Module 1

INTRODUCTION TO FINANCIAL MANAGEMENT

Finance management is a managerial activity which is associated with
planning and controlling of company’s financial resources. The financial
resources are always scarce and limited which needs proper planning and
control in order to achieve the best result out of the complex situation of risk
and uncertainly prevailing in the business world.

SCOPE AND FUNCTIONS OF FINANCIAL

MANAGEMENT

CLASSIFICATION OF FUNCTIONS OF FINANCIAL MANAGEMENT

LIQUIDITY PROFITABILITY MANAGEMENT

FORECASTING CASH COST CONTROL PRICING MANAGEMENT OR

FLOWS RAISING FUNDS FORECASTING FUTURE LONG TERM FUNDS
MANAGING THE FLOW PROFITS MEASURING MANAGEMENT OF
OF INTERNAL FUNDS THE COST OF CAPITAL SHORT TERM FUNDS

Financial management refers to the:

(a) To participate in the process of putting funds to work within the
business and to control their productivity : and
(b) To identify the need for funds and select the sources from which
they may be obtained.
The functions of financial management may be classified on the basis
of:
1. Liquidity of funds
2. Profitability of investments
3. Management of Assets
1. Liquidity:-Liquidity is ascertained on the basis of three important
considerations
(i) Forecasting cash flows ie matching the cash inflows against the
cash outflows
(ii) Raising funds ie financial managers will have to ascertain the
sources from which funds may be raised
(iii) Managing the flow of internal funds ie keeping its accounts
with a number of banks to ensure a high degree of liquidity
with minimum external borrowing.
2. Profitability:-the following factors are to be considered
(i) Cost control-Expenditure in the different operational areas of
an enterprise can be analysed with the help of an appropriate
cost accounting system to enable the financial manager to bring
costs under control.
(ii) Pricing-Pricing is of great significance in the company’s
marketing effort, image and sales level.
(iii) Forecasting Future Profits-Expected profits are determined and
evaluated.
(iv) Measuring the cost of Capital-Each source of funds has a
different cost of capital which must be measured because the
cost of capital is linked with the profitability of an enterprise.
3. Management:- *The management of long-term funds, which is
associated with the plans for development and expansion and
which involves land, buildings, machinery, equipment, transport
facilities, research projects and so on.
*The management of short-term funds, which is associated with the
overall cycle of activities of an enterprise. These are the need which
may be described as working capital needs.
Financial management, in the modern sense of
the term is concentrated on the three major decisions-
(a) Investment decision ie to decide whether to invest the funds in a
particular asset or not
(b) Financial decision ie to decide about the capital structure of the
firm and the various sources of collecting funds
(c) Dividend decision

DEFINE THE TERM FINANCIAL MANAGEMENT

* According to Weston and Brigham, “Financial management is an
area of financial decision making, harmonising individual motives and
enterprise goals.”
* According to Howard and Upton, “Financial management is the
application of the planning and control functions to the finance
function.”

NATURE/CHARACTERISTICS OF FINANCIAL MANAGEMENT

(i) Financial Management is a branch of Business Management.
 (ii) Essence of Managerial Decision
(iii)Important position in the Organizational Structure
(v) Financial Management is a scientific and analytical analysis
(vi) Continuous Administrative Function
(vii) Centralised Nature
(viii) Basis of Managerial process
(ix) A Measure of Performance
(x) Forecasts of Cash Requirement
(xi) Borrowing policy

FUNCTIONS OF FINANCIAL MANAGEMENT

1. Financial Forecasting
2. Investment Policy Decisions or Establishing Asset-Management
Policies The investment policy of fixed and current assets are
popularly known as ‘Asset-management policy’.
3. Dividend Policy Decision or Allocation of net Profit-> After
paying all taxes, the available net profits of the concern can be
allocated for three purposes-
(a) For paying dividends to the shareholders of the company as a
return upon this investment
(b) For distributing bonus to the employees and company’s
contribution to other profit sharing plans
(c) Retention of profits for the expansion of business
4. Cash Flows and Requirements
5. Deciding upon Borrowing Policy
6. Negotiations for New Outside Financing
7. Supervision of cash receipts and disbursements and safeguarding
of cash balance
8. Proper custody and safeguarding of important and valuable papers,
securities and insurance policies
9. Taking care of all mechanical details of financing
10. Record-keeping and reporting
11. Cash planning and credit management

Note: Functions can also be classified as recurring and non-

recurring in nature (refer ppt archived)

IMPORTANCE OF FINANCIAL MANAGEMENT

The following are the points to highlight the importance of finance:
(i) Finance for business promotion
(ii) Finance management for optimum use of firm
(iii) Use for co-operation in business activities
(iv) Useful in decision making
(v) Determinant of business success
(vi) Measurement of performance
(vii) Basis of planning, co-ordination and control
 (viii) Useful to shareholders and investors
This can be summed up as
1. It provides an easy approach to capital budgeting
2. It provides an easy emphasis the composition of a firm’s assets
3. It is useful for implementation of its investment decisions
4. It is useful to increase business profits
5. It is useful to control costs
6. It is useful for minimizing risks
7. It has long period values-profit maximization
8. Wealth maximization-The wealth of the owner of a company is
maximized by raising the price of a common stock.

