LAB FILE

ON

“FINANCIAL PLANNING”

Submitted To: Submitted By:

PG Department of Name : SUKHCHAIN

Commerce Class : B.A.F. 2nd

Roll No. : 9007

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DECLARATION

I hereby declare that the Lab File entitled “FINANCIAL PLANING” is bonafide work done by

‘SUKHCHAIN AGGARWAL’ a student of B.com (Accounting & Finance) 2nd and is submitted to

“Prof. Rohini Gupta” in partial fulfillment of the requirement for the degree.

This work has never been submitted to any Educational Institution as per good of my

knowledge.

SUKHCHAIN AGGARWAL

B.com (Accounting & Finance) 2nd

9007

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ACKNOWLEDGEMENT

With great pleasure we are presenting this report on the basis of to the “Financial Planing”.

We are highly grateful to “Prof. Bikramjit Singh Sandhu” & “Prof. Rohini Gupta” for giving us the

time, encouragement and guidance for the report. Their critical and detailed comments and full

support helped and benefited us in carrying out the report.

Thanking you,

SUKHCHAIN AGGARWAL

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CONTENTS

Serial No. Headings Page No.

1 Introduction 5

2 Dividend Policy 7

3 Walter Modal 7

4 Gordon Modal 7

5 Capital Structure 13

6 Leverages 15

7 Financial Leverages 15

8 Steps of Financial Leverages 18

9 Reference 20

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INTRODUCTION:

In simple words, a financial plan is a path to help you achieve your life’s financial goals. It is the

process of making learned money management decisions in order to safeguard your future.

A financial plan helps you to fulfill financial goals and meet personal priorities. It takes into

consideration your available resources, responsibilities, lifestyle and risk appetite. Allocating

your savings across various asset classes to achieve an appropriate risk-reward balance and

ensuring long-term financial security are the basics of financial plan.

You need to ask yourself some questions before making a financial plan, like: What is your

current financial situation? What is your vision of your future financial situation? How do you plan

to achieve your vision?

You need to analyze what your financial needs and goals are. Then, you measure the resources

you need to meet those goals in money terms. Specify the time period during which you want to

achieve these goals. Then you write an action plan to fulfill your goals, like, what products to buy

and what types of savings to make.

You can of course make your financial plan yourself, but a financial planning expert can offer the

right financial skills and tools to help you realize your financial plan.

In general usage, a financial plan is a series of steps or goals used by an individual or business,

the progressive and cumulative attainment of which are designed to accomplish a fin al financial

goal or set of circumstances, e.g. elimination of debt, retirement preparedness, etc. This often

includes a budget which organizes an individual's finances and sometimes includes a series of

steps or specific goals for spending and saving future income. This plan allocates future income

to various types of expenses, such as rent or utilities, and also reserves some income for short-

term and long-term savings. A financial plan sometimes refers to an investment plan, which

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allocates savings to various assets or projects expected to produce future income, such as a

new business or product line, shares in an existing business, or real estate.

In business, a financial plan can refer to the three primary financial statements (Balance sheet,

income statement, and cash flow statement) created within a business plan. Financial forecast

or financial plan can also refer to an annual projection of income and expenses for a company,

division or department. A financial plan can also be an estimation of cash needs and a decision

on how to raise the cash, such as through borrowing or issuing additional shares in a company.

While the common usage of the term "financial plan" often refers to a formal and defined series

of steps or goals, there is some technical confusion about what the term "financial plan" actually

means in the industry. For example, one of the industry's leading professional organizations, the

Certified Financial Planner Board of Standards, lacks any definition for the term "financial plan"

in its Standards of Professional Conduct publication. This publication outlines the professional

financial planner's job, and explains the process of financial planning, but the term "financial

plan" never appears in the publication's text.

