Strategic Financial Management (SFM)

Basic Text Books:

T1 Khan and Jain Financial Management TMH

2nd Edition, 2011

T2 Ravi M. Kishor Strategic Financial

Management Taxmann Latest, 2011

T3 Ashvarath Damodar Corporate Finance Wiley

India Latest , 2010

Syllabus
Chapter 1 1-2 Financial Strategy and Planning

T 2 CHAP 1

Chapter 2
3-5 Project Planning and Control

T 2 CHAP 2

Chapter 3
6-10 Risk Evaluation and Capital Budgeting Chapter 4 11-12 Dividend and Retention Policies Chapter 5 13-16 Valuation of Business

T 2 CHAP 4

T 2 CHAP 7 T 2 CHAP

14

Syllabus
Chapter 6 17-19 Analysis of Risk and Uncertainty

T 1 CHAP 12
Chapter 7 20-23 Business Restructuring and Industrial sickness

T 2 CHAP 16
Chapter 8

24-27 Designing Capital Structure

T1

CHAP 20
Chapter 9

28-30 Operating Financial and Combined Leverage T 1

Chapter 1
Financial strategy and planning

Strategic Planning
Strategy is defined as where the organization

wants to go to fulfill its purpose and achieve its mission, it provides the framework for guiding choices which determine the organizations nature and direction and these choices relate to the organizations products or services, markets, key capabilities, growth, return on capital and allocation of resources.
It defines what organization wants to become in

the longer term. 1. Developing an integrated, coordinated and consistent view of the route the company

Strategic planning process

1. 2.

3.

4. 5. 6. 7. 8. 9.

10.

Define the organizations mission and its overall purpose Set objectives Conduct environmental scans by internal appraisals of the strengths and weaknesses of the organization and external appraisals of the opportunities and threats which face it(SWOT ANALYSIS) Analyze existing strategies Define strategic issues Develop new or revised strategies Decide on the critical success factors Prepare operational, resource and project plans Implement the plans Monitor results

Financial forecasting
Meaning:

A forecasts is a prediction of a given set of circumstances. The dictionary meaning of forecast is prediction, provision against future, calculation of probable events, foresight, prevision.
It is called the calculation of probable events

In financial forecasting the future estimates are made through preparation of statements like projected income statement, projected balance sheet, projected cash flow and funds flow statements, cash

Techniques of financial forecasting

Days sales Method:

Percentage of Sales Method

Simple Linear Regression Method Multi regression Method Projected funds flow statement Projected cash flow statement Projected Income Statement and Balance Sheet

Benefits of Financial Forecasting

(a) provides basic necessary information

(b) acts as a control device

(c) provides necessary information for decision

making (d) optimum utilization of firms resources. (e) projects the funds requirement in advance. (f) alarms the management events concern going out control. (g) enables the preparation updation (h) information needed for expansion

Financial Forecasting Techniques

External Funds requirement

Internal Growth Rate

Sustainable Growth Rate

Financial Planning Process

Steps: 1. 2. 3. 4.

5.
6. 7. 8. 9. 10.

Clearly defined Mission and Goal Determination of Financial Objectives Formulation of financial Policies Designing Financial Procedure Search for Opportunities Indentifying Possible Course of Action Screening of Alternatives Assembling of Information Evaluation of Alternatives and Reaching Decision Implementation, Monitoring and Control

Decision Making Process

Recognize problem Collect information Identify causes

State aims

Allocate priorities

Specify problem

Examine resources

Decision making process

Examine resources Search for alternative courses of action Evaluate alternative course of action

Implement decision

Select best course of action

Assess possible adverse consequences

Control / results

Recognize problem

Agency theory of Employment

Agency Costs

Constituents of agency theory

value Maximization Management risk Monitoring Motivation through Incentives

o Criticism of Agency Theory o Conflict between shareholders and Debenture

holders

Assignments
Topic Roll number

Limited liability Partnership Corporate Governance

WTO

Chapter 2

Project Planning and Control

Capital Budgeting
Capital investment involves a cash outflow in the

immediate future in anticipation of returns at a future date. The planning and control of capital expenditure is termed as capital budgeting. Capital budgeting is the art of finding assets that are worth more than they cost, to achieve a predetermined goal i.e. optimizing the wealth of a business enterprise.

Capital investment decision process

Search for investment opportunities

Screening the alternatives

Analysis of feasible alternatives Evaluation of alternatives Selection of alternative Authorization Implementation and control

Types of Projects
Balancing projects
Modernization Projects Replacement Projects Expansion Projects Diversification Projects

Initial selection of project ideas

Before a project idea is considered for detailed

study, the promoter must verify the following: a) Project must match with the promoters profile of qualification, experience interest etc. b) Rough estimate of project cost and promoters capability to mobilize the necessary resources to the proposed project. c) Clear idea about market size and growth potential d) The availability of inputs and proximity of market for final products e) Costs involved in production, administration and marketing f) Availability of technology and plant and machinery g) Risks involved with the project.

Feasibility study report

Before a project investment is finalized, the

entrepreneur will conduct a feasibility study to

confirm about the techno-commercial strength of project and prepares a report called feasibility study report
It is not very elaborate, but contains substantial

information for selection of the project.

Feasibility study report

The report normally contains the following details: a) Study of the configuration of the project idea in all b) c) d) e) f) g) h) i) j) k) l)

aspects. Indentifying the type and size of the project with justification Study of location Study of demand of products/services Survey of material requirement Project schedule Project cost and sources of finance Profitability and cash flow analysis Cost benefit analysis Identifying and quantifying risk element Social costs and benefits Study of economics, political and legal environments.

 The above report is also called Pre-investment

Study Report. It is prepared for establishing the projects viability with sufficient backup for the purpose of evaluation of investment proposal by the entrepreneur.
This report is a base for preparation of Detailed

Project Report

Market Survey
Most useful for industrial products, consumer

durables and for other products where buyer plans purchases in advance Useful for new products where no past sales data is available A project investment decision is made only if economical feasibility report suggests that basing on market survey.

