by d r . b. t. c havan
TRANSCRIPT
FINANCIAL MANAGEMENT BY
DR. B. T. CHAVAN ASSIST. PROFESSOR
DAYANAND COLLEGE OF COMMERCE, LATUR
UNIT: 1
INTRODUCTION TO FM
2
INTRODUCTION TO FINANCIAL MANAGEMENT
Management is an activity which is concerned with planning and controlling of different activities in order to achieve a specific objective.
It is also defined as an Art of getting things done through and with people in formally organised groups.
Financial Management: It is a planning and controlling of financial resources of a firm with a specific objective.
Raising of funds
Effective Utilisation
Most efficiently
To achieve aims and objectives. 3
VIEWS OF FINANCIAL MANAGEMENT
Traditional View:
Raising of funds for various requirements
Like Diversification, Expansion etc.
It is not considered as regular part of managerial function
Attention was given to the long term funds only
Sources used for raising funds were mainly Equity and Debentures
Modern View:
It is no longer remained as a fund raising activity only
It is more analytical and decision oriented
Apart from fund raising, utilisation of funds became of paramount importance.
Attention is not only given to the long term but also short term funds
4
DEFINITIONS OF FINANCIAL MANAGEMENT
Joseph and Massie
“Financial management is an operational activity in business responsible for obtaining and effectively utilising funds necessary for efficient operations.”
S. C. Kucchal
“Financial management is procurement of finance and their effective utilisation in business.”
Suleman Johny
“Financial management is concerned with the efficient use of an important economic resource mainly capital funds.”
Howard and Uptom
“Financial management is an application of the financial resources with planning and control functions to the finance function.”
5
CHARACTERISTICS OF FINANCIAL MANAGEMENT
Financial planning and control
Determinant of business success
Focal point of decision making (Focusing): Decision making after intuition and statistical evaluation of alternatives.
Centralised in nature: Decentralisation of other functions is possible but practically it is not possible for finance.
Continuous administration function: Sources, Procurement, budgeting, Utilisation etc.
Measure of performance 6
FUNCTIONS OR RESPONSIBILITIES OF FINANCIAL
MANAGEMENT
A] Executive Finance Functions: These functions require specialised administrative skills.
Financial forecasting
Investment policy decisions and establishing asset management policies: (Fixed assets: Capital budgeting, Current assets: Working capital management)
Dividend policy decision or allocation of net profit (Management of Income)
i) Payment of dividend
ii) Bonus to the share holders
iii) Retention of profit for expansion of business
Cash flows and requirements
Deciding upon borrowing policy: (From commercial banks and issuing shares and debentures) Proportion of debt and equity must be decided keeping in mind cost of capital, return expected and the risk involved.
Comparative study of available options of finance
Negotiations for new outside financing
7
FUNCTIONS OR RESPONSIBILITIES OF FINANCIAL
MANAGEMENT
Procurement of funds
Advise to the top level management
Supply of funds to all departments
Analysis of appraisal of financial performance
Analysis of stock exchange
Increasing capital invested
B] Incidental Finance Functions: These functions are clerical or routine nature
Supervision of cash receipts, disbursements and safeguarding of cash balance
Proper custody and safeguarding of the important and valuable papers, securities and insurance policies.
Taking care of all mechanical details of financing.
Record keeping and reporting
Cash planning and credit management
Preparation of various financial statements
8
IMPORTANCE OF FINANCIAL MANAGEMENT
Financial planning
Acquisition of funds
Proper use of funds
Financial decision
Improve profitability (Budgetary control, Ratio
analysis, cost volume profit ratio)
Increase the value of the firm
Promoting savings
9
RESPONSIBILITIES FINANCIAL MANAGEMENT
Financial Management
The Goal of the Firm
Corporate Governance
Organization of the Financial Management Function
FINANCIAL MANAGEMENT
Concerns the acquisition,
financing, and
management of assets with
some overall goal in mind.
GOAL OF THE FIRM
Maximization of
Shareholder Wealth!
Value creation occurs when we maximize the
share price for current shareholders.
THE MODERN CORPORATION
There exists a SEPARATION between owners and
managers.