A’s OF FINANCIAL MANAGEMENT

The following are the A’s of financial management:
(a) Anticipating Financial needs
(b) Acquiring Financial Resources\
(c) Allocation of Resources for Investment

OBJECTIVES OF FINANCIAL MANAGEMENT

The financial management of a firm has to make three important decisions
namely
1. Investment decision ie where to invest funds and in what
amount?
2. Financing decision ie where to raise funds and in what
amount?
3. Dividend ie how much to pay in dividend and how much to
retain?
There are two widely discussed approaches or criterion or goals of
maximizing owners’ welfare:
(i) Profit maximization
(ii) Wealth maximization
(iii) Value maximisation (To maximize the CV of company’s stock)
(iv) To Maximize Market share
(v) To maximize EPS
(vi) To minimize costs
(i) Goal of Profit Maximization
Arguments in favour of profit maximization
(a) Profit is the test of Economic Efficiency
(b) Efficient allocation of fund
(c) Social welfare
(d) Internal resources for expansion
(e) Reduction in risk and uncertainty
(f) More competitive
(g) Desire for controls
 (h) Basis of decision making
(ii) Goal of Wealth Maximization
The Wealth maximization also known as Value maximization or Net
Present Worth Maximization. The value of assets should be viewed in
terms of benefits it can produce. If inflows are greater than total outflows,
it will be a good decision and other alternatives may be rejected as
because it maximizes the wealth to the owners.
Note: Explain other objectives at least in a paragraph

PROFIT MAXIMIZATION Vs WEALTH MAXIMIZATION

Certain objectives have been raised against the goal of profit

maximization which strengthen the case for wealth maximization as the
goal of business enterprise. The objections against profit maximization:
1. Profit cannot be ascertained well in advance
2. The executive or the decision maker may not have enough confidence
in the estimates of future returns
3. There must be a balance between expected return and risk
4. The goal of maximization of profits is considered to be a narrow
outlook
5. The criterion of profit maximization ignores time value factor

RESPONSIBILITIES OF FINANCIAL MANAGEMENT/FINANCIAL

MANAGER
The main responsibilities of the financial management or financial
manager are as follows:
1. Financial planning
2. Raising of necessary funds
3. Controlling the use of funds
4. Disposition of profits
5. Other responsibilities
(a) Responsibilities to owners
(b) Legal obligations
(c) Responsibilities to Employees
(d) Responsibilities to Customers
(e)Wealth maximization
FUNCTIONAL AREAS OF FINANCIAL MANAGEMENT
Determining financial needs

Determining source of funds

Financial analysis

Optimal capital structure

Cost volume profit analysis

Profit planning and control

Functional
Areas of
Financial Fixed assets management
Management
Project planning and Evaluation

Capital budgeting

Working capital management

Dividend policies

Acquisitions and Mergers

Corporate taxation
RISK-RETURN TRADE-OFF
Risk and expected return move in tandem; the greater the risk, the greater
the expected return. The following figure shows the risk-return
relationship.

Expected
Return Risk premium

Risk-free Return

Risk
Return = Risk-free rate + Risk premium
 Risk-free rate is a rate obtainable from a default-risk free
government security.
 An investor assuming risk from her investment requires a risk
premium above the risk-free rate.
 A proper balance between return and risk should be maintained to
maximize the market value of a firm’s shares. Such balance is
called risk-return trade-off, and every financial decision involves
this trade-off.
 The interrelation between market value, financial decisions and
risk-return trade-off is depicted in the figure shown below. It
also gives an overview of the functions of financial management.
 Financial Management

Maximization of share value

Financial Decisions

Investment Liquidity Financing Dividend

decisions Management decisions decisions

Return Trade-off Risk

Note: Also include a few details of ROI, IRR, risk free rate and expected
return

TIME VALUE OF MONEY

Time value of money concept is based on the fact that a rupee received
today is more valuable than a rupee tomorrow.
A rational individual value the opportunity to receive money is now
higher than a receipt in future. This phenomenon is technically known
as time preference for money or time value of money.
An individual time preference for money is due to the following
reasons:
 Risk and uncertainty
 Investment opportunities
 Preference for consumption (explanation required)
The above statements relates to two different concepts:
1. Compound value concept
2. Present value concept

COMPOUND VALUE CONCEPT

 n
FV= P(1+r)
Compound value of an annuity
An annuity is a fixed cash flow each year over a specified number of
years

n
(1 + r) -1

FV= P i

Present Value or Discounting concept

FV
PV = n
( 1+i )

Present value of annuity/series of cash flow

A A A
PV = + +…………………+
1 2 n
( 1+i ) (1+i ) (1+i )
 Module 2
CAPITAL BUDGETING/ INVESTMENT DECISIONS AND
COST OF CAPITAL
Capital budgeting is selection of an asset or an investment proposal .How much to
invest in a long term asset is the core of capital budgeting decision. Benefits are likely
to be available in future. Assets can be either new or old /existing.
Factors: Cash flows of the project, cost of capital, investment criteria involved
In short (importance) ……capital budgeting decisions includes:
 Long term assets and their composition
 Long term growth and effects
 Large amount of funds involved
 Business risk of the firm
 Concept and measurement of cost of capital
 Irreversible decision

