FINANCIAL MANAGEMENT

What is finance?Finance is the art and science of managing money. Finance is concerned with the process, institutions, markets and instruments involved in the transfer of money among individuals, organisations and governments.

Classification of finance

Finance

Public Finance Private FinanceGovernment Institutions Personal Finance State governments Business FinanceLocal Self-Governments Finance for non-profit Central Government organisations

Meaning of Business Finance Finance of business activities. All creative human activities relating to the production and distribution of goods

and services for satisfying human wants are known as business. Finance may be defined as the provision of flows of money at the time when it is

required. Business finance is an activity or process which is concerned with acquisition of

funds, use of funds, and distribution of profits by a business firm.

DEFINITION OF FINANCIAL MANAGEMENT (CORPORATE FINANCE)

Financial management is referred to that part of management which is concerned with the planning and controlling of firm’s financial resources. It deals with finding various sources for raising funds for the firm and allocation of funds and thus aiming at maximising the profit earning capacity of the organisation and also its wealth.

Finance Function

1. Investment or Long-term asset mix decision2. Financing or capital-mix decision3. Dividend or profit allocation decision

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4. Liquidity or short-term asset-mix decision.

A’s of Financial Management1. Anticipating financial needs2. Acquiring financial resources3. Allocating funds in business

OBJECTIVES OF FINANCIAL MANAGEMENT

The term ‘objective’ is used in the sense of a goal or decision criterion for taking decisions for performing the above four functions.

The term objective provides a normative framework. The term used is in a rather narrow sense of what a firm should

attempt to achieve with its investment, financing and dividend policy decisions.

There are two main objectives of financial management viz., 1. Profit Maximisation and 2. Wealth Maximisation.

PROFIT MAXIMISATION

1. Actions that increase profits should be undertaken and those that decrease profits are to be avoided.

2. The investment, finance, dividend and liquidity decisions of a firm should be oriented to the maximisation of profits.

3. The term profit can be used in two senses. i. As a owner-oriented concept it refers to the amount of share of national

income which is paid to the owners of business, that is who supply the equity capital.

ii. As an operational concept, it signifies economic efficiency. In other words it is a situation where output exceeds input.

The rationale behind profitability maximisation

i. It is a test of economic efficiencyii. Provides yardstick to judge the economic performanceiii. Leads to efficient allocation of resourcesiv. Ensures maximum social welfare

Objections to Profit Maximisation

i. Ambiguity and vagueness of the concept of profit

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ii. It ignores the timing of the returns or benefitsiii. The quality of benefits are ignored i.e., the Risk is

ignored

An appropriate operational decision criterion for financial management should

i. Be precise and exactii. Be based on the bigger the better principleiii. Consider both the quality and quantity dimensions of

benefitsiv. Recognise the time value of money.

The alternative to profit maximisation is wealth maximisation is such a measure.

WEALTH MAXIMISATION

This is also known as value maximisation or net present worth maximisation. The following figure depicts the process of financial decision taking in terms of its impact on the share price of the firm’s stock:

A stockholder’s current wealth in the firm is the product of the number of shares owned, multiplied with the current stock price per share.

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Financial Manager

FinancialDecisionAlternativeAction

Return?Risk?

Increase Share Price?

No

Yes

Accept

Reject

Stock holder’s current wealth in a firm= Number of shares X Current stock price

Owned per share

Wo = NPo

The operational objective of financial management is the maximisation of the Wealth. This can be expressed by using the following formula

n

W = Σ At - Co

t =1 (1+k)t

W = A1 +

A2 +

A3 +……+

An - Co

(1+K) (1+K)2 (1+K)3 (1+K)n

Where W = Wealth i.e., Net worthA

1, A

2, A

3,…., A

n = the stream of cash flows expected to occur from a course of action over a period of time.

K = the appropriate discount rate to measure risk and timing; and C = the initial outlay to acquire that asset or pursue that course of action.

Implications of wealth maximisation

i. Since NPV is the measuring unit, those financial actions which a positive NPV should be accepted while rejecting those with negative NPV

ii. The questions of timing and risk are addressed by choosing an appropriate rate of discount

iii. Since the value of the firm is reflected through the value of its shares, the main the concern of the firm is to maximise the market value of its shares which in turn leads to wealth maximisation.

Criticism of wealth maximisation

i. It is a prescriptive but not descriptive and does not explain of what firms actually do

ii. The objective of wealth maximisation is not necessarily socially desirable

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iii. There is some controversy whether the aim to maximise the wealth of the firm or the shareholder

iv. It also faces some difficulties when ownership and management are separated as in the case of large corporations. Because the managers who act will act towards maximising the managerial utility but not always towards the maximisation of stock holders utility.

Traditional Role of Finance Managers In the past the role of financial manager was passive. He was considered as a part of the accounts department. His role was to maintain the store records, preparing accounting and other

quasi-financial reports, raising funds when needed. He was playing a passive role of an advisor. He was an office staff.

Changing Role of Finance Managers

A financial manager is one of the members of the top management team and his role day-by-day is becoming more pervasive, intensive and significant in solving complex management problems. In this present business context, a financial manager is expected to perform the following functions:

1. Financial forecasting and planning2. Acquisition of funds3. Investment of funds4. Helping in valuation decisions5. Maintain proper liquidity6. Profit planning7. Understanding capital markets

ORGANISATION OF FINANCE FUNCTION

The tasks of financial management are typically distributed between the two key financial officers of the firm viz., the treasurer and controller.

The treasurer is responsible mainly for financing and investment activities The controller is responsible primarily with accounting and control. The chief finance officer who may be designated as Director (Finance) or

Vice-President (Finance) supervises the work of the treasurer and the controller.

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In turn, several specialist managers working under them assist these officers.

The finance function in a large organisation may be organised as shown in the following exhibit.

Stock Holders

Elect

OWNERS

Hires

MANAGERS

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Board of Directors

President(CEO)

Vice President(Human

Resources)

Vice President

(Information Resources)

Vice President

(Manufacturing)

Vice President(Finance)

CFO

Vice President

(Marketing)

Treasurer Controller

Capital Expenditure

Manager

Foreign Exchange Manager

Pension Fund

Manager

Credit Manager

Cash Manager

Financial Planningand

fund raisingManager

Corporate Accounting

Manager

Financial Accounting

Manager

Cost Accounting

Manager

Tax Manager

Figure showing the Organisation of finance function

Treasurer Vs Controller

Treasurer Controller

1Provision of capital (both long term and short term)

1 Accounting

2Liaison with banks and financial institutions

2 Preparation of financial reports

3 Cash Management 3 Reporting and interpreting4 Receivables Management 4 Planning and control

5Protect funds and securities (insurance)

5 Internal audit

6 Investor relations 6 Tax administration

7 Audit 7Economic appraisal and reporting to Government

INDIAN FINANCIAL SYSTEM

The word system in

the term financial system implies a set of complex and closely connected or

interlinked institutions, agents, practices, markets, transactions, claims, and liabilities

in the economy.

The financial

system is concerned about money, credit and finance.

The three terms are

intimately related yet are somewhat different from each other.

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Money refers to the

current medium of exchange or means of payment.

Credit or loan is a

sum of money to be returned, normally with interest; it refers to the debt of an

economic unit.

Finance is monetary

resources comprising debt and ownership funds of the state, company or person.

The following exhibit shows the components of Indian Financial system consisting

of financial institutions, financial markets, financial instruments and financial services:

Regulatory Banking

Intermediaries Non-Banking

`Non-intermediaries Primary Secondary

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Financial system

Financial Instruments

[Claims, assets,Securities]

Financial Markets

FinancialInstitutions

Financial services

Others Organised Unorganised

Short term

Medium term

Primary Secondary Long term

Capital markets Money markets

Relationship between the Financial Institutions and Markets

Funds Funds

Deposits/Shares Loans

Funds

Funds

Securities

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Financial Institutions

Financial Markets

Demanders of funds

Suppliers of funds

Private Placement

Securities

Funds Funds

Securities Securities

Time Value of MoneyMoney has time value. A rupee today is more valuable than a rupee a year hence. This is

because of the following reasons:

1. The future is always uncertain and involves risk.2. People prefer to use their money for satisfying their needs than deferring them 3. In an inflationary period, a rupee today is worth more than what it is in the future4. Money has time value because of the opportunities available to invest the money so that

the available money can be enhanced through investment.

TECHNIQUES OF TIME VALUE OF MONEYThere are two techniques for adjusting the time value of money:

1. Compounding Technique2. Discounting or Present value technique

COMPOUNDING TECHNIQUE

The technique of finding the future value of the present sum of money is called compounding technique. In this technique the future sum is always more than the present value of the same money.

1. Future value at the end of period n can be calculated as under:

Vn= Vo(1+I)n

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ORVn = Vo (CFi,n)

WhereVn = Value after n number of yearsVo = original sum of money i.e., value of money at time 0 I= rate of interestCF = compound factor for i interest rate and n number of years.