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1. DIVIDEND POLICY:

The term dividend refers to that of profits of a company which is distribution by the company

among its shareholders. It is the reward of the shareholders for investments made by them in

the shares of the company. The investors are interested in earning the maximum return on

their investments and to maximize their wealth. A company, on the other hand, needs to

provide funds to finance its long-term- growth. If a company pays out as dividend most of

what it earns, then for business requirements and further expansion it will have to depend

upon outside resources such as issue of dept or new shares.

Dividend policy of a firm, thus affects both the long-term financing and the wealth of

shareholders. As a result, the firm’ decision to pay dividends must be reached in such a

manner so as to equitably apportion the distributed profits and retained earnings. Since

dividend is a right of shareholders to participate in the profits and surplus of the company for

their investment in the share capital of the company, they should receive fair amount of the

profits. The company should, therefore, distribute a reasonable amount as dividends to its

members and retain the rest for its growth and survival.

I. Walter's model:

James E. Walter's model shows the relevance of dividend policy and its bearing on the

value of the share.

Assumptions of the Walter model

1. Retained earnings are the only source of financing investments in the firm, there is no

external finance involved.

2. The cost of capital, k e and the rate of return on investment, r are constant i.e. even if new

investments decisions are taken, the risks of the business remains same.

3. The firm's life is endless i.e. there is no closing down.

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Basically, the firm's decision to give or not give out dividends depends on whether it has enough

opportunities to invest the retain earnings i.e. a strong relationship between investment and

dividend decisions is considered.

Mathematical representation:

Walter has given a mathematical model for the above made statements:

Where,

P = Market price of the share

D = Dividend per share

r = Rate of return on the firm's investments

ke = Cost of equity

E = Earnings per share'

The market price of the share comprises of the sum total of:

Therefore, the market value of a share is the result of expected dividends and capital gains

according to Walter.

Ex. 1. The following information relates to XYZ Ltd.

Rs.

Paid-up equity capital 20,00,000

Earnings of the company 2,00,000

Dividend paid 1,60,000

Price-earnings ratio 12.5

Number of shares outstanding 20,000

You are required to find out whether the company’s dividend payout ratio is optimal, using

Walter’s Model.

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SOLUTION:

As per Walter's Model, the market price of the share is

  P = D + r(E-D)/ke    

    ke ke    

 Where,        

P = Market Price Per Share    

  D = Dividend Per Share    

  r = Internal Rate of Return    

  E = Earnings per Share    

  Ke = Cost of equity capital    

  Earnings per share (E) Total Earnings 2,00,000 10

    No. of Shares 20,000  

  Dividend per share (D) Amount of Dividend Paid 1,60,000 8

      20,000  

  Internal rate of return(r) Total Earnings * 100 2,00,000 * 100 10%

    Total Equity 20,00,000  

  Ke = 1 = 1 = 8%

    Price Earnings Ratio 12.50%  

  P = 8 + 0.10(10 - 8)/.08 = 10.5 131.25

    .08 .08 0.08  

  P = D + r(E-D)/Ke = 0 + .10(10-0)/.08 0 + 12.5    ke ke .08 .08 0.08

  P = 156.25    

Conclusion: We are required to find out whether the company’s dividend payout ratio is optimal,

using Walter’s Model. The firm can increase the market price of the share up to Rs.156.25 by

increasing the retention ratio to 100%; the optimal payout ratio is for the firm is zero.

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II. Gordon's Model:

Gordon model Myron J. Gordon  has also supported dividend relevance and believes in

regular dividends affecting the share price of the firm.

Assumptions of the Gordon model:

Gordon's assumptions are similar to the ones given by Walter. However, there are two

additional assumptions proposed by him:

1. The product of retention ratio b and the rate of return r gives us the growth rate of the

firm.

2. The cost of capital ke, is not only constant but greater than the growth rate i.e. ke>g.

Model description:

Investors are risk averse and believe that incomes from dividends are certain rather than

incomes from future capital gains; therefore they predict future capital gains to be risky

propositions. They discount the future capital gains at a higher rate than the firm's earnings

thereby, evaluating a higher value of the share. In short, when retention rate increases, they

require a higher discounting rate. Gordon has given a model similar to Walter's where he has

given a mathematical formula to determine price of the share.