Modern Corporation
Shareholders Management
ROLE OF MANAGEMENT
An agent is an individual authorized by another
person, called the principal, to act in the latter’s behalf.
Management acts as an agent
for the owners (shareholders) of
the firm.
ORGANIZATION OF THE FINANCIAL
MANAGEMENT FUNCTION
Board of Directors
President
(Chief Executive Officer)
Vice President
Operations
Vice President
Marketing VP of
Finance
Treasurer Capital Budgeting
Cash Management
Credit Management
Dividend Disbursement
Fin Analysis/Planning
Pension Management
Insurance/Risk Mngmt
Tax Analysis/Planning
ORGANIZATION OF THE FINANCIAL
MANAGEMENT FUNCTION
VP of Finance
Controller Cost Accounting
Cost Management
Data Processing
General Ledger
Government Reporting
Internal Control
Preparing Fin Stmts
Preparing Budgets
Preparing Forecasts
FINANCIAL MANAGER
Financial managers try to answer some, or
all, of these questions
The top financial manager within a firm is
usually the Chief Financial Officer (CFO)
Treasurer – oversees cash management, credit
management, capital expenditures, and financial
planning
Controller – oversees taxes, cost accounting,
financial accounting, and data processing
FINANCIAL MANAGEMENT DECISIONS
Capital budgeting
What long-term investments or projects should the business take on?
Capital structure
How should we pay for our assets?
Should we use debt or equity?
Working capital management
How do we manage the day-to-day finances of the firm?
GOAL OF FINANCIAL MANAGEMENT
What should be the goal of a corporation?
Maximize profit?
Minimize costs?
Maximize market share?
Maximize the current value of the company’s stock?
Does this mean we should do anything and
everything to maximize owner wealth?
INVESTMENT DECISIONS
What is the optimal firm size?
What specific assets should be acquired?
What assets (if any) should be reduced or
eliminated?
FINANCING DECISIONS
What is the best type of financing? What is the best financing mix? What is the best dividend policy (e.g.,
dividend-payout ratio)? How will the funds be physically
acquired?
Determine how the assets will be
financed
ASSET MANAGEMENT DECISIONS
How do we manage existing assets
efficiently?
Financial Manager has varying degrees
of operating responsibility over assets.
Greater emphasis on current asset
management than fixed asset
management.
Unit: 2
Financial Goals
Basic Decisions 1) Finance related: From where to raise the fund and at
which cost
2) Investment related: Where to invest fund and how much amount
3) Dividend related: How much to pay and how much to
retain
Basic Functions
1) Raising Fund
2) Effective Utilization
3) Achieving Aims and Objectives
Goals of Financial Management • Profit Maximization: In economics, profit
maximization is the short run or long run process by which a firm may determine the price, input, and output levels that lead to the greatest profit. A financial gain, especially the difference between the amount earned and the amount earned and the amount spent in buying, operating or producing something.
• Wealth Maximization: Increasing the value of a business in order to increase the value of the shares held by stock holders. The most direct evidence of wealth maximization is changes in the price of a company's shares. Wealth is determined by taking the total market value of all physical & intangible assets owned then subtracting all debts.
Profit Maximization
• Maximization of profit is very often considered as the main objective of business firm
• The share holders (owners) invest their funds in the business with the hope of getting higher dividend
• Profitability of the business is an indicator of the sound health of the organization
• Profit safeguards the economic interest of various social groups which are directly or indirectly connected with the business
• The firm should undertake those actions that would decrease profit
• The financial decision should be oriented to the maximization of profit
• Profit provides the yardstick for measuring performance of firm
• Profit makes allocation of resources to profitable and desirable areas
• It also ensures maximum social welfare
• Society’s resources are effectively used
Merits of Profit Maximization
• Profit is the indicator of business efficiency
• Measurement of success
• Efficient allocation and utilization of resources
• Reduction in risk and uncertainty (Develop risk taking and
uncertainty bearing ability)
• Profit is the base for decision making
• Internal resource for expansion of business (Retained profit for
reinvestment which avoids further borrowings)
• Social Welfare (Maximum Dividend, Timely Payment, Wages &
other benefits, Better quality products and reasonable rates,
contribution in key social development)
Demerits of Profit Maximization
• Corrupt and unfair trade practices
• Cut throat competition
• Element of risk
• Avoidance or compromising ethical trade practices
• Ignores risk factor
• Ignores social obligation
• Survival…?