Techniques of capital budgeting

A. Traditional, Non time adjusted or Non -discounted
methods
(i) Accounting or Average Rate of Return method( ARR)

= (Annual average cash inflow after depreciation and tax ÷ Average

Investment)*100
Here
Depreciation = (Original cost-Salvage Value) ÷ Useful life
Average Investment=1/2(Original cost-salvage value) - salvage value+ working
capital

(ii) Simple Pay Back Period

In case of equal cash inflow

= Cash outflow÷ Annual cash inflow after tax before depreciation

In case of unequal cash inflow

= Year up to which cumulative cash inflow is less than cash outflow+
( Total cash outflow- cumulative cash inflow of the above year)
Cash inflow of next year mentioned earlier

B. Modern, Time adjusted or Discounted method

(j) Discounted Pay Back period

=Year up to which cumulative PV of cash inflow is less than cash outflow+

( Total cash outflow- cumulative PV of cash inflow of the above year)
PV of Cash inflow of next year mentioned earlier
 (ii)Net Present Value

= PV of cash inflow-PV of cash outflow

Note: As out flow is already in PV no need to calculate PV

(iii) Internal Rate of Return (IRR)

=Lower Discount Rate + NPV at lower rate

(NPV at lower rate –NPV at higher rate)*(higher rate –lower
rate)

FEATURES OF CAPITAL BUDGETING

1) It involves high risk
2) Large profits are estimated
3) Long time period between the initial investments and estimated returns
CAPITAL BUDGETING PROCESS:
A) Project identification and generation:
B) Project Screening and Evaluation:
C) Project Selection:
D) Implementation:
E) Performance review:
FACTORS AFFECTING CAPITAL BUDGETING:
 Availability of Funds
 Working Capital
 Structure of Capital
 Capital Return
 Management decisions
 Need of the project
 Accounting methods
 Government policy
 Taxation policy
 Earnings
 Lending terms of financial institutions
 Economic value of the project

CAPITAL BUDGETING DECISIONS:

The crux of capital budgeting is profit maximization.
There are two ways to it; either increase the revenues or reduce the costs.
The increase in revenues can be achieved by expansion of operations by
adding a new product line. Reducing costs means representing obsolete
return on assets.

Accept / Reject decision –Generally, proposals that yield a rate of return

greater than a certain required rate of return or cost of capital are accepted
 and the others are rejected. All independent projects are accepted.
Independent projects are projects that do not compete with one another in
such a way that acceptance give a fair possibility of acceptance of another.
Mutually exclusive project decision –Only one may be chosen. The
acceptance of the best alternative eliminates the other alternatives.
Capital rationing decision – In a situation where the firm has unlimited
funds, capital budgeting becomes a very simple process.
In that, independent investment proposals yielding a return greater than
some predetermined level are accepted. But actual business has a different
picture. They have fixed capital budget with large number of investment
proposals competing for it.
Capital rationing refers to the situation where the firm has more acceptable
investments requiring a greater amount of finance than that is available with
the firm.
Ranking of the investment project is employed on the basis of some
predetermined criterion such as the rate of return.
The project with highest return is ranked first and the acceptable projects
are ranked thereafter.

Cost of Capital

 In economics and accounting, the cost of capital is the cost of a

company's funds (both debt and equity), or, from an investor's point of
view "the required rate of return on a portfolio company's existing
securities".
 It is used to evaluate new projects of a company. It is the minimum
return that investors expect for providing capital to the company, thus
setting a benchmark that a new project has to meet its expenditures.
 Many companies use a combination of debt and equity to finance their
businesses and, for such companies, the overall cost of capital is derived
from a weighted average of all capital sources, widely known as the
weighted average cost of capital (WACC).

Components of cost of capital

 Cost of debt
When companies borrow funds from outside lenders, the interest paid on these
funds is called the cost of debt.
The cost of debt is computed by taking the rate on a risk-free bond whose
duration matches the term structure of the corporate debt, then adding a default
premium. The formula can be written as
K D = ( R f + credit risk rate ) ( 1 − T )
 The cost of equity is inferred by comparing the investment to other
investments (comparable) with similar risk profiles. It is commonly
computed using the capital asset pricing model formula:
Cost of equity = Risk free rate of return + Premium expected for risk
Cost of equity = Risk free rate of return + Beta × (market rate of return – risk
free rate of return)
Beta = sensitivity to movements in the relevant market. Thus in symbols we
have
Es=Rf+βs(Rm−Rf)

Es is the expected return for a security;