2. Doubling period

Rule 72Doubling period = 72 Rate of interest

Rule 69Doubling period = 0.35 + 69 Rate of interest

3. Multiple compounding periods

Future value of money

m x nVn= Vo 1+ i

m

Effective Interest Rate

m EIR= 1+ i - 1

m

4. Future value of series of payments

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Vn =R1 (1+i)n-1 + R2 (1+i)n-2 + ………..+ (Rn-1) (1+i) + Rn

Where Vn = future value at a period nR1 = Payment after period 1R2 = Payment after period 2Rn = Payment after period n I = Rate of interest

Compound Value of an annuityAn annuity is a series of equal payments lasting for some specified duration. The

premium payments of a life insurance company are examples. When the cash flows occur at the end of each period, it is called regular annuity or a

deferred annuity. When the cash flows occurs at the beginning of each period, it is called annuity due.

5. Compound value of a deferred annuity

Using Mathematical formula Vn = R [(1+I) n-1 + (1+n) n-2 +…….+ (1+I)1 + 1]

Using compound factor tables Vn = (R ) (ACF I,n)

6. Compound Value of an Annuity Due

Using Mathematical formulaVn = R (1+i) n -1 (1+i)

i

Using compound factor tables Vn = (R ) (ACF i,n) (1+i)

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DISCOUNTING (OR ) PRESENT VALUE TECHNIQUE

This is the technique that is just opposite of the compounding technique. The present value technique tries to know the present of a sum of money which is being received at a future point of time. This is also called as discounting technique. In this the present sum of money is always less than the future sum.

7. Present value of a future receiptIf a single payment is to be received on a future date, or paid after a certain period, the

following formula can be used.

MathematicallyVo = Vn

(1+i)

Using Discount factor table Present Value (Vo)= Future Value(Vn) X DFi,n

8. Present value of a series of payments

n

Vo = Σ Rt where Rt is the payment at period t t=1 (1+i)t

9. Present value of a Regular Annuity If the amount of payment is R, the present value of an annuity can be calculated as under:

Using Mathematical formula

n

Vo = R Σ 1 t=1 (1+i) t

Using Annuity Discount factor tablesVn = (R ) (ADF i,n)13

10. Present value of a Annuity Due

Vn = (R ) (ADF i,n) (1+i)

11. Present value of an infinite life annuityThe present value of an infinite (,α) life annuity can be calculated as under

Vo = (R ) (ADF i,α)OR

Vo = R I

11. Present value of a Annuity growing at a constant rate

When the cash flows grow at a constant rate, we will have to calculate the series of cash flows and then the present value of the series of payments.

PRACTICAL APPLICATIONS OF TIME VALUE TECHNIQUES

1. Sinking Fund ProblemsA finance manager can do sinking fund problems very easily by using compounding

value technique:

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2. Capital recovery problemsThis can be calculated by applying the present value technique:

3. Compound growth rate problems

A finance manager can easily calculate such compound rate of growth by making use of the use of compound factor tables as under

Vn = (R ) (ACF i,n) or R = Vn (ACF i,n)

Vo = (R ) (ADF i,n) or R = Vn (ADF i,n)

Vn = Vo (CF i,n) and than CF i,n = Vo Vn

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INVESTMENT EVALUATION TECHNIQUES(CAPITAL BUDGETING TECHNIQUES)

A capital expenditure is an expenditure, the benefits of which are expected to be received over a period of time exceeding one year. Capital budgeting is the process of making investment decisions in capital expenditures. According to Charles T Horn green Capital budgeting is long term planning for making and financing proposed capital outlays.

Features of Investment Decisions1. The exchange of current funds for future benefits2. The funds are invested in long-term assets3. The future benefits will occur to the firm over a series of years.

Importance of investment decisions1. They influence the firm’s growth in the long run.2. They affect risk of the firm3. They involve commitment of large funds4. They have a long-term effect on profitability5. They are irreversible in nature or reversible at substantial loss6. They are among the complex decisions to make7. They are of national importance

Capital Budgeting Process

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1Identify

investment proposals

5Final Approval

3Evaluate the

proposals

7Review of

performance

6Implementation

of proposals

4Fix Priorities

2Screen Proposals

Capital Budgeting Process

Kinds of Investment Decisions

1. Based on the profitabilitya Those which increase revenueb Those which reduce costs

2. Based on the proposals under considerationa Accept reject decisionsb Mutually exclusive project decisionsc Capital rationing decisions

Investment Evaluation CriteriaThree steps are involved in the evaluation of an investment :

a Estimation of cash flowsb Estimation of the required rate of returnc Application of a decision rule for making the choice

METHODS OF EVALUATION OF INVESTMENT PROPOSALS

The various methods of evaluating profitability of capital investment proposals are as under:

A. Traditional Methods1. Pay-back period method or Pay out or Pay off Method2. Improvement of traditional approach to pay back period method3. Rate of return method or accounting method

B. Time – Adjusted Methods or Discounted Methods1. Net present value method2. Internal rate of return method3. Profitability Index method

A. TRADITIONAL METHODS

1. Pay-back period method or Pay out or Pay off Method1. This method measures the period of time for the original cost of a

project to be recovered from the additional earnings of the project itself. 2. Investments are ranked according to the length of their pay back

period 3. The investment with a shorter pay back period is preferred to the

one which has longer pay back period. 4. In case of evaluation of a single project, it is adopted if it pays

back for itself within a period specified by the management and if not it is rejected

The pay-back period can be ascertained in the following manner:1. Calculate annual net earnings (profits) before depreciation and after; these are

called annual cash inflows.

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2. Divide the initial outlay (cost) of the project by the annual cash inflow, where the project generates annual cash inflows. Thus where the project generates constant cash inflows:

Pay-back period = Cash outlay of the project (or) original cost of the asset

Annual Cash flows

3. Where the annual cash inflows ( profit before depreciation and after taxes) are unequal, the pay-back period can be found by adding up the cash inflows until the total is equal to the initial cash outlay of project or original cost of the asset.

Advantages of Pay-Back Period Method1. It is simple and easy to understand2. It saves cost, consumes les time and labour in capital budgeting

decisions3. It reduces the loss through obsolescence as the project having lesser pay-

back period is preferred4. It is suitable for a firm with limited cash resources and with a liquidity

position which is not very good

Disadvantages of Pay-Back Period1. It does not take into account the cash inflows occurring after the pay back period.2. It ignores the time value of money and does not consider the magnitude and timing of cash

flows.3. It Does not take into account the cost of capital4. It is difficult to determine the minimum acceptable pay-back period5. It treats each asset in isolation to other asset which is not practicable6. It does not consider the true profitability of the project as this is concerned only with the

short-term

2. Improvements in Traditional Approach to pay back period methoda Post Pay-Back Profitability method

pay back period method ignores the cash inflows after pay-back period and hence the true profitability of the project cannot be assessed. In this method the returns receivable beyond the pay-back period are taken into account. The returns are called post pay-back profits.

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Post Pay-back profitability index = Post Pay-Back profits X 100 Investment

b Pay-Back Reciprocal methodSometimes, pay-back reciprocal method is employed to estimate the internal rate of return generated by a project. pay-back reciprocals can be calculated as follows:

Pay-back reciprocal = Annual cash flow Total Investment

This method can be expressed in terms of percentage by multiplying the result by 100.

c Post Pay-Back Period methoda. The main shortcoming of pay back period method is that it ignores the life of the

project beyond the pay-back period. b. This method is also known as surplus life over pay-back method. c. According to this method, the project which gives the greatest post pay-back

period may be accepted.

d Discounted Pay-Back methoda. Another limitation of the pay-back period method is that it ignores the time value

of money. b. Under this method, the present values of all cash inflows and outflows are

computed at an appropriate discount rate. c. The present values of all inflows are cumulated in order of time.d. The time period at which the cumulated present value of cash inflows equals the

present value of cash outflows is known as discounted pay-back period. e. The project which gives a shorter discounted pay-back period is accepted.

3. Rate of Return Method This method takes

into account the earnings expected from the investment over their whole life. It is also known as

accounting rate of return method the accounting

concept of profit (net profit after tax and depreciation) is used rather than cash inflows.

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According to this method, various projects are ranked in the order of the rate of earnings or rate of return.

This method can also be used to make decision as to accepting or rejecting a proposal.

a. Average Rate of Return Method Under this method, the average profit after tax and depreciation is calculated and then it

is divided by the total capital outlay or total investment in the project. In other words, it establishes the relationship between average annual profits to total investments.

Average Rate of Return

= Total profits (after depreciation and taxes) X100

Net investment in the project X No. of years of profits

OR

Annual cash flow X 100 Total Investment

b. Return per unit of investment Method This method is an improvement over the average rate of return method. In this method the total profit after tax and depreciation is divided by the total investment.

Return per unit of investment

= Total profits (after depreciation and taxes) X 100 Net investment in the project

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c. Return on Average Investment Method Under this method, the return on average investment is calculated. Uding of average

investment for the purpose of return on investment is preferred because the original investment is recovered over the life of the asset on account of depreciation.

Return on average investment

= Total profits (after depreciation and taxes) X 100 Net investment in the project 2

d. Average Return on Average Investment Method This method is very suitable method of rate of return on investment. Under this method, average profit after depreciation and taxes is divided by the average amount of investment.

Average Return on average investment

= Average annual profit after depreciation and taxes X 100 Average investment

OR

Net investment in the project = Average annual Profit X 100 Net investment in the project 2

Advantages of Rate of Return Method:1. It is simple to understand and easy to operate2. it uses the entire earnings of a project in calculating rate of return and hence gives a better

view.3. This can be calculated from the financial data as this is based on the accounting concept

of profits.

