Chapter 05

Capital structure
dividends policies
Merger and Acquisition

Lecturer: Moh. Amin Bawar 1

 Capital structure
 Capital structure means the mixture of both
equity and debt.

 this structure can change with the financing

needs and strategies of firm.

 The ratio of debt to equity in firm is decided

by board of directors

Lecturer: Moh. Amin Bawar 2

 Cos of capital
 If company needs to raise money or equity
the firm prints shares and trades them in
stock exchange, the cost which occurs on
the printing and trading shares is called
cost of capital.
 The payment of interest in case of raising
capital through debt is also cost of capital
which is also known as rent of for capital.

Lecturer: Moh. Amin Bawar 3

 WACC “weighted average cost of
capital
 The combined cost of all resources of
financing used by firm, both debt and
equity.
 Or the average rate of raising capital is
called WACC.
 Components of WACC:
 Cost of debt “Bond” Rd
 Cost of equity “stock” Re

Lecturer: Moh. Amin Bawar 4

 Function WACC
 WACC = (wd)(Rd)(1-T)+(We)(Re)(wp)(Rp).

 Wd = weight or amount equity debt

 We = weight or amount of equity
 1-T = corporate tax
 Re = cost of equity
 Wp = weight of preferred cost
 Rp = cost of preferred stockc
Lecturer: Moh. Amin Bawar 5
 example
A company wants to raise finance, It will
sell $10 million of common stock of which
cost is 15% and also will sell $5 million of
bond of which cost is 12%. Corporate tax
rate is 30% find WACC?
 Solution:

 Total value = 10+5=15 millions

 Debt = 5/15 = 0.33
 Equity = 10/15 = 0.67
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 Continue…
 WACC = (0.33)(0.12)(1-0.3)+(0.67)(0.15)
 WACC = 0.02772+0.1005
 WACC = 0.12882
 WACC = 12.822%

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 Dividend Policy
 The policy which is selected for the payment of
dividends by the board of directors. Some of the
common used policies for dividend payments
are as follow:
 1- A bird in hand is better, then two in bush:
shareholders wealth and firm’s value is maximized
by a higher divided payout ratio, because
investers thinks that dividends income is less
risky than capital gain. Therefore dividends is bird
in hand and gain of capital is bird in bush.
This was introduced by (Gorden & linter)
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 Tax preference policy
 Share holder wealth is maximized and cost of
capital is minimized by low dividend payout,
because tax rate on dividend is higher.

Signal theory
The firm decides to increase dividends by
receiving high income in future, they give
positive signal to market about increase in
dividends to motivate investor for buying their
shares through by which the price of stock
increases in market.
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 Client theory
 Change in dividends causes change in
shareholders. Shareholder or investors buys
stocks firm of which policy they likes,
because the income investor will invest in
high dividend stocks, and growth investors
will invest in those stocks which offers high
capital gain in market.

Lecturer: Moh. Amin Bawar 10

 Debt Vs Equity
 Use of debt in a firm’s capital structure is
called leverage.
 The ratio of debt and equity should be
determined, because on debt firm gives
interest which is treated as expense and
causes decrease in tax.
 On equity or share dividends are paid after
the net income. In case tax is already paid,
which causes decrease in income.

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 Assignment

Residual dividend model (RDM)

&
Dividends payout ratio

Lecturer: Moh. Amin Bawar 12

 Working capital management

“Current assets & Liabilities”

Lecturer: Moh. Amin Bawar 13

 Defination
 the capital of a business which is used in its
day-to-day trading operations, calculated as
the current assets minus the current liabilities.

Net working capital

=
current assets – current Liabilities

Lecturer: Moh. Amin Bawar 14

 Current assets
 cash and other assets that are expected to
be converted to cash within a year is
called current assets. It includes the
followings:

 Inventory, A/c Receivable, cash,

marketable securities, advances,
prepaid expense and more.

Lecturer: Moh. Amin Bawar 15

 What amount of working
capital a business should
have at any time?

Lecturer: Moh. Amin Bawar 16

 Continue…
 To answer the above question, following
policies are used by businesses for WC:

1- fat cat policy: keeping large

amount assets (current), not to lose large
order of customers.
Problem with this policy is that large amount
of money will be stacked in assets and will
not generate profit.

