Unit IV Financing And Dividend Decisions

• Introduction

• Cost of Capital – Meaning, Definition

• Basic assumptions of Cost of Capital

• Importance of Cost of Capital

• Classification of Cost of Capital

* Explicit cost and Implicit cost

* Future and Historical cost

* Specific cost and Combined cost

* Average cost and Marginal cost

• Factors affecting the cost of capital

Cost of Capital

• Cost of specific cost of capital* Cost of Debt Capital * Cost of Preference Capital* Cost of Equity share capital

* Dividend yield method* Dividend yield plus growth in dividend

method* Earning yield method and

* Realized yield method, etc• * Cost of retained earnings• * Weighted average cost of capital (WACC)

Capital Structure

• Capital structure is defined as the composition of all the securities the firm issues in order to finance its operations. These securities differ in various respects, with equity and debt as the underlying securities and incorporating several innovative instrument features such as – Leverage, Maturity, Fixed Vs Variable payments, Seniority, Currency, control, contingencies etc.

• Essential features of a sound Capital mix.

• Factors Influencing Capital Structure/Determinants of the Capital Structure

Capital Structure Theories

• Based on several diverse view points which underlines the role of capital structure on the wealth maximization of the share holders, there evolved four major theories/approaches which explain the relationship between capital structure, cost of capital and the value of the firm. They are –

• Net income ( NI) Approach,

• Net Operating Income (NOI) Approach,

• MM Approach and

• Traditional Approach.

Assumptions of the various capital structure theories

• The firm employs only two types of capital – debt and equity. And Preference capital / shares do not exist.

• There are no corporate taxes. This assumption has been removed later.

• The firm pays 100% of its earnings as dividend. Thus, there are no retained earnings.

• The firm’s total assets are given and they do not change. i.e, the investment decision is assumed to be constant.

Assumptions of the various capital structure theories

• The firm’s total financing remains constant. The firm can change its capital structure either by redeeming the debentures by issue of shares or by raising more debt and reduce the equity share capital.

• The Operating Earnings (EBIT) are not expected to grow.• The business risk remains constant and is independent of

capital structure and financial risks.• All investors have the same subjective probability distribution

of the future expected operating earnings (EBIT) for a given firm.

• The firm has a perpetual life.

Basic equations in calculation of Cost of Capital

• ko is the WACC weighted by market values.

debt of ueMarket val

chargesinterest annual kd

equity of ueMarket val

rsshareholde toavailable earnings k s

firm of uemarket val Total

earnings operatingNet k o

Net Income (NI) Approach • Concept: According to this approach the average cost of

capital (ko) declines as gearing increases. The cost of shareholders funds (ks) and the cost of debt (kd) are independent. Since kd is usually less than ks as debt is less risky than equity from the investor’s point of view, an increase in gearing should lead to a decrease in ko.

• Formula for calculating the value of a firm = V = S + B, Where,

V= Value of Firm or hospital

S= Market Value of Equity

B=Market Value of Debt

Assumptions of NI Approach

• Corporate taxes doesn’t exist

• The cost of debt is less than the cost of equity or equity capitalization rate.

• The debt content does not change the risk perception of the investors

Net Operating Income (NOI) Approach • Concept: According to this approach, the market value of the

firm or hospital is not at all affected by changes in its capital structure. The market value of the firm or hospital is ascertained by capitalizing the net operating income at the overall cost of capital (Ko), which is considered to be constant. The market value of equity is ascertained by deducting the market value of the debt from the market value of the firm.

• Formula for calculating the value of a firm =V= EBIT

Where, Ko

V= Value of firm or hospital

Ko= Overall cost of capital

EBIT= Earnings before interest and tax

Assumptions of NOI Approach

• The overall cost of capital (Ko) remains constant for all degrees of debt-equity mix or leverage.

• The market capitalizes the value of the firm or hospital as a whole and, therefore, the split between debt and equity is not relevant.

• The use of debt with low cost of capital increases the risk of equity shareholders, which results in an increase in equity capitalization rate. Thus, the advantage of debt is set off exactly by an increase in the equity capitalization rate.

• There are no corporate taxes.

Concept of Optimum Capital Structure

• According to the Net Operating Income (NOI) Approach, the total value of the firm remains constant irrespective of the debt-equity mix or the degree of leverage. The market price of equity shares will not change on account of change in debt-equity mix. Hence, optimum capital structure doesn’t exist at all. Any Capital structure will be optimum according to this approach.

• In those cases where corporate taxes are presumed, theoretically there will be optimum capital structure when there is 100% debt. This is because with every increase in debt content ‘Ko’ declines and the value of the firm goes up. However, due to legal and other provisions, there has to be a minimum equity. This means that optimum capital structure will be at a level where there can be maximum possible debt content in the capital structure.