Wealth Maximization
• It is widely recognized criteria with which the performance of the business enterprise is evaluated
• The word wealth refers to the net present worth of the firm or value of the firm
• Wealth maximization can be achieved by creating difference between capital investment and amount of gross present worth
• Evaluation of business performance
• Wealth maximization = Value Maximization
• This concept is based upon the concept of cash flows (Inflows & Outflows)
• Net Present worth = Capital invested – Amount of gross present worth
• Wealth and value maximization is accepted against profit maximization
• The value of assets is judged not in terms of its cost but in terms of the benefit it produces
• Any financial action which creates wealth, should be accepted as important factor
• Wealth maximization goal is only an extension of profit maximization goal
The goal of wealth maximization is supposed to be superior to the goal of profit maximization due to the following reasons
1) It uses the concept of future expected cash flows rather than the ambiguous term of profit
2) It consider time value of money. It recognizes that the cash flows generated earlier are more valuable than those generated latter
3) Wealth maximization is only an extension of profit maximization goal
4) If the time period is too short and risk element is minimum, both wealth and profit maximization will mean the same thing
5) The value of a firm is represented by the market price of the company’s stock
6) Short term horizon can fulfill objective of earning profit but may not help in creating wealth. That is why wealth creation needs a longer term horizon
7) For creating maximum wealth, various aspects should be dealt with, like increasing sales, capturing more market share etc. which will take care of profitability
8) Profit maximization is traditional approach and wealth maximization is modern approach
Wealth is goodwill, image, social status and sound
health of the organization for which no body is to be
exploited but profit making is concerned with
monetary transactions and pure commercial
consideration
“Without loosing from anybody, wealth can be
acquired but profit making must have selfish
motive.”
Profit is the main source of wealth maximization. One should focus on wealth maximization in the long run rather than earning high profit in the short run and end up with loss in the long run. Profit Maker considers income and expenditure while wealth maker considers inflows and outflows Net present worth/Value = Difference between the present value of cash inflows and cash outflows Gross Present worth/Value = The total present value of all the cash flows
Key Differences between Profit and Wealth Maximization
Profit Wealth
It is the capacity of the firm in producing maximum output with the limited input
It is the ability of a firm to increase the market value of its common stock over time
The process through which the company is capable of increasing its earning capacity
The ability of the firm in increasing the value of its stock in the market
Tempts to take disastrous decision
It takes care the interest of share holders, creditors, employees and society
In the present era, it is regarded as unrealistic, difficult, inappropriate and immoral
It ensures financial discipline in the management
Short term objective Long term objective
Traditional Approach Modern Approach
Ignores risk and uncertainty Considers both
Profit Wealth
Avoids time value of money Recognizes the time value
Necessary for survival and growth Accelerates the growth and market share of the firm
Maximizes the rupee income Maximizes net present value of shares
Difference between income and expenditure
Difference between inflows and outflows
Competition leads to equilibrium price Benefits are measured in terms of cash flows
It is main objective It is just an extension
Profit brings money power Wealth brings happiness
Indications of wealth maximization: Increase market value of shares, regular payment of dividend , right issue at a low premium, bonus after a gap of 3 to 4 years, high market value of shares
Investment Decision
Financing Decision
Dividend Decision
Wealth Maximization
Selection of Assets
Evaluation of Risk
Profit
Long Term Assets
Current Assets
Financial Risk
Hedging Risk
Dividend Refinancing
Capital Budgeting
Working Capital
Sales Dept.
Production
Dept.
Credit to consumer
Inventory Level
High Debt
Foreign
Exchange Fluctuations
Raising Optimal Funds
Fixed & Working Capital
Owners Expectation
Capital
Appreciation
Regular
Income
Source of
Finance
Debt
Equity
Optimum Mix
UNIT: 3
CAPITALIZATION
MEANING
Capitalization means total amount capital
employed in business.
Capitalization of company means the
combination of both owned and borrowed capital.