Rf is the expected risk-free return in that market (government bond yield);
βs is the sensitivity to market risk for the security;
Rm is the historical return of the stock market; and
(Rm – Rf) is the risk premium of market assets over risk free assets.
 The sensitivity to market risk (β) is unique for each firm and depends on
everything from management to its business and capital structure.
 Cost of retained earnings/cost of internal equity
Cost of internal equity = [(next year's dividend per share/(current market price
per share - flotation costs)] + growth rate of dividends)]
 Weighted average cost of capital
The weighted cost of capital (WACC) is used in finance to measure a firm's
cost of capital.
The total capital for a firm is the value of its equity plus the cost of its debt.
Notice that the "equity" in the debt to equity ratio is the market value of all
equity, not the shareholders' equity on the balance sheet.
To calculate the firm's weighted cost of capital, we must first calculate the costs
of the individual financing sources: Cost of Debt, Cost of Preference Capital,
and
 1.Cost of Debt
Debt may be issued at par, at premium or discount. It may be perpetual or
redeemable.
(a) Debt issued at par: The computation of cost of debt issued at par is
comparatively an easy task.
Kd = (l-T)R
Where,

Kd = Cost of debt;
T = Marginal tax rate;
R = Debenture interest rate.
The tax is deducted out of the interest payable, because interest is treated as an
expense while computing the firm’s income for tax purposes.
(b) Debt issued at premium or discount: In case the debentures are issued
at premium or discount, the cost of debt should be calculated on the
basis of net proceeds realized on account of issue of such debentures or
bonds.
Kd= I(1-T)/NP
 2. Cost of Preference Capital
The accumulation of arrears of preference dividends may adversely affect the
right of equity shareholders to receive dividends. This is because no dividend
can be paid to them unless the arrears of preference dividend are cleared.
On account of these reasons the cost of preference capital is also computed on
the same basis as that of debentures.
Kp=Dp/Np
Where,
Kp = Cost of preference share capital
Dp = Fixed preference dividend
Np = Net proceeds of preference shares.
 3.Cost of Equity Capital
The market price of the equity shares, therefore, depends upon the return
expected by the shareholders.
Conceptually cost of equity share capital may be defined as the minimum rate
of return that a firm must earn on the equity financed portion of an investment
in a project in order to leave unchanged the market price of such shares.
a) Dividend price (D/P) approach)
According to this approach, the investor arrives at the market price of an equity
shares by capitalizing the set of expected dividend payments.
In other words, the cost of equity capital will be that rate of expected dividends
which will maintain the present market price of equity shares.
Ke =D/NP
Where,
Ke= Cost of equity capital;
D= Dividend per equity share;
NP = Net proceeds of an equity share.
(b) Dividend price plus growth (D/P + g) approach
According to this approach, the cost of equity capital is determined on the basis
on the expected dividend rate plus the rate of growth in dividend.
The rate of growth in dividend is determined on the basis of the amount of
dividends paid by the company for the last few years.
Ke = (D/NP) + g
Where,
Ke = Cost of equity capital;
D= Expected dividend per share;
NP = Net proceeds of per share;
g= Growth in expected dividend.
(c) Earning price (E/P) approach
According to this approach, it is the earning per share which determines the
market price of the shares. This is based on the assumption that the
shareholders capitalize a stream of future earnings (as distinguished from
dividends) in order to evaluate their share holdings.
Ke =E/NP
Where
Ke= Cost of equity capital;
D= Earnings per share;
NP = Net proceeds of an equity share.
(d) Realized Yield Approach
According to this approach, the cost of equity capital should be determined on
the basis of the returns actually realized by the investors in a company on their
equity shares.
According to this approach the past records in a given period regarding
dividends and the actual capital appreciation in the value of the equity shares
held by the shareholders should be taken to compute the cost of equity capital.
 MODULE 3

CAPITALSTRUCTURE DECISIONS AND

LEVERAGE ANALYSIS

 The proportion of debt, preference and equity shares on a firm’s balance

sheet.
 A decision about the proportion among the above type of securities.
 Concerned with the qualitative aspect of financial planning.
 Composition of long-term sources of fund

“Capital structure of a company refers to the composition or make-up of its

capitalisation and it includes all long-term capital resources viz: loans, reserves,
shares and bonds.”
Financial structure refers to all the financial resources marshalled by the firm,
short as well as long-term, and all forms of debt as well as equity.
It means the entire liabilities side of the balance sheet.

Patterns of capital structure

Equity Shares only

Equity and Preference Shares
Equity and Preference shares and debt (debentures, long term borrowings)

FEATURES
 Profitability/return
 Solvency/risk
 Flexibility
 Conservation/capacity
 Control

FACTORS AFFECTING/ DETERMINING CAPITALSTRUCTURE

(PRINCIPLES)
 Cost Principle
 Risk Principle
 Control Principle
 Flexibility Principle
 Timing Principle
FACTORS

 Tax benefit of debt

 Flexibility
 Control
 Industry leverage ratios
  Seasonal variation
 Degree competition
 Industry life cycle
 Agency costs
 Company characteristics
 Timing of public issue
 Requirements of investors
 Period of finance
 Purpose of finance
 Legal requirements

OPTIMUM CAPITAL STRUCTURE

Combination of debt and equity that leads to maximum value of firm.