Market survey
The effectiveness of this technique depends upon a

number of variables Number of potential buyers.: if no is small then very high proportion of them can be questioned. II. Clarity of buyers in intentions III. Other factors:
I.

The cost of identifying and contacting buyers II. Buyers willingness to disclose their intentions III. Buyers propensity to carry out their intentions
I.

Invisible walls (Roadblocks) in Project Estimating

a) b)

c)
d) e)

f)
g) h) i) j) k)

l)

Delays in governmental clearances Delays in obtaining sanction of loans from financial institutions Reliability of contractors Hurdles from the local people near the project site Political disturbances Foreign exchange rate variations Unable to quantify the risk properly Locational disadvantages Uncertainty of market and change in consumer preferences Lack of reliable technology Lack of flexibility Financial soundness of participating investors

Reasons for project Failure

(a) Substantial overrun of the projects which makes the project not feasible to implement further

(b) Changes in technology during the implementation of the project

(c) Wrongful estimation of cost of project and its profitability (d) Lack of experienced management team (e) Lack of delegation of authority and responsibility

(f) Lack of proper project monitoring systems

(g) Failure to obtain government clearance and permissions (h) Unfaithfulness of the promoter

Techniques for project control

Basically all techniques go to breakdown the project into numerous short-term measurable targets built on logical baselines like; (a) Watch and measure the achievements at short

intervals
(b) Ascertain current variances and predict future variances (c) Ascertain root causes of variances (d) Take actions to offset the ill-effects of past

(f) Track and measure the quantitative output and cost

inputs. (g) Evaluate targets, output and input in financial terms. (h) Special monitoring of essential tasks by using techniques like red-lists, hotline reports to draw top managements attention.

(i) Introduction of incentives for good performance.

(j) Doing away with red-tapism (avoiding unnecessary rules and regulations) and Bureaucratic procedures.

Incentives in project planning

When considering options for investment, one of

the

major

considerations

are

the

fiscal

incentives that are available with regard to the nature of the industry, the locations of the industry and the product planned to be

produced. The incentives available can be

broadly grouped into categories as stated below;

Incentives in Project Planning

A. Incentives for export oriented units (Fiscal Benefit) B. Incentives for units in Industrially backward area

(Area Benefit) C. Incentives for small scale industries (Product/production benefit) D. Tax considerations in project planning (Fiscal Benefit)

A. Incentives for Export Oriented Units

Government of India offers various incentives for setting up

export oriented projects as a measure for export promotion and for improving the balance of payments position/foreign exchange.
1.

Liberal import facilities are allowed depending on actual import content of product Customs and central excise duties paid on raw material used for manufacture of export products are reimbursable. Raw materials are supplied at controlled prices for specified export products. Priority is accorded by Railways for transport of goods meant for exports.

2.

3.

4.

5.

Export Credit Guarantee Corporation (ECGC) offers special

6.

Insurance against loss in export of goods and services. ECGC also provides guarantees to banks and financial instructions to enable exporters to obtain better facilities from them.

7.

Financial facilities at special confessional rates of interest are given by commercial banks.
100% foreign equity participation is allowed but the company should be an Indian company Imports of capital goods/components and raw material are exempted from import duty.

8.

9.

10. Single point clearance with simplified procedures. 11. Relaxations are allowed in respect of sales tax property tax,

octroi etc.
12. Tax holiday is available for 100% export oriented units.

B. Incentives for Units in industrially Backward Area

To promote balanced regional development. Government of India has announced incentives for industries established in selected backward districts/areas. These incentives are in the form of;
(a) Central outright grant or subsidy scheme (b) Confessional finance scheme (c) Transport subsidy scheme

C. Incentives for Small Scale industries

To promote the development of small scale industries in the country several measures have been announced.
1. Small scale units need not obtain industrial licenses for

certain category of items manufactured.

2. Number of products and services have been exclusively

reserved for small scale units.

3. Government

provides comprehensive assistance to small entrepreneurs through various organizations like Small Industries Development Organization.

4. Priority and assistance is provided in allotment of land. 5. State Financial Corporations provide long and medium

term loans to small industries at concessional rates.

D. Tax Considerations in project planning

Tax

consideration is an important factor in project investment decisions. some projects are located primarily because of tax incentives and benefits associated with them Corporate tax is a very vital element the magnitude and timing of the tax burden associated with projects and should be carefully assessed Normally capital expenditure is not allowed as a tax deductible expenditure but Tax incentives are given for capital expenditure incurred, e.g. 100% deduction of capital expenditure is allowed for tax computation if such expenditure had been incurred on scientific research related to the business carried on by the enterprise

Impact of Liberalization and Globalization on project planning

In the current globalize and liberalized economy,

the Indian industry is facing new challenges and opportunities. In view of the global competition the future Indian projects must focus on the following points;

Under the post liberalization economic scenario, India is facing

Global challenges of advanced technology
Problems concerning energy conservation Rapid automation

Need to have high productivity and low prices

Issues

arising out of efficiency oriented privatisation Challenges of speed and customer orientation

To survive in the globalization situation, the Indian projects will have to

Be cost effective and inexpensive Have low capital base Use advanced technology suitable for Indian

conditions Be safe from pollution and nuclear radiation Be energy efficient Increase speed of delivery Ensure good customer relationship management

All future projects should incorporate adequate provisions for

Using non-conventional energy, natural gas

and coal where possible Partial replacement keeping pace with advanced technology Utmost safety in operation Conservation of resources Good quality control Strategies for staying close to the customer Sticking to the expertise core competence

Future projects should aim at;

Alleviating poverty

Generating mass employment potential

Raise standards of living and quality of life Making the country self-sufficient in

inexpensive essential goods and services Substituting costly imports Safe disposal of waste Adequate environmental protection

Strategic Focus in Project Planning

The global competitive environment requires the strategic focus while planning for setting up a project. The main strategic focus areas include;
A. Economies of scale by consolidation B. Thrust on core business in other words, expand the

business globally where corporate has strength.

C. Upgrading products and technologies to ensure customer

satisfaction with quality and reliable products and services

D. Reduce product development time and cycle time to bring

efficiency
E. Cost effective solution, cost reduction and increasing

value to customers

F. Clear understanding of customers requirement and

ensuring customers loyalty on-going basis.

