000 25Less: Fixed Cost 50,000 50,000Profit form operations 10,000 25,000 150

Comments:1. In situation (i) where there are no fixed costs or

absence of leverage the percentage change in sales and percentage change in operating profit is the same as 25%.

2. In situation (ii) where there are fixed costs, the leverage being occurring, the percentage change in profits (150%) is much more than the percentage change in sales (25%).

3. The fixed cost element has helped in increasing the percentage increase in profits.

Illustration 7

A firm sells a product for Rs. 10 per unit, its variable costs are Rs. 5 per unit and fixed costs amount to Rs. 5000 p.a. Show the various levels of operating profit that result from sales of 1000 units, 2000 units and 3000 units.

3. COMPOSITE LEVERAGEBoth financial leverage and operating leverage

increase the revenue of firm. Operating leverage affects the income which is the result of production. On the other hand, the financial leverage is the result of financial decisions. The composite leverage focuses attention on the entire income of the concern.

Composite Leverage = Operating Leverage x

Financial Leverage

Illustration 8

A company has sales of Rs. 5,00,000, variable cost of Rs. 3,00,000, fixed costs of Rs. 1,00,000 and long term loans of Rs. 4,00,000 at 10% rate of interest. Calculate the composite leverage.

CAPITAL BUDGETING The most important function of corporate finance

is not only the procurement of external funds for business but also to make efficient and wise allocation of these funds. The allocation of funds means the investment of funds in various assets and other activities. It is also known as ‘Investment Decision’, because a choice is to be made regarding the assets in which funds will be invested. These funds which can be acquired fall into two broad categories:

1.short-term or Current Assets;2.Long-term or Fixed Assets.

MEANING OF CAPITAL BUDGETING

Capital budgeting is the technique of making decisions for investment in long-term assets. It is a process of deciding whether or not to invest the funds in a particular asset, the benefit of which will be available over a period of time longer than one year.

“Capital budgeting consists in planning the deployment of available capital for the purpose of maximizing the long-term profitability of the firm”. R.M.Lynch

“Capital budgeting involves the planning of expenditures for assets, the returns from which will be realized in future time periods”. Milton H. Spencer

FEATURES OF CAPITAL BUDGETING DECISIONS

1. Funds are invested in long-term assets.

2. Funds are invested in present times in anticipation of future profits.

3. The future profit will occur to the firm over a series of years.

4. Capital budgeting decisions involve a high degree of risk because future benefits are not certain.

IMPORTANCE OF CAPITAL BUDGETING

1. Such decisions affect the profitability of the firm.

2. Long term periods.

3. Irreversible decisions.

4. Involvement of large amount of funds.

5. Risk

6. Most difficult to make.

KINDS OF CAPITAL BUDGETING DECISIONS

1. Accept – Reject Decisions;

2. Mutually Competitive Decisions;

3. Priority Order Decisions.

TECHNIQUES/METHODS/CRITERION FOR CAPITAL BUDGETING DECISIONS

1. Accounting Profit Criteria – Average Rate of Return Method

2. Cash Flow Criteria

(a) Pay Back Method

(b)Method based on Discounted Cash Flows:

(i) Net Present Value Method (NPV)

(ii) Profitability Index Method (PI)

(iii) Internal Rate of Return Method (IRR)

Average/Accounting Rate of Return Average Annual Profits after TaxesARR = --------------------------------------------- Average Investment Total Profit after

Tax of All years

Av. Annual Profits after Taxes = ---------------------No. of Years

Original Investment + Salvage Value

Av. Investment = ----------------------------------------

2

ILLUSTRATION 1A project having a life of 5 years will cost Rs.

4,00,000. its stream of income before depreciation and taxes is expected to be Rs. 1,00,000; Rs. 1,20,000; Rs. 1,60,000; Rs. 1,70,000 and Rs. 2,00,000 during the life of the project. Depreciation is charged on straight line basis and the rate of tax applicable to the firm is 40 per cent. Calculate ARR.