The capital structure at which the weighted average cost of capital is minimum
and thereby maximum value of the firm.
Capital Structure Theories (Any questions concerning optimum capital
structure)
A viewpoint that strongly support the close relationship between leverage and
value of firm (Relevance theory).
An equally strong body of opinion which believes that leverage has no impact
on value of firm (Irrelevance theory).

SYMBOLS

S = Total market value of equity

D = Total market value of debt
I = Total interest payments
V = Total market value of a firm (V=S+D)
NI = Net income available to equity shareholders

Cost of debt (Kd) = I/D

Value of debt = I/ Kd
Cost of equity (Ke) = (D1/P0) + g
D1= Net dividend
Po = Current market price per share
g = growth rate

1. NET INCOME(NI) APPROACH(RELEVANCE THEORY)

 Suggested by Durand
 CSD is relevant to the value of the firm.
 Debt-equity mix is relevant in deciding value of the firm. Any change in
debt- equity proportion of the firm will leads to (dependent) change in
cost of capital and thus changing value of the firm
  If debt/leverage is increased it will increase value of the firm and
decrease cost of capital. This is due to the advantage of debt as a
cheaper source of finance compared to equity.
 A change in FL will lead to corresponding change in Ko as well as V.
 If the the D/E ratio is increased, the Ko will decline and V will increase.
Conversely, a decrease in leverage will cause increase in Ko and
decrase in V and market price per share.

Assumptions
 There are no taxes
 The cost of debt is less than the equity capitalisation rate or cost of
equity.
 The use of debt does not change the risk perception of investors

2. NET OPERATING INCOME(NOI)

APPROACH( IRRELEVNACE THEORY)
 Suggested by Durand
 Diametrically opposite to the NI approach
 CSD is irrelevant
 Debt-equity mix is irrelevant in deciding value of the firm. Any change
in debt- equity proportion of the firm will not leads to (independent)
change in cost of capital and thus not changing value of the firm.
Refer ppt. archived for graph
 If debt/leverage is increased it will not affect value of the firm and cost
of capital. This is due to the fact that what all advantage associated with
debt as a cheaper source of finance is neutralized or balanced by way of
high dividend demand from equity shareholders.
 Equity holders demand high dividend as they perceive use of debt will
increase their risk. Thus all advantage of debt as a cheaper source will
not effect on cost of capital and value of the firm advantage of debt as a
cheaper source of finance compared to equity.
 The value of the firm, the market price per share and overall cost of
capital is independent of the degree of leverage.
Overall cost of capital (Ko) is constant for all degrees of leverage.
V = EBIT/Ko
Residual value of equity
S=V–D
Cost of equity capital (Ke) increases with the degree of leverage
Ke = Ko + (Ko – Kd) D/S

Assumptions
 Constant kd
 Constant ko
 No split
 Neutralization principle
  No taxes

3. MODIGLIANI –MILLER (MM) APPROACH (IRRELEVANT)

 It supports the NOI approach relating to the independence of cost of

capital of the degree of leverage at any level of debt-equity ratio.
 It provides behavioural justification for constant Ko and V
Refer ppt. archived for graph
 Cost of capital=rate of equity + premium for financial risk
 Switching option
 Value of the firm = NOI/KO

Assumptions
 Perfect capital markets ( free, borrowing power, rational, no transaction
costs, well informed)
 Same expectations
 Homogeneous risk class
 100% dividend payout
 No taxes (removed later)

4. TRADITIONAL APPROACH
 NI approach and NOI approach represent two extremes as regards CS, V and
Ko. The assumptions of MM approach are doubtful of validity.
 Traditional approach is mid-way between the NI and NOI approach
(Intermediate approach).
 The crux of traditional view is that through judicious use of debt-equity
proportions, a firm can increase its V and thereby reduce Ko.
The use of debt having cheaper cost of capital will obviously cause decline in
Ko to a certain extent.
Refer graph

 If the D/E ratio is raised further, the firm would become financially
more risky to the investors who would penalise the firm by demanding a
higher Ke, neutralising the benefit of using cheaper debt.

LEVERAGE ANALYSIS

 Use of source of funds bearing fixed financial payments like debt in the
capital structure. It is the firm’s ability to use fixed cost assets or
sources of funds to magnify the returns to its owners.
 It is the employment of an asset or sources of funds for which the firm
has to pay a fixed cost or fixed return”
Types of leverage
 1. Operating leverage
2. Financial leverage
3. Combined leverage
1. Operating Leverage: Measure of business risk. It is the firm’s ability to
use operating costs
Purpose – magnify the effect of changes in sales on its earnings before
interest and taxes
Operating cost are three types:
Fixed cost
Variable cost
Semi-variable cost
High degree of operating leverage indicates high degree of risk
Operating risk(business risk)-firm is not being able to cover its fixed operating
costs
Particulars
Less: variable cost (units produced *cost per unit)
Contribution
Less :Fixed cost
Earnings before interest and taxes(EBIT)
Less: Interest
Earning Before tax(EBT)
Less: Tax
Earning After Tax (EAT)
Less: Preference Dividend
Earnings available to equity share holders (EAES)
Degree of operating leverage –”Change in the percentage of operating
income(EBIT), for change in percentage of sales revenue”