Modigliani – Miller Approach (MM Approach)

• According to this approach, the value of a firm is independent of its capital structure. The NOI approach is purely definitional or conceptual. MM approach maintains that the average cost of capital does not change with change in the debt weighed equity mix or capital structure of the firm. It also gives operational justification for this and not merely states only a proposition.

Basic Propositions of MM Approach

– The overall cost of capital (Ko) and the value of the firm (v) are independent of the capital structure. In other words, k and v are constants for all levels of debt-equity mix. The total market value of the firm or hospital is given by capitalizing the expected net operating income (NOI) at the rate appropriate for that risk class.

– The cost of equity (Ke) is equal to capitalization rate of a pure equity stream plus a premium for the financial risk. The firm or hospital will have more debt content in its capital structure. As a result, Ke increases in a manner to off set exactly the use of a less expensive source of funds represented by debt.

– The cut-off rate for investment purposes is completely independent of the way in which an investment is financed.

Assumptions of MM Approach

• Capital markets are perfect. This means –– Investors are free to buy and sell securities;– The investors can borrow without restriction on the same terms on which the

firm can borrow;– The Investors are well informed;– The Investors behave rationally; and– There are no transaction costs.

• The firms or hospitals can be classified into homogeneous risk classes. All firms within the same class will have the same degree of business risk.

• All investors have the same expectation of a firm’s net operating income (EBIT) with which to evaluate the value of any firm.

• The dividend pay-out ratio is 100%. In other words, there are no retained earnings.

• There are no corporate taxes. However, this assumption has been removed later.

Arbitrage process

The “arbitrage process” is the operational justification of MM hypothesis. The term ‘Arbitrage’ refers to an act of buying an asset or security in one market having lower price and selling it in another market at a higher price. The consequence of such action is that the market prices of the securities of the two firms or hospitals exactly similar in all respects except in their capital structures cannot for long remain different in different markets. Thus, arbitrage process restores equilibrium in the value of securities. This is because in case the market value of the two firms, which are equal in all respects except their capital structures, are not equal investors of the overvalued firm would sell their shares, borrow additional funds on personal account and invest in the undervalued firm in order to obtain the same return on smaller investment outlay. The use of debt by the investor for arbitrage is termed as ‘home made’ or personal leverage’.

Limitations of MM Hypothesis

• The Arbitrage process is the behavioral foundation for the MM hypothesis. However, the arbitrage process fails to bring the desired equilibrium in the capital markets on account of the following reasons:-

• Rates of interest are not the same for the individuals and the Firms

• Home made Leverage is not perfect Substitute for Corporate Leverage.

• Transaction Costs involved

• Institutional Restrictions

• Corporate Taxes frustrate MM Hypothesis.

Impact of taxes on MM Hypothesis

• The statement of MM hypothesis which says that the value of a firm and its cost of capital will remain constant with leverage (i.e., debt content in the capital structure) does not hold good when corporate taxes exist. Since corporate taxes do exist in real life, in 1963 MM agreed that the value of a firm will increase or the cost of capital will decline, if corporate taxes are introduced in the exercise. This is because interest is tax deductible expenditure. This feature results in a greater market value for a levered firm as compared to that of an unlevered firm.

Impact of taxes on MM Hypothesis• The value of the levered firm would exceed that of the unlevered firm by

an amount equal to the levered firm’s debt multiplied by the tax rate. This can be expressed as:

• VI =Vu + Bt• Where,• Vi = Value of a levered firm;• Vu = Value of an unlevered firm;• B = Amount of debt and• t = Tax rate• The market value of an unlevered firm will be equal to the market value of

its shares. • Symbolically, Vu= S, where• Vu = Market value of an unlevered firm; and• S = Market value of equity:• Profit available for Equity Shareholders• Equity Capitalisation Rate

Impact of taxes on MM Hypothesis

• In other words, the value of Vu can be determined as follows:• Vu = (1-T) EBT• Ke• Where,• EBT = Earnings before tax• T = Tax rate• Ke =Equity capitalization rate• As in an unlevered firm there is no debt content, Earning

before Tax (EBT) refers to Earning before interest and Tax (EBIT).

Traditional Approach

• Concept: The essence of the Traditional Approach lies in the fact that a firm, through judicious use of debt-equity mix can increase their total value and thereby reduce their overall cost of capital. This is because debt is relatively a cheaper source of funds as compared to issue of shares because of tax shield available on interest on debt. However, beyond a point, raising of funds through debt also may involve financial risk and might result in a higher equity capitalization rate. Thus, up to a point, the debt content in the capital structure will favorably affect the value of a firm. Beyond that point, use of debt will adversely affect the value of a firm or hospital. At this point of debt-equity mix, the capital structure will be at its optimum and the average or the composite cost of capital will be the least.