Mathematical representation:

The market price of the share is calculated as follows:

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where,

P = Market price of the share

E = Earnings per share

b = Retention ratio (1 - payout ratio)

r = Rate of return on the firm's investments

ke = Cost of equity

br = Growth rate of the firm (g)

Therefore the model shows a relationship between the payout ratio, rate of return, cost of

capital and the market price of the share.

Ex. 2. A large sized chemical company has been expected to grow at 14% per year for the next

4 years and then to grow indefinitely at the same rate as the national economy, i.e. 5%. The

required rate of return on the equity shares is 12% Assume that the company paid a dividend of

Rs.2 per share last year (D0 = 2). Determine the market price of the share today. You may use

the following table:

Year 1 2 3 4

Discount Factor at 12% 0.893 0.797 0.712 0.636

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SOLUTION:

Calculation of Present value of Expected Dividends During Supernormal Growth Period of 4 Years

Year Expected Dividend (RS.)P.V. Factor at

12% P.V. Of Dividends (Rs.)

1 2(1+0.14)1 = 2.28 0.893 2.036

2 2(1+0.14)2 = 2.5992 0.797 2.0715

3 2(1+0.14)3 = 2.9631 0.712 2.1097

4 2(1+0.14)4 = 3.3779 0.636 2.1483

      8.3655

Calculation of market price of share at the end of year 4

  Pn = Dn+1  

   Ke-gn  

  P4 = D4(1+g) 3.3779(1+0.05)

   Ke-gn 0.12-0.05

    3.5468 50.67

   0.07

 Calculation of Present Value of market value of share at the end of year 4 (at 12%)

 

  P0 = Pn (1)  

    (1+ke)4

 

    

 

    P4 (1)  

    (1+0.12)4

 

    

 

  50.67 * 0.636 = 32.23

 

Market Price of the Share today = Present value of Dividend + P.V. of Market Price of Share

  = 8.3655 + 32.23  

  = 40.6  Conclusion: We are calculating the present value of Expected Dividend during Supernormal Growth Period of 4 year And We calculate the market price of share is Rs. 40.60.

3. CAPITAL STRUCTURE:

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In finance, capital structure refers to the way a corporation finances its assets through

some combination of equity, debt, or hybrid securities. A firm's capital structure is then the

composition or 'structure' of its liabilities. Capital Structure is concerned with the qualitative

aspect. It refers to the kind of securities and proportionate amounts that make up capitalization.

For raising long- term finances, a company can issue three types of securities viz. Equity shares,

Preference Shares and Debentures. A decision about the proportion among these type of

securities refers to the capital structure of an enterprise. For example, a firm that sells $20 billion

in equity and $80 billion in debt is said to be 20% equity-financed and 80% debt-financed. The

firm's ratio of debt to total financing, 80% in this example is referred to as the firm's leverage. In

reality, capital structure may be highly complex and include dozens of sources. Gearing Ratio is

the proportion of the capital employed of the firm which come from outside of the business

finance, e.g. by taking a short term loan etc.

The Modigliani-Miller theorem, proposed by Franco Modigliani and Merton Miller, forms

the basis for modern thinking on capital structure, though it is generally viewed as a purely

theoretical result since it disregards many important factors in the capital structure decision. The

theorem states that, in a perfect market, how a firm is financed is irrelevant to its value. This

result provides the base with which to examine real world reasons why capital

structure is relevant, that is, a company's value is affected by the capital structure it employs.

Some other reasons include bankruptcy costs, agency costs, taxes, and information asymmetry.

This analysis can then be extended to look at whether there is in fact an optimal capital

structure: the one which maximizes the value of the firm.

Different kinds of theories have been propounded by different authors to explain the

relationship between capital structure, cost of capital and value of the firm. In all these kinds of

theories, the Net Income Approach method is very popular for calculation of value of the firm.