Degree of Operating Leverage

=% change in EBIT/% change in sales
OR
Contribution/Operating Profit (EBIT)
 Application:
It is helpful to know how operating profit (EBIT) would change with a given
change in units produced
It will be helpful in measuring business risk
2. Financial Leverage
Long- terms funds for long-term activities like expansion, diversification,
modernization
Long term source- equity and debt
 The use of fixed charges, sources of funds such as debt and preference
share capital along with the equity share capital in capital structure is
described as financial leverage.
Financial leverage =EBIT or operating profit/EBT or taxable income

Degree of financial leverage (DFL)=

% Change in EPS/% Change in EBIT

Application: How EPS would change with a change in operating profit(EBIT)

It will helpful for measuring the financial leverage

3. Combined Leverage:
 The degree of combined leverage may be defined as the percentage
change in EPS due to the percentage change in sales
= % change in EPS /% change in sales
OR
Contribution/EBT
 MODULE 4
DIVIDEND DECISIONS

The term dividend refers to that profit of a company which is distributed by 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 on the other hand, a company needs to provide funds to finance
its long-term growth.
Dividend policy of a firm, thus affects both long-term financing and wealth of
shareholders.
Concept and Significance
The dividend decision is one of the three basic decisions which a financial
manager may be required to take, the other two being the investment decisions
and the financing decisions.
The retained earnings can then be invested in assets which will help the firm to
increase or at least maintain its present rate of growth.
 In dividend decision, a financial manager is concerned to decide one or
more of the following:
- Should the profits be ploughed back to finance the
investment decisions?
- Whether any dividend be paid? If yes, how much dividend be
paid?
- When these dividend be paid? Interim or final.
- In what form the dividend be paid? Cash dividend or Bonus
shares.

 Dividend Decision and Valuation of Firms

The value of the firm can be maximized if the shareholders wealth is
maximized. There are conflicting views regarding the impact of dividend
decision on valuation of the firm.
One of the views suggests dividend decision does not affect shareholders
wealth and hence the valuation of firm.
According to another viewpoint dividend decision materially affects the
shareholders wealth and also valuation of the firm.

 The views are divided under two groups:

1. The Relevance Concept of Dividend a Theory of Relevance.
2. The Irrelevance Concept of Dividend or Theory of Irrelevance.

1.
The Relevance Concept of Dividend
  The advocates of this school of thought include Myron Gordon, James
Walter.
 According to them dividends communicate information to the investors
about the firm’s profitability and hence dividend decision becomes
relevant.
 Those firms which pay higher dividends will have greater value as
compared to those which do not pay dividends or have a lower dividend
payout ratio.
 It holds that dividend decisions affect value of the firm.

Theories are named after (A) Walter’s Approach and (B) Gordon’s Approach.

A. Walter’s Approach:
B. According to Prof. Walter, If r>k (rate of return greater than cost of capital)
i.e. if the firm earns a higher rate of return on its investment than the required
rate of return, the firm should retain the earnings.
C. Such firms are termed as growth firm’s and the optimum pay-out would be
zero which would maximize value of shares.
D. In case of declining firms which do not have profitable investments i.e. where
r<k, the shareholder would stand to gain if the firm distributes it earnings.
E. For such firms, the optimum payout would be 100% and the firms should
distribute the entire earnings as dividend.
In case of normal firms where r=k the dividend policy will not affect the
market value of shares as the shareholders will get the same return from the
firm as expected by them. For such firms, there is no optimum dividend payout
and value of firm would not change with the change in dividend rate.

Assumptions

(i) The firm has a very long life.

(ii) Earnings and dividends do not change while determining the value.
(iii)The Internal rate of return( r ) and the cost of capital (k) of the firm are
constant.
(iv)The investments of the firm are financed through retained earnings only and
the firm does not use external sources of funds.
 EQUATION??????

Criticism

(i) The basic assumption that investments are financed through

retained earnings only is seldom true in real world. Firms do raise fund by
external financing.
(ii) The internal rate of return i.e. r also does not remain constant. As a
matter of fact, with increased investment the rate of return also changes.
 (iii) The assumption that cost of capital (k) will remain constant also
does not hold good. As a firm’s risk pattern does not remain constant, it is not
proper to assume that (k) will always remain constant.

B.Gordon’s Approach :

This model which opinions that dividend policy of a firm affects its value is based on
following assumptions:-
 The firm is an all equity firm. No external financing is used and
investment programmes are financed exclusively by retained earnings.
 r and ke are constant.
 The firm has perpetual life.
 The retention ratio, once decided upon, is constant. Thus, the growth
rate, (g=br) is also constant.
 ke >br

Equation ?????
Gordon argues that the investors do have a preference for current dividends and
there is a direct relationship between the dividend policy and the market value
of share.
Investors are certain of receiving incomes from dividend than from future
capital gains.
In other words, an investor values current dividends more highly than an
expected future capital gain.
Hence, the “bird-in-hand” argument of this model suggests that
dividend policy is relevant, as investors prefer current dividends as against the
future uncertain capital gains.
Symbolically: -

where P = Market price of equity share

E = Earnings per share of firm.
b = Retention Ratio (1 – payout ratio)
r = Rate of Return on Investment of the firm.
Ke = Cost of equity share capital.
br = g i.e. growth rate of firm.