Disadvantages of Rate of Return Method1. It ignores the time value of money2. It does not take into consideration any other cash flows except accounting profits3. It ignores the time period in which the profits are earned.

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4. It cannot be used to a situation where the investment in project is made in parts

B. TIME – ADJUSTED METHODS OR DISCOUNTED METHODS

The traditional methods of capital budgeting suffer from the various limitations like ignorance to the time value of money. The discounted or time-adjusted cash flow methods take into account, the profitability and the time value of money. These methods are also called as modern methods.

1. Net Present Value MethodIn this method, the net present values of the cash inflows and cash out flows occurring during the entire life of the asset is determined separately by discounting these flows by the firms cost of capital or a pre-determined rate. The following steps are to be necessarily followed.

i. Determine the appropriate rate of interest that should be selected as the minimum required rate of return. This is also called as discount rate or cut-off rate.

ii. Compute the present value of the cash outflows at the pre-determined discount rate

iii. Compute the present value of total investment proceeds i.e., cash inflows ( profit before depreciation and after tax) at the above discount rate

iv. Calculate the net present value of each project by calculating present value of cash inflows from the present value of cash outflows for each project

v. If NPV is positive or Zero, the project may be accepted. But if it is negative, the project should be rejected

vi. To choose between mutually exclusive projects, rank them in the order of NPVs and choose the one with the maximum NPV.

The present value PV= 1 (1+r)n

where r = rate of interest / discount raten = number of years

The present value of all the cash inflows for a number of years is thus found as follows:

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PV = A1 + = A2 + A3 +………..+ A3

(1+r) (1+r)2 (1+r)3 (1+r)n

If n is more then the calculation becomes difficult hence the present value factor tables have to be used.

Advantages of NPV Method1. It recognises the time value of money2. It is suitable for all situations of cash flows (even, uneven and uneven intervallic)3. It takes into account the earnings over the entire life of the project and hence true

profitability can be evaluated4. It takes into account the objective of maximum profitability

Limitations of NPV Method1. It is more difficult to understand and operate2. It may not give good results while comparing projects with unequal lives3. It may not give good while comparing projects with unequal investment of funds4. It is not easy to determine the appropriate discount rate

2. Internal Rate of Return Method

o This internal rate of return method is another discounted cash flow technique which takes into account the magnitude and timing of cash flows.

o This methods is also called as yield on an investment, marginal efficiency of capital, rate of return over cost, time-adjusted rate of internal, yield method, trial and error yield method and so on.

Steps involved in internal rate return method:1. Determine the future net cash flows during the entire economic life of the project.

The cash inflows are estimated for future profits before depreciation but after taxes.2. Determine the rate of discount at which the value of cash inflows is equal to the

present value of cash outflows. 3. Accept the proposal if the internal rate of return is higher than or equal to the

minimum required rate of return i.e., cost of capital or cut off rate and reject the proposal if the internal rate of return is lower than the cost of cut-off rate.

4. In case of alternative proposals select the proposal with the highest rate of return as long as the rates are higher than the cost of capital or cut-off-rate.

Determination of IRRa. When the annual net cash flows are equal over the life of the asset

Firstly find out the present value factor by dividing initial outlay (cost of investment) by annual cash flow

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Present value factor = Initial outlay Annual cash flow

Then consult present value annuity tables with the number of years equal to the life of the asset and find out the rate at which the calculated present value factor is equal to the present value given in the table.

b. When the annual net cash flows are unequal over the life of the assetIt is found through trial and error method. This process is summed as under:

i. Prepare the cash flow table using an arbitrary assumed discount rate to discount the net cash flows to the present value.

ii. Find out the net present value by deducting from the present value of total cash flows calculated in (i) above the initial cost of the investment

iii. If the net present value is positive, apply higher rate of discount.iv. If the higher discount still gives a positive net present value, increase

the discount rate further until the NPV becomes negative.v. If the NPV is negative at this higher rate, the internal rate of return

must be between these rates.

Advantages of internal rate of return methodi. It takes into account the time value of moneyii. It considers the profitability of the project for its entire economic lifeiii. The determination of COC if not a pre-requisite for the use of this

methodiv. It provides for uniform ranking of various proposals due to the

percentage rate of returnv. This method is compatible with the maximum profitability.

Disadvantages of internal rate of return methodi. This method is not easy to understandii. It is based upon the assumption that the earnings are reinvested at

the internal rate of return.

3. Profitability Index methodIt is also called as benefit cost ratio method. It is the relationship between the present value of cash inflows and the present value of cash outflows. Hence

Profitability index = Present value of cash inflows Present value of cash outflows

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(OR) Profitability index = Present value of cash inflows Initial cash outlay

P I (net) = NPV (Net Present value) Initial cash outlay

ESTIMATION OF CASH FLOWS Cash flow refers to the cash revenues less cash

expenses Accounting profit refers to the figure of profit as shown

in the profit and loss account.

This cash flow is preferable over the accounting profit due to the following reasons:

1. The main objective of a firm is to maximise the wealth of the shareholders which depends on the cash flow but not the profit.

2. The existence of certain accounting ambiguities in accounting makes cash flow preferable than the accounting profit.

3. The cash flow also takes into account the time value of money which is ignored by accounting profit.

Conventional and Non-conventional cash flows In conventional cash flow, an initial cash outflow i.e., initial investment is

followed by a series of uniform or unequal cash inflows.

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In non-conventional cash flows, there exists a series of cash inflows and cash outflows.

Incremental cash flowsThe screening of investment proposals involves the determination of cash flows. They

may be absolute cash flows or incremental cash flows.

If there is only one proposal and the decision of the investment is to be taken then the absolute cash flows are considered.

If there are more than one proposal, the relative cash flows are considered which is also called as the incremental cash flows.

TYPES OF CASH FLOWS1. Initial Investment or Cash outlay2. Operating cash flow or net annual cash flows3. Terminal cash flows

Initial Investment or Cash outlayRs.

Purchase price of the asset Xxxxxx(+) Insurance, freight, loading

and unloading and installation costs

Xxx

(+) Net increase in working capital requirement

Xxx

(+) Opportunity cost if any Xxx(-) Cash inflows in the form of

sale proceedsXxx

(-) Investment Allowance (25% of the cost of the asset)

xxx xxx

Total xxxxx

Operating cash flow or net annual cash flowsThese are the cash flows calculated after charging the tax but before depreciation.

Cash Revenues – Cash Expenses – TaxOr

Net Earnings After Tax + Depreciation - Tax

Determination of Net Annual Cash Flows

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Rs.Cash Revenues ( Sales) Xxxxxx

(-) Cash Expenses (operating costs) Xxx= EBDT xxxxx(-) Depreciation Xxx= EBT xxxxx(-) Tax Xxx= EAT xxxx

(+) Depreciation Xxx= CFAT (Cash inflow after tax) Xxxx

Terminal cash flowsThese are the cash flows recovered at the end of the useful life of the asset.

Rs.Cash flow from sale of the asset xxxxx

or Sale value of old asset in case of its replacement with a new asset

Xxx

(+) Increase in the net working capital xxxxxTotal xxxxx

REPLACEMENT OF PROJECTS

Replacement of projects is an unavoidable necessity. Replacement may be of two kinds:

o Replacement of like –for – like ------- due to physical wear and tearo Replacement due to obsolescence----- due to the technological

advancements

In case of replacement of an existing asset, the tax is computed on the excess of its sale Value over its book salvage value.

If the cash salvage value exceeds the book salvage value, the difference is treated as ordinary income and taxed. This tax liability is added to the initial outlay.

DEPRECIATION TAX FIELD

Depreciation is an allocation of the cost of fixed assets. Though it involves an accounting entry as an expense, as it is not a cash expense and hence does not constitute part of the computation of cash flow. And hence has no direct impact on the cash flow. But has an impact on the cash flow in the form of reduction of tax liability. Hence it is considered for the computation of after-tax cash flow in spite of the fact that it does not form a part of the cash flow.

Rs.Cash Revenues Xxxxxx

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(-) Cash Expenses (operating costs)+ Depreciation

Xxx

= Taxable Income xxxxx(-) Taxes Xxx= Net Income After Tax xxxx

(+) Depreciation Xxx= NCFAT (Net Cash inflow after

tax)Xxxx

Total xxxxx

CONFLICTS IN RANKING DCFs AND THEIR CRITERIA

Conflicts in NPV vs. IRR Methods In NPV method, the project whose Net present value is

positive is preferred where as in case of IRR method it is accepted if the internal rate of return is ore than the cut off rate.

The projects which have a positive NPV obviously have an internal rate of return higher than the required rate of return.

The conflicts occur when There is a significant difference in the amount of cash

outlay of various proposals under consideration. Problems of difference in cash flow pattern or timing of

various proposals and Difference in the economic life of the assets or the

unequal expected lives of the projects.

In such circumstances, those projects which have higher NPV should be selected since such projects maximise the share holders wealth. Thus NPV is more reliable than the IRR method.