ILLUSTRATION 2 Geet Ltd., is considering the purchase of a machine. Two

machine are available , E and F. The cost of each machine is Rs. 60,000 each. Each machine has an expected life of 5 years. Net profit before tax during the expected life of machine are given below:

Year E F1 15,000 5,0002 20,000 15,0003 25,000 20,0004 15,000 30,0005 20,000 10.000Total 85,000 90,000 Following the method of return on investment, ascertain

which of the following alternatives will be more profitable. The average rate of tax may be taken at 50%.

ILLUSTRATION 3 Determine the average rate of return from the following date of

Machines A and B: Machine A Machine B

Rs. Rs.Cost 56,125 56,125Annual estimatedEarnings after dep.And tax 1st Year 3,375 11,3752nd year 5,375 9,3753rd year 7,375 7,3754th year 9,375 5,3755th year 11,375 3,375Estimated life of machines 5 years 5 yearsEstimated Salvage Value 3,000 3000Average Tax Rate 50% 50%

ADVANTAGES OF ARR

1. Simple;

2. Entire life time of the project is considered.

Disadvantages:

1. It uses accounting income rather than cash flows.

2. Time value of money is not considered.

3. Difficult to fix a pre-determined rate.

4. Size of investment not taken into consideration.

Pay Back MethodThis method calculates the number of years required to

payback the original investment in project. In other words, payback period is the period which is required to recover the original investment in a project.

Actual payback period calculated according to this method is compared with the pre-determined payback period fixed by the management in terms of maximum period during the original investment must be recouped. If the actual payback period is less than the pre determined payback period, the project would be accepted; if not, it would be rejected. Alternatively when many projects are under consideration, they may be ranked according to the length of the payback period. Obviously, projects having the shorter payback period will be selected.

Methods of calculating Payback Period1st Method This method is adopted when the project is generates

equal cash inflow each year. In such case, the initial cost of the investment is divided by the constant annual cash flow:

InvestmentPB = ---------------------------------------- Constant Annual Cash Flow2nd MethodThis method is adopted when the project generates unequal

cash inflow each year. . Under this method, payback period is calculated by adding up the cash inflows till the time they become equal to the original investment.

ILLUSTRATION 4 A project requires initial outlay of Rs. 80000 and

is expected to generate cash flow after tax but before depreciation of Rs. 8000; Rs. 20000; Rs. 14000; Rs. 30000; Rs. 32000 and Rs. 45000 during its 6 years life. Calculate the payback period.

ILLUSTRATION 5 ABC Ltd. Is considering the purchase of a machine. Two machines A and B

are available. Machine A will cost Rs. 60000 and has a life of 5 years. Machine B will cost Rs. 98000 and has a life of 7 years. There will be no salvage value from any machine.

The estimated cash flow before depreciation and tax from the two machines are as follow:

Year Machine A Machine BRs. Rs.

1 30000 428002 24000 356003 22000 284004 20000 212005 14000 180006 ---- 170007 ----- 16400 The company uses straight line depreciation method and tax rate is 50 %.

Which machine should be selected on the basis of payback period.

Advantages of Payback Method

1. Simple

2. Appropriate in case of uncertain conditions

3. Importance to short-term earning

4. Superior to ARR method

Disadvantages

1. It ignores the cash flow after the pay back method.

2. It ignores time value of money

3. It ignores the profitability of the project.

Net Present Value MethodNet Present Value (NPV) method is one of the Discounted

Cash Flow technique. Under this method present value of cash outflows and cash inflows is calculated and the present value of cash outflow is subtracted from the present value of cash inflows. This difference is called the Net Present Value (NPV)

Thus, NPV = PV of Inflow – PV of OutflowIn other words, NPV =Present value of cash inflows of no of

years – present value of cash outflow.If PVF is not given: 1 1NPV = Cash inflow x --------- + Cash inflow of 2nd year x ---------- (1 + r) (1 +r)2