3. The Irrelevance Concept of Dividend(MM Approach)

1. Modigliani and Miller Approach (MM Model)

Modigliani and Miller have expressed in the most comprehensive manner in
support of theory of irrelevance.
They maintain that dividend policy has no effect on market prices of shares
and the value of firm is determined by earning capacity of the firm or its
investment policy.
As observed by M.M, “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 shares”.
Even, the splitting of earnings between retentions and dividends does not affect
value of firm.

 Assumptions of MM Hypothesis
(1) There are perfect capital markets.
(2) Investors behave rationally.
(3) Information about company is available to all without any cost.
(4) There are no floatation and transaction costs.
(5) The firm has a rigid investment policy.
(6) No investor is large enough to effect the market price of shares.
(7) There are either no taxes or there are no differences in tax rates applicable
to dividends and capital gains.
The Argument of MM
The argument given by MM in support of their hypothesis is that whatever
increase in value of the firm results from payment of dividend, will be exactly
off set by achieve in market price of shares because of external financing and
there will be no change in total wealth of the shareholders. For example, if a
company, having investment opportunities distributes all its earnings among the
shareholders, it will have to raise additional funds from external sources. This
will result in increase in number of shares or payment of interest charges,
resulting in fall in earnings per share in future. Thus whatever a shareholder
gains on account of dividend payment is neutralized completely by the fall in
the market price of shares due to decline in expected future earnings per share.
To be more specific, the market price of share in beginning of period is equal to
present value of dividends paid at end of period plus the market price of shares
at end of period plus the market price of shares at end of the period. This can be
put in form of following formula:-
P0 = D1 + P1
1 + Ke
where
PO = Market price per share at beginning of period.
D1 = Dividend to be received at end of period.
P1 = Market price per share at end of period.
Ke = Cost of equity capital.
The value of P1 can be derived by above equation as under.

The MM Hypothesis can be explained in another form also presuming that

investment required by the firm on account of payment of dividends is financed
out of the new issue of equity shares.
Equation ?????

Criticism of MM Approach
MM Hypothesis has been criticized on account of various unrealistic
assumptions as given below.
1. Perfect capital markets does not exist in reality.
2. Information about company is not available to all persons.
3. The firms have to incur floatation costs which issuing securities.
4. Taxes do exit and there is normally different tax treatment for dividends
and capital gains.
5. The firms do not follow rigid investment policy.
6. The investors have to pay brokerage, fees etc. which doing any
transaction.
7. Shareholders may prefer current income as compared to further gains.
Lets Sum Up
· Dividend decision is an important decision, which a financial manager
has to take. It refers to that profits of a company which is distributed by
company among its shareholders.
· There has been a difference of opinion on the effect of dividend policy
on value of firm. Two schools of thought have emerged on relationship between
dividend policy and value of firm.
· On one hand Walter model and Gordon model consider dividend as
relevant for value of firm as investors prefer current dividend over future
dividend.
· On other hand Residuals Approach and MM Model consider dividend is
irrelevant for value of firm. The detention of profit for re-investment is
important. MM Model have introduced arbitrage process to prove that value of
firm remain same whether firm pays dividend or not.
 MODULE 5
WORKING CAPITAL DECISIONS

 Funds invested for short period

 Short term capital or circulating capital
 Decisions relating to working capital and short term financing are referred to as
working capital management Decisions
 Management of Working capital =Management of CA &CL.
 Current assets<Current liability=Working capital deficiency/ working capital
deficit.
 Working capital management = Cash flow to satisfy both maturing short-term
debt and upcoming operational expenses.

Purpose of working capital

To hold……..
 Stock of raw material
 Stock of WIP
 Stock of finished goods
 Grant credit/holding debtors
 Cash balances
Need of working capital
To Finance operating cycle……….
 Time between supply of raw material…………….…………………………
collection of cash
 Cash----------finished goods
 Finished goods-----------receivables
 Receivables --------------cash
Operating cycle of a trading firm
 Conversion of cash into inventory
 Conversion of inventory into Receivables
 Conversion of receivables into cash
 It is defined as “The continuing flow from cash to suppliers, to inventory to
accounts receivable & back into cash “.
 Gross operating cycle=R+W+F+D
 Net operating cycle=R+W+F+D-C
Concepts of Working Capital
 Gross working capital
Total Current assets
Current assets =Converted into cash within an accounting year & include cash,
debtors etc.
Referred as “Economics Concept” since assets are employed for a rate of return
CA= SHORT LIFESPAN (cash balance), SWIFT TRANSFORMATION INTO
OTHER ASSETS
 Net working capital
 NWC=CA – CL
Referred as the ‘point of view of an Accountant’.
It indicates liquidity position of a firm
It can be Positive or negative
NWC=GWC-CURRENT LIABILITIES