G. Down-sizing, delivering and business process re-

engineering to ensure efficiency in operations to service to customers.

H. Deployment of techniques like total quality

management, six sigma, activity based cost management etc.

I.

Strategic alliance with Indian and foreign companies, joint ventures with foreign companies, start new business or revamp existing business

Micro and Macro Considerations

Projects are undertaken at three levels; At National level- Where the investment plans, policies and priorities are formulated and established from the overall economic point of view, i.e. by setting a project in macro economic framework At Sectorial level- Where policies, planning and strategies focus on growth and development of a single sector like industrial or agricultural or social amenities etc. besetting certain parameters. At Project level- Where one single project is planned and studied from all the economic. technical and financial and

Macro Considerations at National Level

A. Overall growth of all sectors in an economy at a given

period of time.
B. Available resources to allocate towards the prioritized

and remove the imbalance among the sectors.

C. Boost both private and public sector undertakings to elicit

desired behavior and spur growth.

D. Allocate the scarce resources towards development of

high- priority public needs.

E. Controlling fiscal monetary frameworks in accordance

with the changing times.

F. Maintaining wage policy, exchange rate policy and other

inflationary pressures.
G. Motivating the economic behavior by rational allocation

Micro considerations at Sectoral Level

A. Ensuring the investment plan to be realistic by matching the

resources available and treating costs and benefits of the projects at par.
B. Ensuring a balance in implementation of multiple projects

which are undertaken notwithstanding the resource crunch and maintaining the resource levels without time or cost overruns.
C. New projects should be kept in waiting till the old backlog gets

cleared and should be accepted if it does not affect the ongoing projects, either in terms of cost or time spent.
D. Rational decisions should be made on the basis of experience

on past projects after which mobilization of idle resources may also be considered.
E. Cost-benefit

analysis has to be meticulously done by exercising great skill of appraisal.

Cost and Time Overruns

It is a common problem in execution of the projects that

the actual cost on the project would exceed than the estimated cost.
Similarly, the project would not be completed within the

time schedule for various reasons. The various reasons at various stages of projects are summarized as follows
1. Pre feasibility stage 2. Evolution stage 3. Choice of technology stage 4. Contracting and procurement stage 5. Construction stage 6. Commissioning and start up stage

1. Pre-feasibility Stage
A.

Bureaucratic

delays

in

obtaining

clearances

e.g.

pollution/ environmental clearance

B.

Securing necessary approvals from regulatory agencies and financial bodies.

C. D.

Inadequate infrastructure facilities like roads etc.

Failure to plan important resources, tie-ups and inputs needed for timely construction and putting into operation.

2. Evaluation Stage
A. The better the evaluation, greater the chances of eventual

project success in terms of meeting time schedule and

budget,
B. A hurried through evaluation an inadequate study. resulting

in lack of clarity in the budget scope, on-freezing of resource and cost estimates.
C. Wrong selection of location influenced by factors other

than technical and the incompetence of consultants who

are selected for extraneous considerations.
D. Wrong

economic studies and misleading fund flow

3. Choice of Technology
A. Selection of wrong and outdated technology. B. Selecting technology on considerations of credit offered

by the supplier rather than of technical necessities.

C. Delay in completing detailed engineering non-availability

of design data, delay in the freezing of design and specifications, absence of an engineering schedule.
D. Improper

scrutiny

and

approval

of

drawing

and

specifications also lead to revisions and rework at a later

stage.

4. Contracting and procurement

A. Improper preparation of tender documents and late

release of those documents.

B. Wrong

selection

of

vendors/fabricators/contractors;

delays in evaluating bids; lowest cost syndrome without regard for the contractor competency and vendor quality.
C. Time consuming procedure concerning procurement of

imported materials.
D. Absence of proper quality control mechanisms.
E. Poor logistic planning.

5. Construction Stage
A. Starting construction activities without proper planning

and even before ensuring the availability of working drawings storage space, supply of equipment and materials and adequate infrastructure
B. Low productivity of contractors, improper coordination

and monitoring of contractors work and contractors financial problems due to delays in settlement of claims.

6. Commissioning and Start-up

A.

Delays in making available manuals , services, feedstock and special tools.

B. Failure of certain equipments or parts, design changes

and delays on the part of equipment suppliers and/or the

commissioning contractors.
C. Defects in erection and installation and teething troubles

resulting from bad quality control during erection and inadequate of equipment.

Methods to Avoid Cost and Time Overrun

A. Master

Schedule/milestone Network/Master BudgetPlan and breakdown the project into Work Breakdown Structure (WBS) and develop from then the Master Schedule, Milestone Network and Master Budget. These major tools will help to control the time and cost factors of project performance.

B. Time and Resources Schedule- From the Master

Schedule and master Budget, detailed schedules of tome and resources are prepared. These are to be integrated with the organization breakdown structure, with the relevant responsibilities/authorities given to the project team functional departments, individuals and

Methods to Avoid Cost and Time Overrun

C. Procurement

Time Schedule, Fabrication/Construction/Commissioning Time Schedule

1. Calendar-time phased constriction work schedule 2. Schedule of contracting 3. Crashing economy analysis 4. Progress report 5. Fund flow analysis 6. Progress status report 7. Cost status report 8. Variance analysis 9. Overall performance

Cost Benefit Analysis (CBA)

Its a tool to measure financial viability of project
Formally, its an analytical tool that enables

systematic comparison between the estimated cost and projected benefits from the project. Basically CBA used to determine
1. Whether or not a specific operation should be

undertaken 2. Which of the possible alternative projects should be Cost Benefit Analysis Procedure selected 1. Determine problem to be considered 3. Which time cycle would be most beneficial to the 2. Ascertain alternative solutions to problem project

Estimate and analyze costs and benefits 4. Appraise estimated costs and benefits 5. Decide on Optimal solution
3.