Conflicts in NPV vs. Profitability Index MethodsIn NPV Method, the project is accepted if it has a positive present value where as in case

of PI method, a project is accepted if its Profitability Index is greater than 1. When there is any mutually exclusive decision involving these two methods, preference

should be given to NPV methods, since PI will be greater than 1 only when the NPV is positive.

COST OF CAPITAL

A project’s cost of capital is the minimum acceptable rate of return on the funds committed to the project. The minimum acceptable rate or the required rate of return is the compensation for the time and risk in the use of the capital by the project. The firm’s cost of capital will be the overall or average required rate of return on the aggregate of the investment projects.

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Significance of cost of capital

1. Investment evaluation 2. Designing debt policy3. Performance appraisal4. Dividend Decisions5. Investment in working capital6. As a basis for taking other financial decisions

Classification of Cost

1. Historical cost and Future cost2. Specific Cost and Composite Cost3. Explicit Cost and Implicit Cost4. Average Cost and Marginal Cost

COST OF DEBT CAPITAL

The cost of debt is the interest rate payable on debt. 1. Cost of Debt before tax

Kdb = I P

Where Kdb = Before tax cost of debt I = Interest P = Principal

2. Cost of the debt raised at premium or discountKdb = I NP

Where Kdb = Before tax cost of debt I = Interest

NP = Net Proceeds3. After-tax cost of debt

Kda = Kdb (1-t) = I NP

Where Kdb = Before tax cost of debtKda = After tax cost of debt I = Interest P = Principal t = Rate of tax

4. Cost of Redeemable DebtKdb = I + 1 (P-NP)

n1 (P+NP)2

where I = Interestn = Number of years in which debt is to be redeemed

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P = Proceeds at par NP = Net Proceeds Kdb = Before tax cost of debt

After-Tax Cost of Redeemable DebtKda = Kdb (1-t)

Where t = Tax rateKdb = same as in a above

5. Cost of debt redeemable at premiuma. Before-Tax Cost of Debt

Kdb = I + 1 (RV-NP) n1 (RV+NP)2

where I = Interestn = Number of years in which debt is to be redeemedP = Proceeds at par

RV = Redeemable value of debt NP = Net Proceeds Kdb = Before tax cost of debtb. After-Tax Cost of Debt

Kda = Kdb (1-t)

Where t = tax rate Kdb = Same as in a above

6. Risk or Inflation Adjusted Cost of Debt

Real Cost of Debt = 1 + Nominal Cost of Debt1 + Inflation Rate

COST OF PREFERENCE SHARE CAPITAL

Preference capital is that capital raise through the issue of preference shares. Preference shares are those shares which give to their share holders, a preference over equity share holders during the distribution of dividend and also the redemption of capital during the winding up of the company.

1. Cost of perpetual Preference CapitalKp = D

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PWhere D = Annual Preference Dividend

Kp = Cost of preference CapitalP = Preference Share Capital Proceeds

2. Cost of Preference Capital issued at Premium/Discount/floatation costs are incurredKp = D NP

Where D = Annual Preference DividendKp = Cost of preference CapitalNP = Preference Share Capital Proceeds

3. Cost of Redeemable Preference Sharesredeemable preference shares are those preference shares which can be redeemed or cancelled on maturity date

Kpr = D + (MV-NP) n1 (MV+NP)2

Where D = Annual Preference DividendKpr = Cost of redeemable preference capitalP = Preference Share Capital ProceedsNP = Net Proceeds of preference shares

COST OF EQUITY SHARE CAPITAL

Equity share capital is that capital which is raised through the equity shares. The equity shareholders are the real owners of the company. The cost of equity capital is a function of the expected return by its investors.

1. Dividend Yield Method or Dividend/Price Ratio MethodAccording to this method, the cost of equity capital is the discount rate that equates the present value of the expected future dividends per share with the net proceeds (or current market price) of a share. It is represented by the following formula:

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Ke = D or D NP MP

Where D = Expected Dividend per shareKe = Cost of Equity Capital

NP = Net Proceeds per share MP = Market price per share

Basic assumptions of this method are:i It does not consider future earnings or retained earningsii It does not take into account the capital gains

This method is suitable only when the company has a stable earnings and stable dividend policy over a period of time.

2. Divided Yield Plus Growth in Dividend Method:

a. The cost of capital is to be calculated

When the dividend is being paid at a constant rate and there is a growth in the percentage of dividend every year at a constant rate, then the cost of capital may be computed by using this method. The following formula can be used:

Ke = D 1 + G NP

Where D1 = Expected Dividend per share at the end of the yearKe = Cost of Equity Capital

NP = Net Proceeds per shareG = Rate of Growth in dividend

b. The cost of existing equity share capital Under this model, the cost of existing equity share capital when there is a constant growth

rate in the dividend, is computed by taking into consideration, the Market Price per share.Ke = D 1 + G MP

Where D1 = Expected Dividend per share at the end of the yearKe = Cost of Equity Capital

MP = Net Proceeds per shareG = Rate of Growth in dividend

3. Earnings-Price Ratio MethodAccording to this method, the cost of equity capital is the discount rate that equates the present value of the expected future earnings per share with the net proceeds (or current market price) of a share. It is represented by the following formula:

Ke = EPS or NP Cost of existing cost of

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EPSMP

Capital

Where EPS = Expected Earnings per shareKe = Cost of Equity Capital

NP = Net Proceeds per share MP = Market price per share

COST OF TERM LOANS

A company can also raise debt funds by taking term loans. These term loans can be raised from Banks or Financial Institutions. Term loans are the loans that are taken for a fixed period of time. Interest is paid annually on the loans taken from the institutions. The following formula is used to find out the cost of term loans:

a Cost of term loans before tax

Kdb = I P

Where Kdb = Before tax cost of debt I = Interest P = Principal

b After-tax cost of term loans

Kda = Kdb (1-t) = I NP

Where Kdb = Before tax cost of debt (term loan)Kda = After tax cost of debt (term loan) I = Interest P = Principal t = Rate of tax

CAPITAL ASSET PRICING MODELIt s a model that describes the relationship/trade-off between risk and expected/required

return. The CAPM provides a frame work for basic risk and return trade-offs in portfolio

management. It enables to draw certain implications about risk and the size of risk premium

necessary to compensate for bearing risk.

Types of risk:

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i. Diversifiable/unsystematic/avoidable risk

ii. Non-diversifiable/systematic/unavoidable risk

The Model:The model links the relevant (systematic) risk and returns of all assets/securities. The

measure/index of systematic risk is Beta Coefficient (β). It measures the sensitivity of return of

a security to changes in returns on the market portfolio. In other words, Beta Coefficient is an

index of the degree of responsiveness of security return with market return.

The beta for the market portfolio is equal to 1. It is thus an index of the systematic risk

of an individual security relative to that of the market portfolio.

The interpretation of β=1 is that the excess return for the security vary proportionately

with excess returns for the market portfolio, that is, the security has the same systematic risk as

the market as a whole.

The beta of a portfolio is simply the weighted average of the individual security betas in

the portfolio, the weights being the proportion of total portfolio market values represented buy

each security.

Thus, the beta of a security represents its contribution to the risk of a highly diversified

portfolio of securities.

Required Return

ke = kf + (km-kf)β

SML

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Risk Premium

(km-kf)β

kf

Risk βFigure showing the Cost of Equity under CAPM

According to CAPM, the required rate of return, ke for a share is ke = Risk free rate of interest (Rf)+ Risk premium (1)

Risk Premium = (Market return of a diversified portfolio – Risk free return)x βi

═> βi (Rm – Rf) (2)Therefore, the cost of equity, according to CAPM can be calculated by substituting

equation 2 in equation 1. The resultant equation is as under:

ke = Rf + βi (Rm – Rf)

where,

ke = Cost of equity capital

Rf = Risk free rate of return

βi = Beta coefficient of the firm’s portfolio

Rm = Risk-free rate of return

Rf = Market return of a diversified portfolio

COST OF RETAINED EARNINGS Retained earnings are the amounts that have been kept aside by the company during times

of prosperity for the purpose of expansion and diversification of it activities. The cost of retained may be considered as the rate of return that the existing shareholders

may obtain by investing the after-tax dividends in alternative opportunities of equal opportunities.

1. Cost of Retained EarningsThe cost of retained earnings is arrived at, by using the formula:

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Kr = D + G NP

Where D = Expected Dividend per shareKr = Cost of retained earnings

NP = Net Proceeds per share G = Growth Rate

2. Cost of retained earnings after adjusting tax and cost of purchasing new securities

Kr = D + G x (1-t) x (1-b) NP

Where D = Expected Dividend per shareKr = Cost of retained earnings

NP = Net Proceeds per share G = Growth Rate

t = Tax Rateb = Cost of purchasing new securities or brokerage expenses

WEIGHTED AVERAGE COST OF CAPITAL

Also called as overall cost of capital or composite cost of capital. The weighted average cost of capital is calculated by multiplying the weights of the various sources of capital with the cost of capital of that particular source. Weight is the proportion of each source of fund in the capital structure.