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 2. Lean and mean police
 Keeping small amount of current assets
because it will generate or maximize the
turnover on assets cause of more cycling of
the inventory.

 Current asset turn over = Sales/current assets

Lecturer: Moh. Amin Bawar 18

 Current assets
 Cash:

 Cash is king in business, and only cash

can pay bills in business.
 Firm should maintain some cash to
maintain liquidity, meet unexpected
expenses and get trade discount.
 When interest rate raises the opportunity
cost of holding cash also raises. In case
cash in hand and in bank does not
generate profit.
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 Cash management policies
Interest based policy:
 When interest rate is high the opportunity cost
of keeping capital inform of cash is higher, in
case investment is better of surpluses amount
in marketable securities, which can be
converted soon to cash if needed.

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 Cash flow synchronization policy
 Synchronization means happening of events
in same time or rate.
 This policy indicates to use billing cycle to
justify the cash outflow just after the cash
inflow.

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 Speed up cash collection policy
 It is difficult to collect cash or sell on cash, so
firms mostly sells on credit and this is cause
of competition in market.
 Causes of lots sells on credit company faces
problem of collection, to solve this company
uses cash collection staff to collect it.

Lecturer: Moh. Amin Bawar 22

 Inventory management policies
 Use software for inventory management.
 JIT “just in time policy”: this policy was
introduced and developed by Toyota
corporation.
 Objective of JIT is to order the inventory just a
few hours before of its usage, which do not
need storing cost.
 From another side there wont be of stacking
cash in inventory.

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 Out sourcing
 Instead of making all the parts of a project
or product by yourself, buy some of it
from outside manufacturers by low cost.
Or hiring other companies to do certain
tasks for a company.

Example: customer service of Etisalat.

marketing

Lecturer: Moh. Amin Bawar 24

 WC financing
 Generally following policies are used for WC
financing:
Aggressive policy: using of short term
financing for temporary current assets buying.
Conservative policy: using long term financing
for buying fixed assets.
Moderate policy: using long term financing for
fixed and short term for current assets.

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 NWC analysis
 NWC>0 : means that current assets are
more than current liabilities and means it
is a liquid fir.
 NWC<0: means that current assets are
less than current liability. In case firm
needs short term fund to fill the gap.
 NWC=0: means current assets are equal to
current liability and firm is in break even
point.

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 Merger and acquisition

Lecturer: Moh. Amin Bawar 27

 Defination
Mergers and acquisitions (M&A)
are defined as consolidation of companies.
Differentiating the two terms, Mergers is the
combination of two companies to form one,
while Acquisitions is one company taken over
by the other. M&A is one of the major aspects of
corporate finance world.

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 Why M&A
 To reduce risk
 Make synergy
 To improve financial, physical and human
resources.
 To buy large number of shares of a leading
company and take it over.
 When market value of a similar firm is less
than cost of replacing own assets, in case
acquisition of another firm is better.
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 Merger
 When two or more firms combines to form
one firm and get benefit of synergy.
 Types of merger:
1- financial merger: the merger in which
finance of two firms are merged but the
operation of them is not integrated.
It Is also called financial combination.

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 Continue..
2- Operating mergers:
Combination of operations of two firms, but
in case the operation of the firms should be
same.
3- Horizontal merger:
merger of same products competitors, aims
to lead to market monopoly.

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 Continue..
4-Vertical merger:
Merger of firms of same industry or different
which has relation of supplier and buyer.
5- congeneric merger:
Merger of firms from same industry.
6- conglomerate merger:
Merger of firms of unrelated industry.

Lecturer: Moh. Amin Bawar 32

 Acquisition
 Purchase of one firm through other firm is
called acquisition. Firm which purchases
another firm is called acquiring firm and
firm which is to be bought is called target
firm.
 Types of acquisition:
1-divesture: getting benefit of efficient
reallocation of resources.

Lecturer: Moh. Amin Bawar 33

 Continue..
2- hostile acquisition: taking high vote of
shareholders to become part of board of
directors and make decisions.

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  End

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