Techniques of CBA
A. Discounted Cash Flow (DCF)

Net Present Value 2) Internal Rate of Return

1)

B. Benefit / Cost comparison C. Benefit / Cost Ratio (Profitability Index)

Benefits of CBA
CBA can be used simply to ensure that value for money is

obtained from a project which requires the investment of funds.

they produce and the costs that will be incurred CBA

studies attempt to allow for social costs and benefits.

Public sector projects, the discipline of trying to apply a

consistent method of measurement in these areas should help to produce better decisions which take important subjective factors into account.
Placing realistic values on such things as good healthy,

quiet houses or protection from a potential enemy CBA have sometimes attempted the impossible and the task of listing relevant costs and benefits of in itself a valuable discipline.

Limitations of CBA
The accuracy of data input. Not only are estimated costs and benefits difficult to

forecast, but often they are even more difficult to quantify. A special form of capital budgeting which is applicable to public sector. Subjective judgment will also bean important part of costbenefit analysis Procedures for public sector project appraisal, the technique makes a significant contribution towards improved decision-making.

Social Cost Benefit Analysis

Social cost means sacrifice or detriment to society

(For Ex. : Pollution, erosion of soil, deforestisation, production of dangerous products and explosives) Social Benefit means compensation made to the society (For Ex. : Increase in per capita income, employment opportunity, building social places in forms of gardens, hospitals, schools etc., tree plantation program) SCBA means a systematic evaluation of an organization's social performance as distinguished from its economic performance

Indicators of Social Desirability of a Project

A project is also assessed from the social angle in addition

to assessment of its commercial viability.

The following social desirability factors will be considered in

accept or reject decisions of a project

A. Employment Potential B. Foreign Exchange Earnings C. Social Cost-Benefit Analysis D. Capital-Output Ratio E. Value Added per unit of Capital

Economic Appraisal of Project

1. Economic Rate of Return
ERR is a discount rate at which the cash inflows and cash

outflows of the project are equated.

The cash inflows and outflows are termed as economic

benefits and economic costs respectively which will arise during the life of the project.
ERR is the rate of return arising out of the project to the

national economy or society and not to the private promoters and other agencies involved in promotion of the project
It does not consider the rate of return at the individual

level to the promoters who have set up the project ERR is determined on the basis of shadow prices which reelect real cost of inputs to the nation and the real benefit of output to the nation instead of market prices

Economic Rate of Return

In calculation of ERR, international prices are regarded

as the relevant economic prices.

The

domestic market prices are substituted with international prices for all non-labor inputs and outputs for ascertaining the ERR,

A. For all tradable items where international prices are

available directly C.I.F. prices for inputs and F.O.B. prices for outputs are used.
B. For tradable items where international prices are not

available and for non-tradable items, social conversion factors are used to convert actual rupee cost into social or benefit.

Domestic Resource Cost

The domestic resource cost (DRC) represents the resource

cost of a product manufactured indigenously without importing such product or cost of such product if it can exported.
DRC measures the resource cost of manufacturing a

product as compared to importing/exporting cost to it The comparative advantage that a country enjoys if its domestic resource cost of a product is lesser than the cost of its importing.
This can save the foreign exchange outgo by manufacturing

the product within the country. The product can also be exported to earn foreign exchange to the country.
DRC is computed as the quantum of domestic resources or

costs deployed in production i.e. the costs incurred in

Effective Rate of Protection

(ERP) indicates the degree of protection a project

receives from international competition

The ERP offered to a particular stage of manufacture of a

product is an important consideration in determination of competitive strength of the product.

indicator of competitive strength of a product in the

international market.
In calculation of ERP, the basic parametial is value

added which is the difference of selling price of a product and the cost of material inputs. ERP.

Value addition is the basic parameter in calculation of

Effective Rate of Protection

Due to domestic protection given by the

government to the project there will be a difference in value addition at domestic prices as compared with the international prices. If the measures of protection are absent domestically and abroad the theoretical value addition at domestic price must be equal to the value addition at international price. The difference in the value added is arising due to measure of protection given to the domestic product If measures of protection are absent domestically and abroad, theoretically, the value added computed at domestic prices will be equal

Effective Rate of Protection

ERP= Value added at domestic prices Value added at world prices (a) ERP will be zero when value added at domestic prices is equal to value added at world prices. (b) Higher the value of ERP, higher the implied protection enjoyed by the project. (c) The domestic selling price will not include taxes and excise duties, but it is inclusive of selling commission. (d) The selling price at world price is the C.I.F. price for import and F.O.B. price for export, ERP is calculated as follows; Value added at domestic prices- Value added at world prices* 100 ____________________________________________ Value added at world prices Relationship of DRC and ERP DRC = (ERP + 1) Exchange Rate

Chapter 3

Risk Evaluation in Capital Budgeting

Decision making under risk and uncertainty

1.

Business risk and financial Risk Business risk is determined by how it invest its funds i.e. the type of projects which it undertakes. A company's competitive position, the industries, market share, rate of growth and stage of maturity all influence the business risk. Financial risk is determined by how it finances these investments. It is primarily influence by the level of financial gearing, interest cover, operating leverage and cash-flow adequacy.

Conti.
2. Consideration of risk and uncertainty - The taking of right decision at right time is essential for the business. There are many occasions when one decision can lead to more than one outcomes, such situation are beset with uncertainty. - Uncertainty arises because of the lack of experience and knowledge, and mainly arise because of Date of completion, level of capital outlay required, level of selling price, level of sales volume, level of revenue, level of operating cost and taxation rules,

Conti
3. Risk analysis in project selection - The acceptability of projects depends upon cash flows and risk. - risk must be considered when estimating the required rate of return on project. - There is trade-off between risk and return which must be reflected in the discount rates applied to investment opportunities. - Project will be accepted which has probable lower risk and higher rate of return.

Risk Management
Risk management is the process of measuring or assessing risk and developing strategies to manage it. Objectives of RM - Anticipating the uncertainty and the degree of uncertainty of the events not happening the way they are planned. - Channelizing events to be happen the way the are planned. - Setting right deviations from plans, whenever they occur. - Ensuring that objective of the planned events is

Conti.
Steps in RM Process

- Identifying and classifying the areas and nature of

-

risks Evaluating degree of risks Eliminating the risks, wherever possible Overcoming the risk by timely action Transferring the risks appropriately

Conti
Enterprise risk management

It is defined as a process, effected by an entitys board of directors, management and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity, and manage risk to be within its risk appetite, to provide reasonable assurance regarding the achievement of entity objective. ERM is comprehensive and integrated approach to addressing corporate risk. ERM enables management to effectively deal with uncertainty and associated risk and opportunity, enhancing capacity to build value.