Steps involved in calculation of Weighted Average Cost of Capital

a. Calculate the cost of specific sources of fundsb. Multiply the cost of specific sources by its proportion in the capital structure

(weight)c. Add the weighted component costs to get the firm’s weighted average cost of

capital

Calculation of Weighted Average Cost of CapitalThe weighted average cost of capital is calculated by using the formula:

n

ko = Σ ktwt t=1

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where ko = Weighted average Cost of capital

k = K is the component cost

w = Weights of various types of capital employed

MARGINAL COST OF CAPITAL The weighted average cost of new or incremental capital is known as the marginal cost of

capital. The marginal cost of capital is the weighted average cost of new capital using the

marginal weights. The marginal weights represent the portion of various funds the firm intends to employ.

DIVIDEND CAPITALISATION MODEL

This is a popular model explicitly relating the market value of the firm to dividend policy. This model was developed by Myron Gordon in 1962 The Valuation formula under this model is as under:

P = E (1-b) (OR) P = E (1-b) Ke-br Ke-g

Where P = Price of sharesE = Earnngs per share b = Retention ratioKe = Cost of Equity capitalbr = g = Growth rate in r i.e., rate of return on investment of an all equity firm D = Dividend per share

What is working capital?It is the amount of capital required for running the day-to-day activities of the business. It

is the funds required to cover the cost of operating the enterprise. It is also called as Revolving capital or Circulating capital or short-term capital.

Concepts of working capital

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a Gross working capital: This is the amount of the current assets present in the organisation..

b Net-working capital: This can be defined in two ways: (i) the excess of current assets over current liabilities (ii) It is that portion of current assets which is financed with long-term funds.

WORKING CAPITAL MANAGEMENT

Meaning of Working Capital ManagementWorking capital management is concerned with the problems that arise in attempting to

manage the current assets, the current liabilities and the inter-relationship that exists between them.

Components of Working Capital

a Currents Assets: The term current assets refers to those assets which in the ordinary course of business can be, or will be, converted into cash with in one year without undergoing a diminution in value and without disrupting the operations of the firm.

i. Cash in hand and at bankii. Marketable securitiesiii. Accounts receivable (less provision for bad debts) iv. Inventoryv. Temporary investment of surplus fundsvi. Prepaid expenses vii. Accrued incomes

b Current Liabilities: Current Liabilities are those liabilities which are intended, at their inception to be paid in the ordinary course of business with in a year out of the current assets or earnings of the concern.

i. Bills payableii. Accounts payableiii. Accrued or outstanding expensesiv. Short term loans, advances and depositsv. Dividends payablevi. Bank overdraft

Importance of Working Capital

i. It helps in maintaining the solvency of the businessii. It helps in timely payment to suppliers thus maintaining of goodwilliii. It helps in getting easy loans on favourable termsiv. It also helps to get cash discounts on purchases

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v. It ensures a regular supply of raw-materials and thus ensuring smooth productionvi. It aids in regular payments of salaries, wages and other day-to-day commitmentsvii. Exploitation of favourable market conditions is possibleviii. It provides an ability to face crisis situations effectivelyix. It facilitates quick and regular return on investmentsx. It improves the morale of the organisation and also its overall efficiency

FACTORS INFLUENCING WORKING CAPITAL REQUIREMENTS

i. Nature of businessii. Size of businessiii. Sales and demand conditionsiv. Production policyv. Technology and manufacturing policyvi. Length of the production cyclevii. Seasonal variationsviii. Working capital cycleix. Credit policyx. Availability of creditxi. Operating efficiencyxii. Price level changesxiii. Business cycles

CURRENT ASSETS POLICY

It represents the ration of currents assets to the fixed assets in an organisation.Assuming a constant level of fixed assets, a higher CA/FA ratio indicates a conservative

current assets policy and a lower CA/FA ratio means an aggressive current assets policy assuming other factors to be constant. A conservative policy implies greater liquidity and lower risk; while an aggressive policy indicates higher risk and poor liquidity. The current assets policy of the most firms may fall between the two extreme policies. This shows that they follow an average current assets policy.

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Figure showing the alternative current asset policies

In the above figure, the most conservative policy is indicated by alternative A, where the CA/FA ratio is greatest at every level of output. Alternative C is the most aggressive policy as CA/FA ratio is lowest at all levels of output. Alternative policy which is the average policy lies between A and B.

Lev

el o

f C

urr

ent

Ass

ets

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Policy CA/FA Ratio Risk Return LiquidityAggressive Lowest Very High High LowAverage Medium Medium Average MediumConservative Highest Very Low Low High

The above table shows the Current Assets to Fixed Assets Ratio, Risk Level, Returns and Liquidity for various Current Asset Policies

CURRENT ASSETS FINANCING POLICY

a. Long-term financing b. Short-term financing c. Spontaneous financing

a. Matching ApproachIn Matching approach, long term financing will be used to finance fixed assets and

permanent current assets and short term financing to finance temporary or variable current assets.

Temporary Current Assets

Short term financing

Permanent Cas

Long-term financing Fixed Assets

Time

Graph showing the financing under the matching plan

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b. Conservative Approach Under a conservative plan, the firm finances its permanents assets and also a part of

temporary current assets with long-term financing. When the firm has no temporary current assets [ex: in situation (a)], the long-term funds released can be invested in marketable securities to build up the liquidity position of the firm.

Temporary Current Assets Short term financing

(a)

Permanent Cas Permanent Cas Permanent Cas

Long-term financing Fixed Assets

Time

Graph showing the financing under the conservative plan

c. Aggressive ApproachUnder an aggressive policy, the firm finances a part of its permanent current assets with

short term financing. Some extremely aggressive firms may even finance a part of their fixed assets with short-term financing.

Temporary Current Assets Short term financing

(a)

Permanent Cas Permanent Cas Permanent Cas

Long-term financing Fixed Assets

Time

Ass

ets

Permanent Cas

Ass

ets

Permanent Cas

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Graph showing the financing under the aggressive plan

Short-Term Vs Long-term Financing: A Risk-Return trade-offA firm should decide whether or not it should use short-term financing. If short term

financing has to be used, the firm must determine its portion in total financing. This decision of the firm will be guided by the risk-return trade-off. Short-term financing may be preferred over long-term financing over two reasons:

i. The cost advantageii. Flexibility

OPERATING CYCLE

Operating Cycle: The operating cycle is the length of time for a company to acquire materials, produce the product, sell the product, and collect the proceeds from customers.

The operating cycle, which is also known as the cash-to-cash cycle, is the process of using cash to purchase current assets that are to be sold at a profit and collected as cash.

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.

CALCULATING THE OPERATING CYCLE

O = R+W+F+D-C for a manufacturing firm

O = F+D-C for a trading firm

Where O = Length of operating cycleR = Time for which Raw materials were held in stockW = Time period for which Work-in-progress was held F = No. of days for which Finished goods were held in stock D = Time allowed to debtors for repaymentC = Time allowed by creditors for repayment

CASH CYCLE

The duration between the purchase of a firm’s inventory and the collection of accounts receivable for the sale of that inventory. Also known as Cash Conversion Cycle

Cash conversion Cycle In Days

=Inventory processing

period+

Days to collect receivables

Cash cycle can also be depicted as under:

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Business Operations

Cash Collections

ESTIMATION OF WORKING CAPITAL REQUIREMENTS

1. Current Assets Holding period

2. Ratio of sales

3. Ratio of fixed Investment

FINANCIAL STRUCTURE VS CAPITAL STRUCTURE

Financial structure is the mixture of all items that appear on the left hand side of the balance of a company.

Capital structure is the mix of the long term sources of funds used by the firm.

Financial structure – Current Liabilities = Capital Structure

MEANING OF CAPITAL STRUCTURE

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Information and Control

Cash Payments

Deficit

Surplus

Borrow

Invest

Capital structure collective term, which refers to the various sources from which the long-term

funds are raised. The capital structure refers to the proportion of equity capital, preference

capital, reserves, debentures and other long-term debts to the total capitalisation.

Capitalisation refers to the total amount of securities issued by a company

According to Gerestenberg, ‘Capital structure of a company refers to the make-up of its capitalisation and it includes all long term capital- Shares, loans, reserves and bonds.

CHARACTERISTICS OF A SOUND CAPITAL STRUCTURE

1. Simplicity i.e., simple and easy to understand and not complicated

2. Profitability i.e., maximise the profits and minimise the cost of funds

3. Solvency – the debts should be a reasonable proportion of the total capital

4. Flexibility i.e., there should room for expansion or reduction of capital

5. Intensive use of funds and not causing scarcity or surplus of funds

6. Conservation i.e., the debt raising capacity of the concern should not be exceeded

7. Provision for meeting future contingencies

8. Control over the company

9. Economy in cost of maintaining different securities

FACTORS INFLUENCING CAPITAL STRUCTURE

1. Trading on equity

2. Idea of retaining control

3. Flexibility of the capital structure

4. The cost of financing i.e., cost of capital

5. The purpose of financing

6. Requirements of the potential investors

7. Capital market conditions

8. Legal requirements

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9. Period of finance

10. Nature of business

11. Asset structure

12. Provision for future

13. Corporate tax rate

14. Cost of floatation

FORMS / PATTERNS OF CAPITAL STRUCTURE

The following are the various forms of capital structure that a company can have:

1. Equities only Under this form, the entire capital is raised from share holders and there is only one class of share known as equity shares.

2. Equities and preference shares Under this form, the capital structure of a company consists of mixture of equity and preference shares.