Capitalization includes shares & debentures.
Capitalization is also called as financial plans.
DEFINITION
According to Gerstenberg-
“ Capitalization as the total accounting value of all the capital employed regularly in the business”.
Thus, the capitalization includes;
1) Ownership capital which includes capital stock & surplus.
2) Borrowed capital which consist of bonds or similar long term debts.
SOURCES OF CAPITALIZATION
Share capital
Debentures
Bonds
Reserves and surplus
Long term loans
Short term loans
BASES OF CAPITALIZATION
After estimating fund requirements for the
enterprise, a financial manager faces the problem of
determining the value at which firm should be
capitalized. Because, firm will have to raise funds
accordingly.
Two important theories have been propounded
which act as guideline in determining the amount of
capitalization;
1. Cost theory of capitalization
2. Earning theory of capitalization
COST THEORY
Capitalization of a firm is determined on the basis of
cost of different assets.
A firm need to acquire fixed assets, meet
promotional & organizational expenses and to meet
current assets requirements of enterprise.
Therefore, sum of the cost requirements of the
above assets gives the amount of capitalization.
EARNING THEORY OF CAPITALIZATION
A firm should be capitalized on the basis of expected earnings of the firm.
Value obtained by multiplying annual net income of a firm by appropriate multiplier would be the real value of the firm. The multiplier would be the capitalization rate.
Capitalization =
Annual net earnings x capitalization rate
OR
NOI
Current Market Value
The Capitalization rate is the rate of return on a
real estate investment properly based on the income
that the property is expected to generate.
Example
Investment Rs. 9,00,000
NOI (profit after operating cost) Rs. 1,25,000
Capitalization Rate = 1,25,000 / 9,00,000
= 0.1389 X 100
=13.89%
For the purpose of determining amount of
capitalization in an enterprise the finance
manager has to first estimate the stream of
annual net income of the enterprise and
capitalization rate.
1. Estimating annual net earnings.
2. Determining the capitalization rate.
ESTIMATING ANNUAL NET EARNINGS
Estimating future returns are difficult task so in the case
of established concern, future earnings can be based on
the past income since past earnings give a partial
evidence of what future earnings will be. Therefore, for
estimating annual net earnings, the period of time will be
selected which represents a normal picture of both the
good and bad year in company’s recent history.
The estimations are then compared with actual figures of
firms engaged in the same industry.
DETERMINING THE CAPITALIZATION RATE
The capitalization rate refers to the rate of return that is
required to attract capital for enterprise.
The rate of capitalization can be best determined by
studying
1. The rate of earnings of similar situated companies in
the same industry .
2. The rate at which market is capitalizing the earnings.
Actual earning price ratio = capitalization rate
TYPES OF CAPITALIZATION
Over-capitalization
Watered Capitalization
Undercapitalization
Net Profit Rs. 50,000
Rate of Return – 10%
Then capitalization should be – 5,00,000 (watered Capital)
If capital is more – over capitalized
If capital is less – under capitalized
OVER-CAPITALIZATION
Over capitalized concern have been found short of
funds due to over expectation.
Over capitalization denotes that the firm is not
earning reasonable income on its funds.
Over capitalization means firm’s inability to earn
reasonable income on its funds or investment.
DEFINITION
According to Bonneville, Dewey and Kelly-
“ When a business is unable to earn a fair rate of return
on its outstanding securities, it is over capitalized”.
According to Gerstenberg-
“ a corporation is overcapitalized when its earnings are
not large enough to yield a fair return on the amount of stock &
bonds that have been issued”.
KEY FACTORS
Over capitalization refers to that state of affairs where earnings of the
corporation do not justify the amount of capital invested in the business.
(Earning doesn’t justify)
Over capitalizes company earns less than what it what it should have
earned at fair rate of return on its total capital. (Earns less than the
capacity)
If the company’s rate of return is less than the average rate of return, it is
indicative of the fact that company is not able to earn fair rate of return on
its capital. i.e. over capitalization. (Indication of not earning fair rate of
return)
When par value of shares of the company is higher than the market
value then company would be in state of over capitalization.
When book value of shares is higher than the real share value then
its is overcapitalized.