Capital Structure

• Features of an appropriate Capital Structure

• Leverages

• Operating Leverage – OL and Degree of Operating Leverage

• Financial Leverage – FL and Degree of Financial Leverage, and

• Combined leverages

• Indifference point

• EBIT – EPS Analysis

• Financial Break Even Point

• Pecking Order Theory

Dividend Policy

• Meaning, concept of Dividend

• Forms of Dividend – Cash dividend, Stock dividend, Stock split, Reverse split, Stock repurchase etc

• Types of Dividend Policies – Regular dividend policy, Stable dividend policy, Irregular dividend policy, no dividend policy

• Determinants of Dividend policies – Legal restrictions, Magnitude and trend of earnings, Desire and size of shareholders, Nature of industry, Age of company, Govt. policy, future financial requirements, Taxation policy, Inflation, Control aspects, Requirements of Institutional investors, Stability of dividends, Liquid resources etc.

Forms of Dividend

• Cash dividend

• Stock dividend

• Stock split

• Reverse split

• Stock repurchase etc

Types of Dividend Policies

• Regular dividend policy

• Stable dividend policy– Constant dividend per share – Constant Payout Ratio (P/O)– Stable rupee dividends plus extra dividend

• Irregular dividend policy

• No dividend policy

Determinants of Dividend policies

• Legal restrictions: Legal provisions relating to dividends as laid down in Sections 93, 205, 205 A, 206 and 207 of The Companies Act, 1956 lay down a frame work within which dividend policy is framed. They imply that dividends can be paid only out of current profits or past profits after depreciation or out of funds provided by the government for the payment of dividends in pursuance of a guarantee given by the Government. Under the Companies (transfer of profits to reserves) Rules of 1975, a Company providing more than 10% dividend has to transfer a certain percentage of its current year profits to reserves. The Companies Act, 1956 provides that, dividends cannot be paid out of capital.

Determinants of Dividend policies

• Magnitude and trend of earnings• Desire and size of shareholders• Nature of industry: Stable or cyclical• Age of company• Govt. policy: Conditionalities on payment of

dividend• Future financial requirements• Taxation policy

Determinants of Dividend policies

• Inflation: More reserves for replacement of worn out assets as depreciation may not be sufficient

• Control aspects• Requirements of Institutional investors: Usually they

prefer a regular payment of cash dividend and may stipulate their own demands on dividend payments to equity share holders

• Stability of dividends• Liquid resources etc.

Dividend theories• Relevancy concept of Dividend: According to

this aproach, a firm’s dividend policy has a profound effect on the firm’s position in the stock market. Higher dividends increase the value of stock while lower dividends decrease their value. This is because dividends communicate information to the investors about the firm’s profitability.– James Walter’s theory– Myron Gordon’s theory

Dividend theories• Irrelevancy concept of Dividend: This school of thought

is associated with Solomon, Modigliani & Miller. According to them, dividend policy has no effect on the share prices of a company and is therefore, of no consequence. In their opinion, investors do not differentiate between dividends and capital gains, as they only want to gain higher returns on their investment. In case the company has adequate investment opportunities giving a higher rate of return than the cost of retained earnings, the investors would be content with the firm retaining the earnings. However, if the expected return on projects is likely to be less than what it would cost, investors would prefer to receive dividends. Thus, the dividend decision is essentially a financing decidion.– MM Approach

MM Approach – Irrelevancy of Dividend• Theory – “under conditions of perfect capital

markets, rational investors, absence of tax discrimination between dividend income and capital appreciation, given the firm’s investment policy its dividend policy may have no influence on the market price of the shares”.

• Proof: Po= D1 + P1

(1+Ke)

Where Po= Prevailing market price of the share; D1 = Dividend in period 1; P1 =Mkt price of the share in period 1; Ke =Cost of equity capital

MM Approach – Irrelevancy of Dividend

• P1 = Po(1+Ke)- D1

• Computation of the number of new shares to be issued

m x P1 = I-(X – nD1)Where m=Number of new shares to be issued

P1 = Price at which new issue is to be madeI = Amount of investment requiredX= Total net profit of the firm during the period

nD1 = Total dividends paid during the period

MM Approach – Irrelevancy of Dividend• Assumptions

– Capital markets are perfect

– Investors behave rationally, as information is available freely to them and there are no flotation costs and transaction costs

– There are either no taxes or there are no differences in the tax rates applicable to capital gains and dividends

– The firm has a fixed investment policy

– Risk or uncertainty does not exist. Investors are able to forecast future prices and dividends with certainty and one discount rate can be used for all securities at all times.

The Indian Money Market

• Money market is a market for financial assets which are close substitutes for money. It is an overnight market for procuring short-term funds and instruments having a maturity period of one or less than one year. It does not refer to a physical location, but refers to an activity that is conducted over telephone. Money market constitutes a very important segment of the Indian financial system.