3. Equity shares and debentures Under this form the capital structure of a company consists of a mixture of equity shares and debentures.

4. Equities, Preference shares and debentures Here the components of the capital structure are equity shares, preference shares and debentures.

CAPITAL STRUCTURE AND MARKET VALUE OF FIRM

There are many theories put forth by the thinkers in the field of management who are of varied views about the relationship between the effects of capital structure on the market value of a firm.

1. NET INCOME APPROACH This is a relevance theory. According to the Net Income Approach suggested by Durand,

the capital structure decision is relevant to the valuation of the firm. In other words, a change in the financial leverage will lead to a corresponding change in the overall cost of capital as well as total value of firm.

This approach is based on the following three assumptions:i. There are no taxes

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ii. The cost of debt is less than the cost of equity i.e., the equity capitalisation rateiii. The use of debt does not change the risk perception of the investors.

The market value of the firm is found by using the formula:V=S+D

Where V = Total market value of the firmS = Market value of the common share of the firmD = Market value of the firm’s Debt

S = Net Income available to equity share holders Capitalisation rate

Overall Cost of capital is calculated by using the formula ko = EBIT

V2. NET OPERATING INCOME APPROACH

Another theory of capital structure, suggested by Durand, is the Net Operating Income Approach. The essence of this Approach is that the capital structure decision is relevant. Any change in leverage will not lead to any change in the total value of the firm and the market price of shares as well as the overall cost of capital is independent of the degree of leverage.

The NOI Approach is based on the following propositions:

i. Overall Cost of Capital / Capitalisation Rate (ko) is ConstantV = EBIT

ko In other words, the market evaluates the firm as a whole. The split of the capitalisation

between the debt and equity is, therefore, not significant.

ii. Residual value of equityThe value of equity is a residual value which is determined by deducting the total value

of debt (D) from the total value (V) of the firm. Symbolically this is represented as under: S = V- D

iii. Changes in Cost of Equity CapitalThe equity-capitalisation rate/cost of equity (ke) increases with the degree of leverage.

ke = (ko - kd) B S

iv. Cost of DebtThe cost of debt has two parts:

a. Explicit cost which is represented by the rate of interest.

b. Implicit or hidden cost. In crease in the degree of leverage or the proportion of debt to equity causes an increase in the cost of equity capital. This increase in ke, is attributable to the increase in the debt, is the implicit part of kd

The real cost of debt and the real cost of equity, according to the NOI Approach, are the same and equal to ko

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v. Optimum Capital StructureThere is nothing such as an optimum capital structure. Any capital structure is optimum,

according to NOI Approach.

3. TRADITIONAL APPROACH

The traditional view, which is also known as an intermediate approach, is a compromise between the net income approach and the net operating approach. According to this view, the value of a firm can be increased or a judicious mix of debt and equity capital can reduce the cost of capital. This approach very clearly implies that the cost of capital decreases within the reasonable limit of debt and then increases with leverage.

4. IRRELEVANCE OF CAPITAL STRUCTURE: THE M&M HYPOTHESIS WITHOUT TAXES

Modigiliani and Miller argue that, in the absence of taxes, a firm’s market value and the cost of capital remain invariant to the capital structure changes. The reason they give is that though debt is cheaper than equity, with increased use of debt as a source of finance, the cost of equity increases. This increased cost of equity offsets the cheaper cost of debt. Thus although the leverage affects the cost of equity, the overall cost of capital remains constant.

Assumptions of this theory:i. There are no corporate taxesii. There is a perfect marketiii. Investors act rationallyiv. The expected earnings of all firms have identical risk characteristicsv. Firms distribute all their earnings in the form of dividends to their shareholders.vi. Risk of investors depends on the random fluctuations of the expected earnings and the

possibility that the actual value of the variables may turn out to be different from their best estimates.

Firm’s total market value V = EBIT ke

Firm’s market value of equity S = V – DFirm’s leverage cost of equity = Cost of equity + (Cost of equity – Cost of debt)

5. RELEVANCE OF CAPITAL STRUCTURE: THE M&M HYPOTHESIS UNDER TAXES

In reality, corporate income taxes exist, and interest paid to debt holders is treated as a deductible expense. Dividends paid to share holders is not a tax-deductible expense. Thus unlike dividends, the return debt-holders is not subject to the taxation at the corporate level. This makes the debt financing advantageous. Modigiliani and Miller say that the value of the firm will increase with debt due to the deductible nature of interest charges for tax computation, and the value of the levered firm will be higher than the unlevered firm.

Value of an unlevered firm, Vu= EBIT (1-t) ke

Value of a levered firm Vl= Vu +tDWhere t is the tax rate and D is the quantum of Debt used in the mix.

PLANNING THE CAPITAL STRUCTURE

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The following are the important considerations involved in determination of the capital structure of a firm:1. Control2. Widely-held companies3. Closely-held companies4. Flexibility5. Loan covenants6. Early repayability7. Reserve capacity8. Marketability9. Market conditions10. Floatation costs11. Capacity of raising costs12. Agency costs

SOURCES OF LONG TERM FUNDS IN INDIATwo long-term securities are available to a company for raising capital.

They are ownership and borrowed sources.

ISSUE OF SHARESA company has an option to issue shares to raise the long-term finance for its operations.

EQUITY SHARES These are also termed as ordinary shares or common stock. The owners of these shares are the real owners of the company.

Characteristic Features Equity shares have a number of special features which distinguish it from other securities.

These features relate to the rights and claims of ordinary shareholders.

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1. Risk Capital2. Fluctuating Dividend3. Changing market value4. Growth prospectus5. Protection against inflation6. Voting rights7. Claim assets8. Right to control9. Pre-emptive rights10. Limited liability

Advantages of equity shares1. No compulsion for the company to pay dividends2. Equity capital has no maturity and hence the firm has no obligation to redeem.3. Dividends are tax-exempt in the hands of investors.4. Enhances the creditworthiness of the company.

Disadvantages of equity shares1. Sale of equity shares to outsiders dilutes the control of the existing owners2. The cost of equity share capital is the highest and hence the expectations the equity shares is

also very high.3. Equity dividend is paid out of profit after tax while interest is a deductible expenditure. This

makes the cost of equity relative more.4. The cost of issuing equity shares is higher than the cost of issuing other securities.

PREFERENCE SHARES

Preference share capital represents a hybrid form of financing – it partakes some characteristics of equity and some attributes of debentures.

Characteristic features1. Return of income2. Return of capital3. Fixed dividend4. Non participation in prosperity5. Non participation in management6. No voting rights

Kinds of Preference Shares1. Redeemable and irredeemable preference shares2. Cumulative and non-cumulative preference shares

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3. Convertible and non-convertible preference shares4. Participation and non-participating preference shares

Advantages of preference share capital1. There is no legal obligation to pay dividend2. These shares are particularly useful if its assets are not acceptable as collateral security for

creditor ship securities like debentures and bonds.3. These shares save the company from payment of high interest if debentures were to be

borrowed.4. The property need not be mortgaged as in case of debentures if these shares are issued.5. Preference shares since they bear fixed yield and enable the company to declare higher rates

of dividend for the equity shareholders6. The promoters can retain control over the company

Disadvantages of preference share capital1. Though there is no compulsion on the part of the company to declare dividend,

but frequent delays and non-payment adversely affects the creditworthiness of the firm.2. Preference share dividend is not a deductible expense like debenture interest.3. Since the holders of these shares do not carry any voting right, they remain at the

mercy of the management for the payment of dividend and redemption of their capital.4. The rate of dividend on preference shares is less than compared to the equity

shares.5. The share holders of do not have any charge on the assets

DEBENTURES

The debenture is an acknowledgement of debt issued by a company for the amount of loan taken from them and carrying a definite time period of maturity and also a certain rate of interest. A debenture holder is a creditor of the company.

Features of debentures1. They have a fixed maturity period2. They carry a fixed rate of interest3. The debentures have a claim on the company’s income4. They have a claim on the assets of the company5. They do not have any control over the company and 6. The debenture holders are the creditors of the company.7. The debentures have call feature.

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Types of Debentures1. Simple or naked or unsecured debentures2. Secured or mortgaged debentures3. Bearer Debentures and Registered Debentures4. Redeemable and irredeemable debentures5. Convertible and non-convertible debentures6. Zero Interest Bonds7. Zero Coupon Bonds8. First Debentures and Second Debentures9. Guaranteed Debentures10. Collateral Debentures11. Callable Bonds12. Deep Discount Bonds13. Inflation Adjusted Bonds

Advantages of Debentures1. Debentures provide long-term funds to a company2. The rate of interest payable is less than the dividend payable on shares3. The interest paid is tax deductible4. The investor can have a fixed and constant source of income.5. They have a charge on the assets of the company

Disadvantages of Debentures1. The debenture interest is a fixed obligation for the company2. They do not carry any voting rights3. They have no control on the company4. The prices of debentures in the market changes with the changes in the market interest

rate.5. These holders are only the creditors to the company but not the owners.

TERM LOANS

The debt capital of a company may consist of either debentures or bonds which are issued to the public for subscription or term loans which are obtained directly from banks and financial institutions. Term loans are sources of long term debt. In India, they are generally obtained for financing large expansion, modernisation and diversification projects. Therefore, this method of financing is also called as project financing.