Probability analysis
It is measure of likelihood of an event happening or

not happening, as planned. It is basically statistical technique to measure probability of occurrence an event and probability of its non-occurrence. The whole theory of probability is based on the following three axioms: 1. The probability (p) of an event ranges from zero to one. 2. The p of entire sample space is 1. 3. If A and B events are mutually exclusive events then probability of occurrence of either A or B denoted by: P(A+B) = P(A) + (B).

Conti
Advantages:

- Simple to understand and calculate

- Represent whole distribution by single figure - Arithmetically take account of the expected

variability of all outcomes. Disadvantages: - It ignores the other characteristics of the distribution that is ranges and skewness. - It assumes that risk is neutral. Example: 4.1

Best and worst estimates

Worst possible and best possible approach

- The worst possible/best possible outcomes can

be evaluated from the pessimistic and optimistic attitude of the decisions made. - An optimistic decision maker consider most favorable outcome and vice versa. - Decision maker should consider both the outcomes that best and worst.

Conti
Optimistic, most likely and pessimistic Approach.

- This analysis will help in understanding the full

range of possible outcomes from a decision and will help the decision Example: 4.2

Value of Information
Information can reduce the uncertainty Value of Perfect Information: it removes all doubt and uncertainty from a decision and it would enable managers to make decisions with complete confidence. Value of Imperfect Information: market research findings or information from pilot tests and so on are likely to be reasonable accurate, but they can still be wrong , they provide imperfect information. It is possible to arrive at an assessment of how much it would be worth paying for such imperfect information, given that we have a rough indication of how right or wrong it is likely to be. Example: 4.3

Sensitivity analysis
Sensitivity analysis is made along with uncertainty and probability

analysis, to determine the extent of action to be taken. The higher the sensitivity of influence on event, higher the risk and the damage. It can help to mitigate the impact of influence, depending upon the severity of damage occurring out of risks. It is study of key assumption on which management decision is based in order to predict alternatives outcomes of that decision if different assumption are adopted. It aids in identifying the most sensitive factors, that may cause the error in estimation. It involves the three steps Identification of all those factors having influence on the projects NPV or IRR. Define quantitative relationship among them. Analyze impact of each of them on project.

Simulation
It is representation of a system by a model which will

react to change in a similar way to that which is being simulated. There are several technique of simulation, among them Monte Carlo method is more popular. It uses random numbers and is used to solve the problem which involves conditions of uncertainty. In simulation, generally computer is used. Some problems are too complex to solve with pure mathematics or risk situation that defy a practical mathematical solution. In such situation simulation is used.

Conti
Steps in simulation process - Define the problem precisely. - Introduce the variable associated with the problems. - Construct a numerical model. - Set up possible courses of action for testing. - Run the experiments. - Consider the results and possibilities to modify the

model of change data inputs. - Decides what course of action to take.

Conti
Advantages - It can be used to investigate the behavior of problems -

which are too complex to be modelled mathematically. It can also be used when the variables in the problem. E.g. arrival time, service time do not follow the standard distribution required for the mathematical models, i.e. Poisson distribution, Normal exponential distribution It does not interfere with the real world system but only with table model and therefore, it results in savings of cost. It is micro analysis of big and complicated system by breaking into each subsystem and studying the interface of the various subsystems. It saves time and it allows us to study interactive effect of each variable.

Conti
Disadvantages - It is not an optimizing technique, it simply allows us to

select best alternatives. - Reliable results is only possible if simulation will continued for long period. - A computer is essential to cope up with amount of calculation in simulation modeling. - To develop simulation model means consumption of voluminous data and it may be very costly. Each model is unique and same solution cannot ne applied for another situation. - It does not produce answers by itself. - It is not as efficient as analytical methods. Example: 4.5

Hertz Simulation Model

Hertz has used simulation modeling in capital budgeting

decision when the planning process of a complex project cannot be solve with the mathematical modeling. He suggested that having derived the distributions of all the input variables, i.e. standard deviation and shape of distribution of each variable, simulation exercise can be performed by using all these factors. The model suggest that the first run may be performed with a low market share and with high operating cost to ascertain the NPV. In the second run, take a large market share and with moderate operating cost and then ascertain the NPV. Like wise large number of runs can be conducted to find out the feasible solution.

Standard Deviation and Coefficient of variation

Example: 4.6

Hillier Model for Risk Analysis

In this model, risk associated with capital investment

decisions determined by the variation of the expected cash flow. If the cash flow of the project are less uncertain, there would be lesser deviation from the mean cash flows and vice-versa. The determination of standard deviation of various levels of cash flow will be required to ascertain the uncertainty factor of cash flows of a project. Based on the above argument he has developed a model to evaluate the various alternatives cash flow by taking mean of PV of the cash flows and the standard deviation of such cash flow

Certainty Equivalent Approach

It takes into account the risk factor in making

estimation and appraisal of capital investment decisions. In this, the estimated cash flows are adjusted by using risk-free rate to ascertain risk-free cash flows. The expected cash flows of the project are converted to equivalent riskless amounts. The technique varies with the risk adjusted discount rate. Example: 4.7

Risk Adjusted Discount rate

It attempts to handle the problem of risk and uncertainty

in a more directed thoughtful way as investors are risk averse. It takes the commonsense approach to handling risk in investment appraisal of adjusting the level of the minimum acceptable return to reflect the projects level of risk. The approach taken is usually to add a risk premium to the risk free rate of return. The greater the risk, greater the risk premium. Sometimes the decision rule will not be on the basis of what type of investment it is, but rather on a subjective measure of how risky the investment is. E.g. all new investment in a company could be divided into high risk investments, moderate risk investment and

Project Beta
The measure of risk is expressed as Beta ().