Ex 3:- AB Ltd. Needs Rs. 10,00,000 for expansion .The expansion is expected to yield an

annual EBIT of Rs. 1,60,000.In choosing a financial plan, AB Ltd. Has an objective of

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maximizing earning per share. It is considering the possibility of issuing equity shares and

raising debt of Rs.1,00,000 or 4,00,000 or 6,00,000.The current market price per share is Rs.25

and it is expected to drop to Rs.20 if the funds are borrowed in excess of Rs.5,00,000.

Funds can be borrowed at the rates indicated below:-

(a) Upto Rs.100000 at 8%

(b) Over Rs.100000 and upto Rs.500000 at 12%

(c) Over Rs.500000 at 18%

Assume a tax rate of 50%.Determine EPS for three alternatives and the alternative which would

meet the objectives of management.

Solution:-

AlternativesPlan 1(Debt=Rs.100000)

Plan 2(Debt=Rs.400000)

Plan 3(Debt=Rs.600000)

EBIT 160000 160000 160000Less: Interest 8000 44000 74000EBT 152000 116000 86000Less: Tax @50% 76000 58000 43000EAT 76000 58000 43000Number of shares 900000/25 600000/25 400000/20

36000 24000 20000Earning per share(EAT/No. of shares)

76000/36000 58000/24000 43000/20000

2.11 2.42 2.15

Conclusion:-As the company has an objective of maximizing earning per share, so the company chooses alternative II, because EPS is highest in case of alternative II.

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4. LEVERAGES:

The meaning of term ‘Leverages’ 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 leverage. This concept of leverages 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. James Horne 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”. The fixed cost and fixed return remains constant irrespective of the change in

volume of output or sales. Thus the employment of an asset or sources of funds for which the

firm has to pay fixed cost or return has considerable influence on the earnings available for

equity shareholders. However higher the degree of the leverage, higher is the risk as well as

return to the owners.

TYPES OF LEVERAGES:

There are basically two types of leverages, (1) operating leverage, and (2) 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 is known as financial leverage.

In addition to these two kinds of leverages, one could always compute ‘composite leverage’ to

determined the combined effect of the leverages. The types of leverages are explained as

below:

4. Financial Leverage Or Trade 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

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structure of the firm. So financial structure is represented by the left side of the balance sheet.

The use of long term fixed interest bearing debt and preference share capital along with equity

share capital is called financial leverage or trade on equity. The long term fixed interest bearing

debt is employed by a firm to earn more from the use of these resources then their cost so as to

increase the return on owner’s equity. It is true that the capital structure does not affect the total

earnings of a firm but it can affect the share of earnings of equity shareholders.

The fixed cost funds are employed in such way that the earnings available for common

stockholders are increase. A fixed rate of interest is paid on such long term debts. The interest is

a liability and must be paid irrespective of revenue earnings. The preference share capital is also

bear s a fixed rate of dividend. But the dividend is paid only when the company has surplus

profits. The aim of financial leverage is to increase the revenue available for equity shareholders

using the fixed cost funds. A firm is known to have a favorable leverage if its earnings are more

than what debts would cost. On the contrary, if it does not earn as much as the debt costs then it

will be known as unfavorable leverage.

Impact of Financial Leverage:

The financial leverage is used to magnify the shareholders earnings. It is based on the

assumption that the fixed cost 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. The impact of financial leverage can

be analysed while looking at earning per share and return on equity capital.

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4. A Ltd. Company has equity share capital of Rs. 5,00,000 dividend into share of Rs. 100

each. It wishes to raise further Rs. 3,00,000 for expansion cum modernization plans. The

company plans the following financial schemes.

a) All common stock

b) Rs. One lakh in common stock and Rs. Two lakh in 10% debentures.

c) All debts at 10% p.a.

d) Rs. One lakh in common stock and Rs. Two lakh in preference capital with the rate of

dividend at 8%.

The company is expected earnings before interest and tax are Rs. 1,50,000. The

corporate of tax is 50%.

You are required to determined the earnings per share in each plan and comment on the

implement of financial leverage.