Par value – face value of shares.
Market value – price at which shares are quoted in stock exchange.
Book value= capital stock + surplus accounts/ No of shares
outstanding
Real value= capitalized value of company’s assets/outstanding
number of shares.
CAUSES OF OVER CAPITALIZATION
1. Promotion of company with inflated assets (Trade mark, Goodwill,
payment to promoters)
2. Company promoted with high promotion expenses
3. Over estimating earnings at the time of promotion
4. Applying high capitalization rate to capitalize earnings
5. Company formed or expanded during inflationary period.
6. Shortage of capital
7. Defective depreciation policy
8. Liberal dividend policy
9. Raising excessive capital
10. Fall in the value of fixed assets
11. Borrowing at higher rate of interest
CONSEQUENCES OF OVER CAPITALIZATION
To company
- company’s financial stability collapse
- Company loses investors confidence
- Due to poor profitability it can not internally finance its
projects
- Company fails to pay dividend
- Falls market value of shares
- Fails to make regular payments.
- Reputation of company lowers
To share holders-
- Share holder do not get fair rate of return on their
investment
- Repayment of shares become uncertain
- Shares are not actively traded in stock exchange
- Low market value of shares
To customer-
- Increased prices of goods and services
- Reduction in quality goods
To society-
- Problem of unemployment
- Scare resources are poorly employed
REMEDIES OF OVER CAPITALIZATION
1. Reduction in bonded debts
2. Reduction in fixed charges on debt (Interest)
3. Redemption of high dividend preferred stock
4. Reducing par value of shares
5. Reducing number of shares
6. Utilizing idle money
UNDER-CAPITALIZATION
Under -capitalization is used to denote the state of affairs just
converse of over-capitalization.
When company succeeds in earning abnormally large income
consistently for long time, then the symptoms of under-
capitalization gradually develop in the company. (Consistently
high income)
Under-capitalization is indicative of sound financial health and
good management of the company. (Good Management)
Under-capitalization will happen when market value of shares
of the company becomes higher than its book value. (High
market value of shares)
Under Estimation of the capacity
DEFINITION
According to Bonneville and Dewey-
“Under-capitalization is not an economic problem
but a problem in adjusting the capital structure”.
According to Gestenberg-
“A corporation may be under-capitalized when the
rate of profit, it is making on the total capital is
exceptionally high in relation to the return enjoyed by
similarly situated companies in the same industries or
when it has too little capital with which to conduct its
business”.
CAUSES OF UNDER-CAPITALIZATION
1. Under-estimation of initial earnings
2. Using low capitalization rate.
3. Deflationary condition.
4. Conservative dividend policy.
5. Maintaining high standards of efficiency
CONSEQUENCES OF UNDER-CAPITALIZATION
To company-
- Competition increases
- Tax liability of under-capitalized concerns increases in
correspondence with increase in volume of profit (Tax
liability increases)
- Marketability of shares of under-capitalized firm tends
to be narrow because of exceptionally high market price
of these shares. (Low demand & marketability of shares
due to high price)
- Due to high profitability, workers may demand increase
in their wages rate. (Workers may demand higher
wages)
To share- holders
- Under-capitalization is advantageous to share holders.
- Share holder get high rate of dividend.
- Share holders get regular dividend.
To society
- Increase employment.
- Encourages new entrepreneurs to set up new ventures.
- Development of workers and employees with large
amount of profit.
- Effective utilization of natural resources
REMEDIAL MEASURES
Capitalization of surplus of the company
Fresh Issue of shares
Increase in Par value
Issue of Bonus shares-Reduce Dividend Per share and earning per share
Splitting up of shares-Reduce Dividend Per share
FAIR CAPITALIZATION
Liabilities Amount Assets Amount
Share Capital 10,00,000 Fixed Assets 15,00,000
Debentures 5,00,000 Current Assets 10,00,000
Current Liab 10,00,000
Total 25,00,000 Total 25,00,000
Here fixed liabilities and fixed assets are equal. Hence, this firm is fairly
capitalized
OVER CAPITALIZATION
Liabilities Amount Assets Amount
Share Capital 10,00,000 Fixed Assets 12,00,000
Debentures 5,00,000 Current Assets 13,00,000
Current Liab 10,00,000
Total 25,00,000 Total 25,00,000
Here the excess of fixed liabilities over fixed
assets is Rs. 3,00,000. Thus we say that the
firm is over capitalized.