• Features of Indian Money Market• Functions of Money Market• Benefits of an efficient Money Market• Money Market Instruments ( TBs, CDs, CP, Call Money, CBs,

CBLO etc)

The Indian Capital Market

• The Indian Capital Market is an important constituent of the Indian Financial System. It is a market for long term funds – both equity and debt raised within and outside the country.

• The Capital Market aids economic growth by mobilizing the savings of the economic sectors and directing them towards channels of productive use.

• Functions of Capital Market

• Structural Framework of Indian Capital Market

• Primary Capital Market and Secondary Capital Market

Various sources of Finance

• The Corporate Sector draws its capital needs from the following sources:

– Promoters Contribution,

– Equity & Preference Capital raised from the shareholders (generally referred to as equity capital),

– Bonds/Debentures raised from the Public (generally referred to as Debt Capital),

– Term Loans from Banks & Financial Institutions,

– Short-term Working Capital from Banks,

– Unsecured Loans & Deposits, and

– Internal generation of Funds (Profits/surpluses re-ploughed).

Methods of floating securities in the market

• Corporate may raise capital in the primary market by way of an initial public offer(IPO), rights issue or private placement. An IPO is the selling of securities to the public in the primary market. This Initial Public Offering can be made through the fixed price method, book building method or a combination of both.

• The methods by which new issues are made are – (i) Public issue through prospectus(ii) Tender/Book building(iii) Offer for sale(iv) Private placement and (v) Rights issue.

Raising Foreign funds

• Apart from raising funds from domestic primary market or secondary market, a firm or a hospital can raise funds from international markets also. Indian companies or hospitals have raised resources from international capital markets through –

• Global Depository Receipts (GDRs)

• American Depository Receipts (ADRs)

• Foreign Currency Convertible Bonds (FCCBs) and

• External Commercial Borrowings (ECBs).

Debt finance through term loans

• A term loan is a loan made by a bank / financial institution to a business having an initial maturity of more than 1 year. The primary source of this mode of finance is financial institutions. Term loans or project finance is provided by financial institutions for new projects and also for expansion / diversification and modernization whereas the bulk of term loans extended by banks are in the form of working capital term loan to finance the working capital gap. Though they are permitted to finance infrastructure projects on a long-term basis, the quantum of such financing is only marginal.

Loan financing

• A firm may meet its financial requirements by taking both short-term loans or credits and long term loans.

• The short term loans or credits are obtained for working

capital requirements. Some of the popular sources of short term loans or credits are – trade credit, loans from commercial banks in the form of loans, cash credits, hypothecation, pledge, overdrafts, bills discounted and purchased, public deposits, loans from finance companies in the form of leasing and hire purchasing, merchant banking, equity research and investment counseling, accrual accounts, loans from indigenous bankers, advances from customers and other miscellaneous sources.

Foreign Currency Loan Guidelines

• A foreign currency loan is a loan denominated in a currency other than that of the borrower’s home country that must be repaid also in this currency. The majority of foreign currency loans are granted with a maturity of up to 25 years, but are rolled over every three or six months. The interest rate is linked to the London Inter bank Offered Rate (LIBOR) of the relevant currency. The bank charges an additional 1.5% to 2%, depending on the size of the loan, the nature of customer relations, the collateral provided, etc.2) Interest (and principal) payments are due retroactively upon maturity and have to be made in the currency in which the loan is denominated. In many cases, the borrower may repay the loan before it is due or switch to another currency (including euro) at the rollover dates.

SEBI and government guidelines

• In 1988 the Securities and Exchange Board of India (SEBI) was established by the Government of India through an executive resolution, and was subsequently upgraded as a fully autonomous body (a statutory Board) in the year 1992 with the passing of the Securities and Exchange Board of India Act (SEBI Act) on 30th January 1992. In place of Government Control, a statutory and autonomous regulatory board with defined responsibilities, to cover both development & regulation of the market, and independent powers has been set up. Paradoxically this is a positive outcome of the Securities Scam of 1990-91.

SEBI and government guidelines

• In 1988 the Securities and Exchange Board of India (SEBI) was established by the Government of India through an executive resolution, and was subsequently upgraded as a fully autonomous body (a statutory Board) in the year 1992 with the passing of the Securities and Exchange Board of India Act (SEBI Act) on 30th January 1992. In place of Government Control, a statutory and autonomous regulatory board with defined responsibilities, to cover both development & regulation of the market, and independent powers has been set up. Paradoxically this is a positive outcome of the Securities Scam of 1990-91.

SEBI

• Basic objectives 0f SEBI

• Functions of SEBI

• SEBI in India’s Capital Market

• Recent amendments of SEBI

• RBI – Functions of RBI

• FIPB