Beta is an expression of the market sensitivity of

an investment, or how volatile it is compared with the normal volatility of the market. Example: 4.8, 4.9, 4.10, 4.11

Decision tree analysis

It is branching diagram which is similar to

probability tree. It represents problems in a series of decisions to be made under conditions of uncertainty. Any one of the decisions may be dependent on the previous outcomes. Figure 4.2 Example: 4.12

Other Risk Management Models

1.

Uncertainty analysis: It is a method of grouping the expectations into problem and no-problem areas so that problem areas can be given better attention. Find out the controllable and no-controllable factors to solve the problems

Conti
2. Statistical Exponential Analysis: - It is a study of pattern of occurrence of events and influence over periods of time based on past experience. - It is a graphical representation to extend the past into the future with necessary weightage.

Conti
3. Computer Analysis - It is not a method by itself but the use if computers to capture, collate and analyze the mass data to derive at the pertinent information.

Conti
4. ELGI Approach: - It means Estimate, learn, group, Implement - Scientific approaches of ELGI are: Uncertainty analysis Probability analysis Sensitivity analysis Statistical Exponential analysis Information analysis SWOT analysis

Chapter 4

Dividend and Retention Policies

Dividends
The dividends are periodic cash payments by the

company to its shareholders. The dividends payable to the preference shareholders is usually fixed by the terms of the issue of preference shares. But the dividend on equity share is payable at the discretion of the board of directors of the company.

Kinds of Dividend
a) The dividend payments may be interim of final.

This date on which the announcement is made of new dividend is called dividend declaration date b) The dividend payment will be made to the members whose names appear in the register of members on a particular date is called record date c) The date from which the stock begins to trade without the right to receive the dividend declared is called ex-dividend date d) The date on which the company actually mails the dividend warrants is called payment date

Dividend may be
Interim dividend

Final dividend
Preference dividend

DETERMINANTS OF DIVIDENDPOLICY
Transaction costs

Firms transaction costs Shareholders transaction costs

Personal taxation Dividend clientele Dividend Payout Ratio

Dividend per share Earnings per share Dividend Cover Profit after tax Dividend

 Dividend signalling Divisible profits Liquidity

Rate of expansion
Rate of return Stability of Earnings

Stability of Dividends
Legal provisions Contractual constraints Cost of financing Degree of control Capital Market Access State of Economy

Dividend Policies
Constant dividend payout Policy

Constant Dividend Rate Policy

Optimum dividend Policy

Constant Dividend Payout Policy:

(Constant payout ratio method)
The concept of Stability of dividends means always

paying a fixed percentage of the net earning every year.

If earnings vary, the amount of dividend also varies

from year to year.

The

company follows regular practice of retain

earnings.
For most Firms earning are quite volatile, fluctuating

with changes in the economy and firms own special circumstances.

Constant Dividend payout:

EPS & DPS (Rs.) EPS

DPS

No. of Years The relation of EPS and DPS under this policy is shown in figure

CONSTANT DIVIDEND RATE POLICY:

Most popular kind of dividend policy which advocates the

payment of dividend at a constant rate, even earnings vary from year to year.
This may be possible only when the earnings pattern of

the company does not show wide fluctuations.

This

possible is only through the maintenance of Dividend equalization reserve. sum current investment so as to manage the liquidity of the necessary funds in time of need.

The company than invest funds equal to such reserves in

CONSTANT DIVIDEND RATE POLICY:

Firms are generally careful to set the dividend at a

sustainable level and raise it only when the firm can sustain the higher level.
Occasionally

firms may cut dividends in adverse

situation.
Firms are against cutting dividends, because of the

extremely unfavorable news it conveys to the market.

Multiple dividend increase policy: Regular dividend plus extra dividend policy: Uniform cash dividend plus bonus share policy:

Constant Dividend Rate payment:

EPS & DPS (Rs.) EPS DPS

No. of Years The relation of EPS and DPS under this policy is shown in figure

Optimum dividend policy:

Market Price Per share (Rs.)

B (combined effect)

Dividend payout ratio

 Dividend valuation model assumes, a constant level

of growth in dividends in perpetuity. Gordon growth model is a theoretical model used to value ordinary share equity share. The main proposition of the model is that the value of share reflects the value of future dividends accruing to that share. The model holds that shares market price is equal to the sum of shares discounted future dividend payments.

Assumptions
The firm is an all-equity firm and has no debt

External financing is not used in the firm. Retained

earnings represent the only source of financing. The internal rate of return is the firms cost of capital k. It remains constant and is taken as the appropriate discount rate. Future annual growth rate dividend is expeted to be constant. Growth rate of the firm is the product of retention ratio and its rate of return.

 Cost of capital is always greater than the growth

rate. The company has perpetual life and the stream of earning are perpetual. Corporate taxes does not exist. The retention ratio b, once decided upon, remains constant. Therefore, the growth rate g=br, is also constant forever.

Example

A Company earns Rs. 10 per share at a internal rate of

15%, the firm has policy of paying 40% earning as dividend, if the cost of capital is 10% determine the price of share by Gordon Model.

Criticism
In real world ,the constant dividend growth and

earnings growth is a fallacy. The model implies that if Do is zero, the value of share is nil. The capital gains are igonred by the model. The false assumption is that investors will buy and hold the shares for an infinite period of time.

 The model ignores the allowance for corporate

and personal taxation. The diminishing marginal efficiency of investment is ignored. The effect of charge in the firms risk-class and its effect on firms cost of capital in ignored.

WALTERS VALUATION MODEL:

Prof. james E. Walter argues that the choice of dividend

policies almost always affect the value of the firm and in the long run the share price reflect only the present value of expected dividends. Retention influence stock price only through their effect on future dividends. Walter has formulated this and used the dividend to optimize the wealth of the equity shareholder. Formula of expected market price of share:

D + R (E-D) a Rc P= R

Valuation
Market price per share is the sum of the present

value of the infinite stream of constant dividends and present value of the infinite stream of capital gains.