UNDER CAPITALIZATION
Here fixed fixed assets over fixed liabilities is Rs. 1,00,000. Hence, this
firm is under capitalized
Liabilities Amount Assets Amount
Share Capital 10,00,000 Fixed Assets 16,00,000
Debentures 5,00,000 Current Assets 9,00,000
Current Liab 10,00,000
Total 25,00,000 Total 25,00,000
Over Capitalization Under Capitalization
Lower Earnings High earnings
Poor Management Good Management
Over Estimation of Resources Under estimation of resources
Promotion of Company with inflated assets
Promotion of company with deflated assets
Applying high capitalization rate Applying low capitalization rate
Formation during inflationary period Formation during deflationary period
Defective depreciation policy Defective depreciation policy
Liberal dividend policy Conservative dividend policy
Raising excessive capital Raising less capital
Borrowing at high interest rate Borrowing at low interest rate
Fall in the value of fixed assets Increase in the value of fixed assets
Low efficiency High efficiency
UNIT: 4
CAPITAL STRUCTURE
CAPITAL STRUCTURE
Capital means funds employed in business for a period of
twelve months and above
Capital excludes short term funds employed i.e. working
capital
It explains the debt to equity ratio or relationship
The term capital structure simply means the mix of
source from which an organization raises its long term
funds
Capital structure gives us the various components of
capital (Debt & Shares)
PROBLEMS BEFORE FINANCIAL MANAGER
Which sources to be used?
How much to borrow from each source
In planning the capital structure one must consider
following points
• Different capital structures will
be required for different types of
undertakings. So there is no any
standard for debt-equity ratio.
• Government policy regarding
banks
• Taxation laws (Dividend on
preference shares is not
deductible)
• Cost of funds
• Flexibility in raising funds and
also in repayment
• Lesser risk
• Control over capital
• Earning per share
• Legal requirements (Pvt. &
Public Ltd.)
• Availability of funds
• Purpose of finance
• Period of finance
• Investors perceptions
QUALITIES OF OPTIMUM CAPITAL STRUCTURE
Combination of debt and equity that leads to the
maximization of the value of the firm
Minimizes the firms overall cost of capital
Leverage should be used only to the extent the cash flows
are available to service debt.
The debt-equity ratio of a firm must not vary widely from
that of a similar firm in the industry
Flexibility in capital structure should be there so that it can
be tuned with changing economic conditions
Cost of capital should be less than return
Effect on goodwill (Capital should enhance the goodwill)
High level of debt-Greater financial risk-Higher cost of
capital-Depress market price of shares (Capital structure
should not be like this)
FACTORS AFFECTING CAPITAL STRUCTURE
The profitability of the organization
Reliable cash flows (Organizers reliability)
Degree of risk associated with the enterprise
Managers risk aversion attitude (Conservative management prefers more internal
capital)
Tax concessions (IT Industry)
Availability of debt instruments like
Deep discounted bonds (20% or more, market price is less than face value)
Floating rate notes (where the rate of interest is adjusted to the market rate)
Attitude of the promoters towards financial and management control (if this is high,
first preference would be given for debentures and then preference shares and last
preference would be given for public equity where managerial control is likely to be
affected)
Nature of the industry (more competitive-higher equity & less debt, more
monopolistic-less equity & more debt)
Cost of capital (should be less than return)
Trading on equity (industry wise)
Investors attitude, Flexibility, Growth Rate, Marketability etc.
APPROACHES TO CAPITAL STRUCTURE
Net income approach
Net operating income approach
MM approach (Modigliani-Miller)
Traditional approach
NET INCOME APPROACH
According to this approach, the value of the firm and the value
of equity are determined as;
NI approach was presented by Durand. The theory suggests
increasing value of the firm by decreasing the overall cost of
capital which is measured in terms of WACC. This can be done
by having higher proportion of debt by having a higher
proportion of debt which is cheaper source of finance compared
to equity finance.