Features of Term Loans1. Fixed Maturity period2. Direct Negotiation3. Requirement of a security4. Restrictive covenants5. Convertibility into equity

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6. Predetermined repayment schedule

INTERNATIONAL FINANCING INSTRUMENTS

The most important sources of international finance are:a. Eurocurrency loans

Euro currency is a freely convertible currency deposited in banks outside the country of the origin. The rate of interest is determined by LIBOR.

b. Euro bondsThese are the bonds sold outside the country in whose currency they are denominated. They are issued directly by the borrowers to the issuers. They are normally issued as bearer bonds.

c. Foreign BondsA foreign bond is a bond denominated in the currency of the country where it is being issued and is subjected to the laws and regulations of that country. Ex: Samurai bonds if in Japan, Yankee Bonds in USA and Bulldog bonds if in UK.

d. American Depository ReceiptsA depository receipt represents the number of foreign shares that are deposited in a bank in a foreign country.

American Depository receipts are certificates traded in the United Sates denominated in American Dollar.

e. Global Depository ReceiptsGlobal Depository Receipts are the Depository receipts that traded in a foreign country but denominated in the currency of the nation of their origin.

LEASING VS HIRE PURCHASE

Both leasing and hire purchasing are a form of secured loan. Both displace the debt capacity of the firm since they involve fixed payments. However they differ in the following ways.

Hire Purchase Financing Lease Financing Depreciation Hirer is entitled to claim

depreciation tax shield. Depreciation Lessee is not entitled to

claim depreciation tax shield. Hire purchase payments Hire purchase

payments include interest and repayment of principal. Hirer gets tax exemption only on the interest.

Lease payments Lessee can charge the entire lease payments for tax purposes. Thus he or she saves taxes on the lease payments.

Salvage Value Once the hirer has paid all instalments, he becomes the owner

Salvage Value Lessee does not become owner of the asset. Therefore, he has

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of the asset and can claim the salvage value.

no claim over the asset’s salvage value.

INSTITUTIONAL FINANCE AVAILABLE IN INDIA. There are various institutions in India providing finance to the business institutions in

India. Some of them are:i. ICICI

ii. IDBIiii. IFCIiv. SIDBIv. SISI

vi. IFBs of Commercial Banks

THE DERIVATIVES CONCEPT

Derivatives are contracts whose payoffs depend upon the value of an ‘underlying’. The ‘underlying’ can be commodity, a stock, a stock index, a currency, or interest rate, or literally anything-not necessarily an asset.

These are designed to shift risk from one party to another allowing an ever widening array of risks to be traded. Derivatives mainly consist of futures and forwards (agreements to buy or sell an asset in the future at a fixed price), options (which give you the right, but not the obligation, to buy an asset, say a share or a lump of foreign currency, in the future at an agreed price) and swaps (which enable you to exchange a future string of payments in one currency for one in another).

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FUNCTIONS OF DERIVATIVES MARKETS

Derivatives markets provide three essential economic functions viz., risk management, price discovery and transactional efficiency.

1 Risk ManagementThe hedger’s primary motivation is risk management. Faced with an unacceptable level

of risk, the hedger may choose to reduce or eliminate it. The objective is to use futures markets to reduce a particular risk that be faces. This risk might relate to the price of oil, foreign exchange rate, or some other variable. A perfect hedge is one that completely eliminates the risk. In practice, perfect hedges are rare.

2 PRICE DISCOVERY

Futures and option markets play a vital role in discovering the future price of any commodity or financial asset. The role of price discovery is an essential part of an efficient economic system. The prices in the market must reflect exactly the relative cost of production and the relative consumption utilities if optimum allocation of resources is to be achieved in an economy. The futures and option markets provide a pricing mechanism through which relative cost and utilities are brought to an alignment both in the present and in the future.

3 Transactional efficiencyDerivative markets allow institutions to transact more efficiently than otherwise. They

reduce the direct cost of transacting in cash/ financial markets and also provide, through clearing houses, an efficient mechanism to deal with counter party risk. The following chapter on futures will give the t\reader an insight into the various ways in which derivative markets contribute to transactional efficiency.

4 Financial Engineering The relatively new field of financial engineering refers to the practice of using

derivatives as building blocks in the creation of some specialized products. A financial engineer selects from the wide array of puts, calls, futures, and other derivatives in the same way that a cook selects ingredients from the spice rack or a chemist mixes compounds in the laboratory.

PARTICIPANTS IN THE DERIVATIVES WORLD

1. Hedgers

2. Speculators

3. Arbitrageurs

4. Intermediary Participants

(i) Brokers(ii) Jobbers

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INSTITUTIONAL AND LEGAL FRAMEWORK

(i) Exchange

(ii) Clearing House

(iii) Custodian / Warehouse

(iv) Regulatory Framework

FUTURESA future is a financial contract which derives its value from the underlying asset.For example, sugar cane or wheat or cotton farmers may wish to have contracts to sell their harvest at a future date to eliminate the risk of change in price by that date. Transactions take place through the forward or futures market. There are commodity futures and financial futures. In the financial futures, there are foreign currencies, interest rate and market index futures. Market index futures are directly related with the stock market.

ForwardsA forward is a contract to buy or sell at a predetermined future date for a current price

i.e., paying today’s price for the delivery of the asset at a future date. If the price goes up or down, the asset is to be delivered on the due date and no further payment is to be made for the difference.

Forwards are good tools to ensure that future price volatility does not entail losses to the business. The gains of a buyer and seller are depicted in the following graph:

Payoff

Future Price

O Forward Price

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Loss

Figure showing the gains of a forward buyer

Payoff

OForward Price

Loss Future Price

Figure showing the gains of a forward seller

The forward buyer will make profits if the future price is higher than the price at which the forwarded has been struck and the forward seller will make profit if the future price is lower than the price at which the forward deal has been struck.

Features of Forwards The main features of forward contracts are:

Forwards are transactions involving delivery of an asst or a financial instrument at a future date, and therefore, are over -the -counter (OTC)contracts. OTC products are customized contracts which are written across the counter or struck on telephone, fax or any other mode of communication by financial institutions to suit the needs of their customers.

Both the buyer and seller are committed to the contracts. They have to take delivery and delivery respectively, the underlying asset on which the forward contract was entered into.

Forwards perform the function of ‘price-discovery’ for commodities and financial assets. Both the buyer and seller of a forward contract are bound to the price decided upfront.

As there is no performance guarantee in a forward contract, there is always counterparty risk.

In most cases, one of the counterparties to a forward contract is a bank or a trader squaring up his positions by entering into a reverse contracts. These transactions do not take place simultaneously, so the bank or trader will normally keep a large bid-ask spread to avoid any loss due to price fluctuations. This procedure increases the cost of hedging

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Despite these limiting features, forwards flourished because they provide price guarantee. For example, a coffee manufacturer cannot change the price of his product as and when there is a change in the price of coffee beans. Hence to avoid the risk of a price in the raw material, the manufacturer locks in the future prices of beans up to a particular period. He would search for a person ho is prepared to sell him beans on various future dates for a fixed price. Such a person could be a speculator(or a firm that possesses or is likely to posses the required stock of beans) who wants to protect himself against a likely fall in the value of his stock. Both the manufacturer and the speculator can enter into a forward contract under which the coffee manufacturer buys the forward coffee beans contract, and the stockist sell the forward beans contract for the required quality at a particular rate. In most markets middlemen are required to bring buyers and sellers of forward contracts together. These middlemen charge a fee, for their services.

Futures: -A futures contract can be defined as an agreement to buy or sell a standard quantity of a

specified instrument at a predetermined future date and at a price agreed between the parties through an open outcry on the floor of an organised futures exchange.

It is a standardised forward contract; usually traded in the futures exchange with “mark–to–market” on daily basis.

Features of Futures

Futures are traded on organized exchanges with clearing associations that act as intermediaries between the contracting parties.

Futures are highly standardized contracts that provide for the performance of the contract either through deferred delivery of an asset or a final cash settlement.

Both the parties pay a margin to the clearing association. This is used as a performance bond by contracting parties. The margin paid is generally market to the market price every day.

Each futures contract has an association month which represents the month of contract delivery or final settlement, for example-a September T-bill, a March Euro, A November Nifty futures, etc.,

Index futures The stock index futures are the futures contract made on the major stock market index. The stock index futures has the following characteristics:

i) It is an obligation and not an optionii) Settlement value depends (a) on the value of stock index and the price at which the

original contract is struck and (b) on the specified times the difference between the index value at the last closing day of the contract and the original price of the contract.

iii) Basis of the stock index futures is the specified stock market index. No physical delivery of stock is made.

MarginDepending upon the nature of the buyer and seller, the margin requirement to be deposited with the stock exchange is fixed.

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Futures and Forwards – DifferencesThe following are some of the basic differences between futures and forwards:

Sl. No.