P (DIV / k )

(r / k ) (EPS DIV) k

Where , P= Current market price of equity share E= Earning per share D= Dividend per share (E-D)= Retained earning per share Ra = Rate of return on firms investment Rc= Cost of equity capital ASSUMPTION: Internal financing Return on investment remain constant Infinite time 100% payout or retention Constant EPS and DIV IRR and cost of capital constant.

IMPLICATION BEHIND THE WALTERS MODEL: The optimum dividend policy of firm is determined by the relationship of Ra and RC . If R>R , the firm can retain the earning and that firms are called as growth firms and their dividend policy would be the plough back earnings. optimum payout ratio for a growth firm is nil.
If R<R, the optimum dividend policy would be to distribute the entire earnings as dividend and that firms are called declining firms. optimum payout ratio for this firm is 100%. If R=R, it does not matter whether the firm retains or distribute its earnings, and such firms are called normal firms and optimal payout ratio is irrelevant. The price per share does not vary with changes in dividend payout ratio.

Modigliani and Millers Dividend Irrelevancy Theory

Modigliani and Millers has argued that a firms

dividend policy has no effect on its value of the assets. For example, if the rate of dividend declared by a company is less, its retained earning will increase and so also the net worth and vice versa. Their argument is that the value of the firm is unaffected by dividend policy i.e., dividends are irrelevant to shareholders wealth.

Basic Tenets
MM-Dividend Irrelevancy Theory is based on the

following tenets:
(1) Investment Policy (2) Earning Power

(3) Signaling Effect

(4) Information Content (5) Clientele Effect

 MM dividend irrelevance model holds good in a world of

certainty and confirms to condition of symmetric market rationality, which requires the following:
(1) All investors are expected to maximize their wealth.
(2) All investors will have similar expectation. (3) All investors behave rationally and believe that other

market participants also behave rationally.

 According to MM model the market price of a share,

after dividend declared, is calculated by applying the following formula:

P0
=

P1 + D1 1 + Ke

Where, P0 = Prevailling market price of a share P1 = Market price of a share at the end of period one D1 = Dividend to be received at the end of period one Ke = Cost of equity capital

 The number of shares to be issued to implement the new

projects is ascertained with the help of the following formula: I ( E nD1 )

N =
P1
Where, N = Change in the number of shares outstanding during the period I = Total investment amount required for capital budget E = earnings of the net income of the firm during the period n = Number of shares outstanding at the beginning of the period D1 = Dividend to be received at the end of the period one P1 = market price of the share at the end of the period one

Assumptions
(1) There are no personal or corporate taxes. (2) There are no stock flotation costs, transaction costs (3)

(4)
(5)

(6)

and brokerage fees. Dividend policy has no effect on the firms cost of equity. The firms capital investment policy is independent of its dividend policy. Investors and managers have equal and cost less access to information regarding future opportunities. All investors can lend or borrow at the same rate of interest.

(7) No buyer or seller of securities can influence prices. (8) Dividend decision are not used to convey information. (9) Perfect capital market exists with free flow of information. (10) Investors have rationally, they try to increase their income and wealth and are indifferent to the form in which a given increase to their income or wealth takes place viz, dividend or capital gain. (11) No tax differential between distributed and undistributed profits as also between dividends and capital gains. (12) Investment opportunities and future net income of all companies are known with certainty to all market participants.

BONUS SHARES
If a Company is profit making, its accumulated profits and reserves will go on increasing. Thus, actual capital employed i.e. share capital plus accumulated free reserves is much higher than the amount of share capital. The profit earned might appear to be much higher as compared to share capital. To avoid this abnormality in the capital structure, part of free reserves can be distributed among the existing shareholders by issue of bonus shares. Sometime, bonus shares also called as scrip dividends. As an alternative to paying out cash dividends every year, a company may choose to pay a scrip dividend. This is essentially a transfer to the shareholder of a no. of additional equity shares without the shareholder having to subscribe additional cash.

However, bonus share cannot be issued in lieu of dividend. The bonus issue increases the voting power of promoters marginally. The reason being, that the small shareholders position and representation gets diluted and spreads across the nation. Due to the increased volume of stock in hand, promoters are in a better position to trade and speculated well in the market without risk of being voted out.

PURPOSE OF BONUS SHARES

To restore the stock prices to a normal or acceptable rage of trading. To signal the future growth and earnings. To increase yield to shareholders. To expand equity base or its representation. To increase the quantum of cash dividend in future. To make the stock more attractive in the market, so that it is easy to sell future issues. To maintain companys historical dividend policies and practices. To achieve an optimal debt-equity ratio.

ADVANTAGES
It preserves the companys liquidity as no case leaves the company. The shareholder receives a dividend which can be converted into cash whenever he wises through selling the additional shares. It broadens the capital base and improves image of the company. It is an inexpensive method of raising capital by which the cash resources of the company are conserved. It reduces the market price of the shares, rendering the shares more marketable. It is an indication to the prospective investors about the financial soundness of the company. The quantum of cash dividend will increase in future years. It improves liquidity for the stock in the market, as more shares available in the markets, as well as, the stock becomes attractive. The bonus decision signals about the future growth and earning of the company.

DISADVANTAGE
The future rate of dividend will decline. The future market price of share falls sharply after bonus issue. Issue of bonus shares involves lengthy legal procedures and approvals. The chances of reaching a peak stock price performance may be lost. The company may not be in a position to maintain the same percentage dividend after a bonus issue. Retail shareholders have no choice except to accept the decision to bonus issue. Bonus shares cannot be declared in lieu of dividend. Bonus shares cannot be declared out of revaluation reserve.

IMPACT OF BONUS ISSUE DECISION

Increased no. of shares in the market Increased no. of shareholders Increased debt-equity ratio Decreased earning per share Increased cost of capital No change in cash position Changed composition of shareholders Increased cost of printing and issuing share certificates. Additional and increased annual fee to be paid to the registrar of companies.