Constituents of working capital

 CURRENT ASSETS
Inventory
Sundry Debtors
Cash and Bank Balances
Loans and advances
 CURRENT LIABILITIES
Sundry creditors
Short term loans
Provisions
Types of working capital

Permanent working capital

Variable /temporary working capital

 Minimum level of investment in current assets that is required to continue the

business without interruption ---Permanent /hardcore working capital

 Investment required over and above the minimum WC to meet seasonal

fluctuations in business activity or other temporary requirements---
Temporary /seasonal working capital

Approaches to working capital or current asset financing

Excessive investment in current assets: Low profitability, high liquidity
Inadequate investment in current assets: High profitability, low liquidity
Based on:
How much to invest?
How to finance? LTF, STF
1. Aggressive approach:
Temporary current assets-short term source of fund
Portion of permanent current assets-short term source of fund
Portion of permanent current assets- long term source of fund
2. Conservative approach
All permanent current assets-long term sources of funds
Portion of temporary current assets-long term source
Portion of temporary current assets-short term source
3. Matching/ hedging approach
Permanent current assets-long term source of funds
Temporary current assets- short term source
  FACTORS DETERMINING WORKING CAPITAL
Nature of business Price level changes
Size of business Operating efficiency
Manufacturing cycle Profit margin
Business cycle Taxation policy
Production policy Depreciation policy
Credit policy Dividend policy
*essay
Availability of credit Inventory policy question-
Growth and expansion activities Conditions of supply details required
Market conditions

 SHORT TERM / WORKING CAPITAL SOURCE OF

FINANCING

Trade credit Working capital demand loan

Advances from customers Factoring
Discounting bills of exchange Commercial paper
Bank overdraft Cash credit
Bills finance Letter of credit
*DETAILS required an important essay question

COMPONENTS OF CURRENT ASSETS

 1. INVENTORY MANAGEMENT
Objectives:
 Avoid situation of excessive and inadequate inventory
 Determine and maintain optimum inventory
 Transaction motive:
Smooth production and sales
 Precautionary motive:
To meet contingencies
 Speculative motive:
Profitable opportunities

 2. CASH MANAGEMENT (same motives as inventory)

1. Transaction motive –holding cash to meet routine expenses.

2. Precautionary motive – holding cash for meeting unforeseen contingencies.
3. Speculative motive – to take advantage of profitable opportunities.
4. Compensative motive – cash balances are kept with bank for providing certain
services and loans.

Objectives
  To meet cash disbursement needs.
 To minimize funds committed to cash balances.
 These are mutually contradictory and the task of cash management is to
reconcile them.
 Hence the crucial problem of cash management is to solve the liquidity-
profitability dilemma.

Process of cash management

 Controlling levels of cash - Cash planning(preparation of cash budget)
 Managing cash flows(cash flow statement and fund flow statement
 Determining optimum cash balance (Baumel’s model and Miller-Orr model)
 Managing cash deficit/surplus

 3. RECEIVABLES MANAGEMENT

 Management of accounts receivables may be defined as the process of making

decisions relating to the investment of funds in this asset which will result in
the maximizing the overall return on the investment of the firm.
Receivables management is also referred to as Trade Credit Management.
What are receivables?
 Receivables are sales made on credit basis.
Why do we need receivables?
 Achieving growth in sales potential
 Increasing profits
 Meeting competition
 Understanding Receivables
 As a part of the operating cycle
 Time lag b/w sales and receivables creates need for working capital

Factors affecting receivables management

 Level of sales
 Credit Policies
 Terms of trade
 Credit period
 Cash discount
Receivables Management Policies

These policies relate to:

(i) Credit standards: The term credit standards represent the basic criteria for
extension of credit to customers.
The levels of sales and receivables are likely to be high, if the credit standards are
relatively loose.
The firm’s credit standards are generally determined by the five C’s – character,
capacity, capital, collateral and conditions.
 (ii) Credit terms: It refers to the terms under which a firm sells goods on
credit to its customers. The two components of credit terms are:
(a) Credit period – Specify the length of time over which credit is extended to a
customer and the discount, if any, given for early payment. For example,“2/10, net 30.”
The total length of time over which credit is extended to a customer to pay the bill. For
example, “net 30” requires full payment to the firm within 30 days from the invoice
date.
(b) Cash discount: Cash Discount Period – The period of time during which a
cash discount can be taken for early payment. For example, “2/10” allows a cash
discount in the first 10 days from the invoice date.
Cash Discount – A percent (%) reduction in sales or purchase price allowed for early
payment of invoices. For example, “2/10” allows the customer to take a 2% cash
discount during the cash discount period.

(iii) Collection procedures

 Letters
 Phone calls
 Personal visits
 Legal action
 The firm should increase collection expenditures until the marginal reduction in
bad-debt losses equals the marginal outlay to collect

Sources of financing working capital

Trade credit Working capital demand loan

Advances from Factoring

customers
Discounting bills of Commercial paper
exchange
Bank overdraft Cash credit

Bills finance Letter of credit

Note: Practice problems from 1.Discounted PBP, 2. NPV, 3. IRR,

4.ARR, Leverage, Walter’s model, Gorden’s model (dividend), and
working capital estimation.