Criteria Futures Market Forward Market

1. Location Futures Exchange No fixed location2. Size of contract Fixed (standard) Depends on the terms

of contract3. Maturity/ Payment date Fixed (standard) Depends on the terms

of contract4. Counterparty Clearing House Known Bank or Client5. Market Place Central Exchange floor in

the world wide network Over the telephone in the world wide network

6. Valuation Marked-to-Market every day

No unique method of valuation

7. Variation margins Daily None8. Regulations in trading Regulated by the concerned

stock exchange Self regulated

9. Credit Risk Almost non existent Depends on the counter party

10. Settlement Through clearing house Depends on the levels of contract

11. Liquidation Mostly by offsetting the positions, very few by delivery

Mostly settled by actual delivery. Some by cancellation at cost

12. Transaction costs Direct costs such as: commission, clearing charges, exchange fees are high.

Indirect costs such as: Bid-ask spreads are low

Direct costs are thoroughly low but Indirect costs are high in the form of high bid ask spread.

Bid ask spread: The simple difference between the selling price and buying price of an asset.OPTION

Options are also a type of Derivatives. Option means choice. It is a firm market created through a financial contract. This financial contract gives a right to its holder to enter into a trade on or before a specified date.

The underlying assets

These are called ‘Underlying assets’ or ‘underlying’. They include:- Stocks, Stock Indices, Foreign Currencies.- Debt instruments, Commodities and Futures Contract.

The options for the above various type of assets are called:Stock options, Index options, Currency options, Commodity options and Futures options.

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MEANING OF AN OPTIONOptions: -

An option means a choice. It gives the holder the right (but no obligation) to enter into a deal at or before a specified future date. These options are:

Call Options (Option to purchase) and Put Options (Option to sell)

Depending on the type of asset, the options may be stock options, index options, commodity options, currency options etc.,

Meaning:In a broad sense, an Option is a claim without any liability. It is a claim contingent upon the occurrence of certain conditions. Thus, an option is a contingent claim. More specifically, an option is a contract that gives the holder a right, without any obligation, to buy or sell an asset at an agreed price on or before a specified period of time.

An Option is the right, but not the obligation to buy or sell something on a specified date at a specified price. In the securities market, an option is a contract between two parties to buy or sell specified number of shares at a later for an agreed price.

An option is a contract in which the seller of the contract grants the buyer the right to purchase a designated instrument or asset at a specific price, which is agreed upon at the time of entering into a contract.

The options buyer has the right but not as obligation to buy. But if the buyer decides to excise the options, then the seller has an obligation to deliver or late delivery of the modifying amount at the afford price.

Terms used in options:- Call Option: A call option is a contract giving the right to buy the shares.

The writer gives the right to buy the asset to the other party- Put Option: A put option is a contract giving the right to sell the shares .

The writer gives the right to sell the asset to the other party- Exercise date: The date on which the contract matures - Strike Price: The price at which an asset is agreed to be brought or sold.It

is also called as exercise price.

Option is a legal contract which gives the holder the right to buy or sell a specified amount of underlying asset at a fixed price within a specified period of time.

- It gives the holder a right to buy (or) sell an asset- But however he is not obliged to buy or sell it

Parties Involved:Three parties are involved in the option trading, the option seller, buyer and the broker.

≈ The option seller or writer is a person who grants someone else the option to buy or sell. He receives a premium on its price.

≈ The option buyer pays a price to the option writer to induce him to write the option.

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≈ The securities broker acts as an agent to find the option buyer , and the seller, and receives a commission or fee for it.

1. Buyer – takes long position i.e. buys the option.2. Seller – takes short position i.e. sells the option.

- He writes the option.- Hence called the writer of the option.

Transactions:Call option – short to long

Strike prices:♣ In the money – An Option is said to be in the money when it is advantageous to exercise it.

For a call option, if the strike price is below the current spot price of the underlying asset, it is said to be in the money.For a put option, the strike price is above the current spot price of the underlying asset

♣ (At) Near the money – In this case the Exercise price = current spent price. If the option holder does not lose or gain whether he exercise his option or buys or sells the asset from the market, the option is said to be at-the-money

♣ Out of the money – For a call option, the strike price is above current spot price For a put option, strike price is below the current spot price

The Option is out-of-the-money if it is not advantageous to exercise it

FACTORS INFLUENCING OPTIONS:FACTORS AFFECTING THE VALUE OF CALL OPTION

1. The Market price of the underlying asset For a given striking price, higher the stock price, the higher will be the call option price.

2. The striking priceHigher the striking price, lower is the call option price because the amount of gain is limited.

3. Option periodLonger the option period, the higher will be the option price. The longer option period gives

greater chance for the stock price to increase above the exercise price.4. Stock volatility

If the underlying stock price is volatile, there is a probability of rise in price and gain. At the same time, there is a risk of fall in price and incurring loss. These chances affect the owner of the call option to a lesser degree than the owner of the stock because, if there is a rise in price he stands to gain and if ther is fall in price his loss is limited. Hence the value of the call option is high.5. Interest rates

When the interest rates are higher, the value of the strike price would be lower anc at the same time the call price would be higher. The influence of the interest rate depends upon its own variability and its relationship with the stock prices.6. Dividends

The call option price is lower at the ex-dividend date compared to the pre-dividend date. The change in stock prices during the ex-dividend period would be lower hence, the call price also would be lower.

American Option and European Option

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An American Option can be exercised on any business day within the life of an option including the expiration date.

An European Option can be exercised on the life of organisation on the expiration date.

Stock Options:Shares are involved.

Index Options:Underlying amount is stock Index.Vohra & Bagri page no. – 238

This is useful for institutional investors. An index option to call or put is like a stock option:

- In an index put option buyer stands to gain if the index end falls below the predetermined exercise price.

- In an index call option, the buyer stands to loose of the index level raises above the exercise price

SWAPSSwaps are risk management tools, which involve the exchange of one set of financial

obligations for another, aiming at reducing the financial obligation rate of the parties involved into the deal. Swaps can be:

Interest rate swaps Currency Swaps

Meaning of Swap:Swap means:

- Exchange or Substitute- An Act of exchanging one thing for another

- “Swap is a contract between two parties to exchange a set of cash flows over a pre-determined period of time”.

- Financial Swaps are an asset – liability management technique that permits a borrower to access one market and then exchange the liability for another type of liability.

- An agreement between two parties to exchange a series of payments, the terms of which are predetermined can be regarded as a financial swap.

- Swaps by themselves are not funding instruments; they are devices to obtain the desired form of financing indirectly through reduction of risk.

Notional Capital:It is the principal amount on which the interest calculation is made.

Basis Pints:Basis point means 1/100th of 1%. Percentage i.e.,10 Basis Pints = 0.1%

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Principles behind Swaps:a) Comparative Advantage and Absolute Advantage. b) Offsetting Risks.

Limitations of Swap Markets:1. Difficulty for Broker/ dealer in identifying the counter party once a party has approached

him.2. Swap deal cannot be terminated without the agreement between the parties involved.3. Existence of inherent default risk.4. Swaps are not easily tradeable because of under developed secondary markets. 5. Comparative advantage is illusory since it is for a short period of time.6. The market is OTC but not controlled by stock exchange. Hence extra caution is needed.

Swap Facilitators:

- Swaps are internal obligations among the Swap parties.- Swap Dealer (Swap Broker) is involved.- Swap Broker collectives called Swap Banks (or) ‘Banks’.

a) Swap Broker:- A mere intermediary - Initiates the transaction and disassociates. - Charges a fee (commission).- Not a party to Swap.- An economic agent helping in identifying the palatial counter parties to a

swap transaction.- Called “Market Maker”.

b) Swap Dealer:

- Bears the financial risk involved.- Becomes a party to the swap transaction.- Earn profit by completing the swap transaction. - 2 problems he faces:

i) Pricing of Swapsii) Managing the default risk of the counterparty.

Swap Coupon: The fixed rate of interest on Swap.

Types of Swaps

Thee are basically two major types of swap structures (i) interest-rate swaps (IRS) and (ii) currency swaps.

An IRS is a contractual agreement between counter-parties to exchange a series of interest payments for a stated period of time. The nomenclature arises from the fact that typically, the payments in a swap are similar to interest payments on a borrowing. A typical IRS

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involves exchanging fixed and floating interest payments in the same currency. The other important points to be noted in the context of interest rate swaps are:

There is no exchange of principal Only the interest payments are exchanged. They are usually netted on the settlement dates

and only the net value is exchanged between counterparties. This reduces credit risk in an IRS.

Any underlying loan or deposit is not affected by the swap. The swap is a separate transaction.A currency swap is a contractual agreement between counterparties in which one party

makes payments in one currency and the other arty makes payment in a different currency for a stated period of time. The other important points to be noted in the case of currency swaps are:

It usually involves an exchange of currencies between the counterparties at the outset of the agreement and at its maturity. If there is no exchange of currencies up front, then there must be an exchange at maturity.

The interest payments on the settlement dates are usually paid in full, unlike in an IRS. The interest payments on the two currencies can be calculated on a fixed or floating basis for both currencies, or payments for one currency can be on a fixed bases and the other, on a floating basis.

Due to the exchange of principal as also exchange of interest payments in full (as stated above), the credit risk in a currency swap is higher than that in an IRS.

The other popular types of swaps include commodity swaps and equity swaps. A commodity swap is a contractual agreement between counterparties, wherein at least one

set of payments involved is set by the price of the commodity or by the price of a commodity index.

An equity swap or an equity index swap is a contractual agreement between counterparties, wherein at least one party agrees to pay the other a rate of return based on a stock index during the life of the swap.

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