Value of firm V = S+B OR
V = EBIT / Ko
Where;
S = Market value of equity B = Market value of debt
Ko = Overall cost of capital
Market value of equity = Net income available for equity
holders / Equity capitalization
rate (ke)
Net Income = EBIT – Interest EBIT (earning before interest
and tax)
ASSUMPTIONS
Kd < Ke i.e. cost of debt less than cost of equity
Corporate taxes do not exist
Debt content does not change the risk perception of
the investors
Example: ABC Ltd. On a profit of Rs. 20 Lakhs before providing for interest and tax. The company’s capital structure is as follows;
i. 4 lakh equity shares of Rs. 10 each and its market capitalization
rate is 16%
ii. 25,000 14% secured redeemable debentures of Rs. 150 each
Calculate value of the firm under NI approach. Also calculate overall
cost of capital of the firm
Value of the firm (V) = S + B
Profit before interest and tax 20,00,000
Less debenture interest (14%) 5,25,000
Net income for Equity Holders 14, 75,000
Market Value of Equity = NI / Ke
= 14,75,000 / 0.16 (16/100)
= 92,18,750
Value of the firm (V) = S + B
= 92,18,750 + 37,50,000 (25,000*150)
= 1,29,68,750
Overall cost of capital (Ko) = EBIT / V
= 20,00,000*100/1,29,68,750
= 15.42%
WACC (Weighted Average Cost of Capital) = Kd{B/(B+S)}+Ke{S/(B+S)}
Answer = 15.42%
According to this approach the market value of the firm
depends upon the net operating profit or EBIT and the
overall cost of capital WACC. The financing mix or the
capital structure is irrelevant and does not affect the
value of the firm. Equity capitalization rate decreases
with the decrease in the degree of leverage
By Durand-According to this approach the change in the
capital structure will not lead to any change in the total
value of the firm and the market price of shares as well
as overall cost of capital.
NET OPERATING INCOME APPROACH
Value of the Firm = EBIT / WACC
Value of Equity (S) = V-B (Value of Debt)
Value of the firm = EBIT / Ko
= 5,00,000 / 0.16
= 31,25,000
Value of Equity = V-B
= 31,25,000 – 20,00,000
= 11,25,000
Example: XYZ has earned a profit before interest and tax Rs. 5
Lakhs. The company’s capital structure includes 20,000 14%
debentures of Rs 100 each. Overall capitalization rate of firm is 16%.
Calculate total value of the firm and the equity capitalization rate.
Equity Capitalization Rate (Ke) = EBIT-I / V-B * 100
= 5,00,000-2,80,000 / 31,25,000-20.00,000 * 100
= 2,20,000 / 11,25,000 * 100
= 19.55%
Verification
Ko = Ke(S/V) + Kd(B/V)
Answer = 16%
MM APPROACH
MM has considered tax relief available to a geared
company when the debt component is existing in the
capital structure. The tax burden on the company will
lessen to the extent of relief available on interest payable
on the debt which makes the cost of debt cheaper.
Gearing means the ratio between a company’s stock price
and the price of its debt.
WACC of a geared firm
Kg = (Cost of Equity * % of equity) + (1-T) (cost of debt * % of debt)
Kg = (Cost of Equity * % of equity) + (1-T) (cost of debt * % of debt)
= (24% * 0.33) + (1-0.40) (16% * 0.667)
= 8% + 6.4% = 14.4%
Example: LMN ltd. has the following capital structure.
Equity capital – Rs. 30,00,000
Debt Capital (16%) – Rs. 60,00,000
Corporate tax rate is 40%. The cost of equity is assumed to be 24%.
Calculate WACC of the company.
MM theory assumes that the value of the geared company will always be greater than the ungeared company with similar business risk but only by
the amount of debt associated tax saving of the geared company.
All investors have the same expectation of the firms net operating income.
Business risk is equal among all firms within similar operating
enviornment.
TRADITIONAL OR WACC APPROACH
According to this approach the optimum capital structure
is determined at a point where WACC is minimum and at
this point the value of the firm is minimum and at this
point the value of the firm is maximised.
Ke & Ko will increase with the increase in debt capital