Solution:

Particulars Plan 1 Rs. Plan 2 Rs. Plan 3 Rs. Plan 4 Rs.Earnings before interest and tax 1,50,000 1,50,000 1,50,000 1,50,000Less: interest 20000 30000

1,50,000 1,30,000 1,20,000 1,50,000Less: Tax @ 50% 75000 65000 60000 75000Earning after tax 75000 65000 60000 75000Less: Preference dividend @ 8% 16000Earnings available for common 59000stockholdersNo. of common shares 8000 6000 5000 6000Earnings per share 9.375 10.83 12 9.83

Comments: In the four plans of fresh financing, plan 3 is the most leveraged of all. In this case

additional financing is done by raising loans@10% interest .plan 2 has fresh capital stock of Rs.

one lakh while Rs two lakh are raised from loans. Plan 4 does not have fresh loans but

preference capital has been raised for Rs two lakhs.

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5. STEPS OF FINANCIAL PLANING:

I. Establishing Financial Objectives:-

The financial objectives of a company should be clearly determined. Both short-term and long-term objective should be carefully prepared. The main purpose of financial planning should be to utilise financial resources in the best possible manner. There should be an optimum utilisation of funds. The concern should take the advantage of prevailing economic situation.

II. Formulating Financial Policies:-

The financial policies of a concern deal with procurement, administration and distribution of business funds in a possible way. These should be clear-cut plans of raising required funds and their possible uses. The current and future needs for funds should be considered while formulating financial policies.

III. Formulating Procedures:-

The procedures are formed to ensure consistency of actions. The procedures follow the formulation of policies. If a policy is to raise short-term funds from banks, then a procedure should be laid to approach the lenders and the persons authorized to initiate such actions.

IV. Providing For Flexibility:-

The financial planning should ensure proper flexibility in objective, policies and procedures so as to adjust according to changing economics situation. The changing economics environment may offer new opportunities. The business should be able to make use of such situations for the benefit of the concern. A rigid financial planning will not let the business use new opportunities.

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Ex.5: From the following, prepare income statement of company A, B, C.

Company A Company B Company CFinancial Leverage 3:1 4:1 2:1Interest 200 300 1000Operating Leverage 4:1 5:1 3:1Variable cost as a % of sales 66.67% 75% 50%Income-tax Rate 45% 45% 45%

And also calculate the EBIT and Sales.

Solution:-

Calculation of EBIT

Company A Company B Company C

Financial Leverage=EBIT/EBT 3/1 4/1 2/1EBIT 3*EBT 4*EBT 2*EBTEBIT 3(EBIT-I) 4(EBIT-I) 2(EBIT-I)

3(EBIT-200) 4(EBIT-300) 2(EBIT-1000)EBIT(solving the equation) =300 =400 =2000

Calculation of Sales

Company A Company B Company COperating Leverage=Contribution/Sales 4/1 5/1 3/1EBIT 300 400 2000Contribution 4*300=1200 5*400=2000 3*2000=6000Variable Cost(% of sales) 66.67% 75% 50%Contribution(% of sales) 33.33% 25% 50%Sales 1200*300/100 2000*100/25 6000*100/50

=3600 =8000 =12000Calculation of Income Statement

Company A Company B Company CSales 3600 8000 12000Less: Variable Cost 2400 6000 6000Contribution 1200 2000 6000Less: Fixed Cost(balancing figure) 900 1600 4000EBIT 300 400 2000Less: Interest 200 300 1000EBT 100 100 1000Less: Tax@45% 45 45 450

EAT 55 55 550

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Reference:

o “Financial Management”, “Sharma. R.K.” & “Gupta. Shashi K.”, “KALYANI PUBLISHER”,

“2010-2011”.

o http://en.wikipedia.org/wiki/Dividend_policy

o http://www.investopedia.com/terms/w/workingcapitalmanagement.asp

o http://en.wikipedia.org/wiki/Financial_plan

o http://www.themanagementor.com/enlightenmentorareas/finance/cfa/WorkingCapOpe.htm

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