Chapter 5

Valuation of Business

Introduction
The valuation of shares and business is resorted

when the mergers and acquisitions proposals are under consideration. Based on the value of business the purchase consideration is determined. It may also be warranted at the times of business alliance, joint venture, employee stock option plan, wealth tax assessment, purchase of controlling interest or block of shares, conversion of shares, pledging of shares as security for obtaining loan etc.
1 3 5

Conti
The

1 3 6

valuation of shares and business require expertise knowledge and hence a specialist valuer is appointed for the purpose. Value of business depends not just on assets it carries but is determined mostly by the projects in hand, the risk profile of the different classes of business it carries and intangible assets it possess. It is not at all possible to ascertain the value of business accurately, but the valuer uses his skill, experience and knowledge in determination of fair value of business. It is done by determining its market price. In publically quoted companies, whose shares re regularly traded on the stock exchange, the valuation of a company is simply valued by multiplying up the share price by the number of shares in issue.

Value of Share and company

Value per share

Shareholders equity No. of equity shares outstanding

Value of company = value per share * No. of

Equity share outstanding

1 3 7

Conti
Another way of ascertaining the value of

company is:
Enterprise Value = Equity value + Market Value

of Debt + Monitory interests + pension provisions + Other claims Value per share = Shareholders equity No. of equity shares outstanding
1 3 8

Conti
Difficulties in Valuation:

- Business are not alike and interchangeable

- Subject to corporate strategy - Auctions are often oligopolistic - Imperfect information - Management makes a difference - Closed auctions.

1 3 9

Conti
Capital Structure and Business Value

- A levered firm carries debt along with equity.

- The difference in the value of the levered

company is not just the value of debt. - The debt will bring with it interest tax shields which have a value in themselves, and it will also impose a different risk profile on the equity. - the more debt, the more the equity.

1 4 0

Asset Based Valuation

The value of the enterprise indicated the net assets 1 4 1

of the enterprise as shown in the books of account, it does not reflect the profitability of the business. Calculation of net assets should considers the following points: All tangible and intangible at net realizable value. All fictitious assets are to be ignored. Present worth of goodwill should be included in net assets. All outside liabilities are to be taken at payable date. Any appears of dividends, provision of tax , provision of doubtful debt etc. should be considered. From the amount of net assets, claim of preference shareholder is to be deducted to get the net amount of assets available to equity shareholders

Conti
Intrinsic Value of Equity share = Net Assets available to equity shareholders Number of Equity shares Example: 14.1 Example: 14.3

1 4 2

Valuation relative to Industry Average

Four methods:

Dividend yield method 2. Earning yield method 3. Return on capital employed method 4. Price/earning method
1.

1 4 3

Conti..
1.

Dividend yield method Value per share = (companys dividend per share / Industry average dividend per share) * Nominal value of companys share. Value of business = value per equity share * total number of equity shares.

1 4 4

Conti
Disadvantages: - It ignores the elements of capital gain which is the

1 4 5

important financial justification for investing in shares. - The growth of a company could be seen as being a mean to securing the flow of dividends to shareholders in future, rather than a goal in itself. - The method is based on the assumption that dividend policy will remain constant. In practice, companies can and do change their dividend policies. - In case of unquoted company, it is not suitable. Example: 14.3 Example: 14.4 Example: 14.5

Conti..
2. Earning yield method calculation of earning yield value involves three steps: A. Predict the future maintainable profits of the company being valued. B. Identify the required earning yield by reference to the results of similar companies. C. Apply the earnings yield to future profits using the following formula. Value of business = Companys expected future maintainable profits Industrys normal earning yield Example: 14.6, 14.7, 14.8, 14.9
1 4 6

Conti..
3. Return on capital employed method Steps are: a. Select the past period of investigation. b. Estimate the future maintainable profits, after making any necessary adjustments. c. Establish the acceptable normal rate of return on capital invested in a similar typr of company, allowing for the industry effect, the size of the company, and the level of capital gearing. d. Capitalize maintainable profits at a rate established as the acceptable rate of return. Value of Business: Companys estimated future maintainable profits Industrys normal rate of return on capital employed Example: 14.10, 14.11

1 4 7

Conti..
4. Price/earning method Value of business = Companys expected future maintainable profits * Industrys average P / E ratio. Value of Shares = Company's expected earnings per share * Industrys average P / E ratio. Example: 14.12
1 4 8

Conti
Fair Value of Share

It is = (Value of share under net asset method + value of share under dividend yields method) / 2 Example: 14.13, 14.14, 14.15

1 4 9

Discounted Cash flow valuation Models

Four models:

Discounted Dividend Model 2. Discounted Cash flow Model 3. Discounted Internal Rate of Return Model 4. Discounted Economic Value Added Model
1.

1 5 0

Conti
Discounted Dividend Model It estimates the equity value based on the view that the value of the equity equals all future dividends discounted back today. Steps are: a. It requires the estimation of future expected dividend payments, say first five to ten years which us called as explicit period and then discounted back today using the appropriated cost of capital for each year. b. After the explicit period, long term dividend growth and the appropriate long term cost of capital need to be forecasted in order to determine the terminal value of equity after the explicit period to infinity.
1.
1 5 1

Conti
c. The terminal value then need to be discounted back to present. d. The cost of capital used in calculation should reflect the inherent risk in that particular cash flow. The higher the risk, the higher the cost of capital. e. Only one cost of capital and one growth rate is used in terminal value calculation. Equation : page No. 754

1 5 2

Conti
2. Discounted Cash flow Model It equals the enterprise value of all future cash flows discounted back to today using the appropriate cost of capital. Steps are: a. Forecast the free cash flows and WACC for each year of the explicit period. b. Cash streams are discounted today. c. Cash streams after explicit year to infinity are calculated, assuming the cost of capital and growth rate are constant after the explicit period. Equation : page No. 754
1 5 3

Conti
3. Discounted Internal Rate of Return Model in this, the future cash flows are discounted using the weighted average internal rate of return of all projects with the company. Equation: page no. 755

1 5 4

Conti
4. Discounted Economic Value Added Model In this, the enterprise value equals the current capital stock plus the present value of all future EVA discounted to the present. It is measure of companys profitability and it is a variant of economic profit as determined by the accounting principles and practices.

Equation: page no. 755

1 5 5

Theoretical valuation model

Dividend growth valuation model 2. Walters share valuation model 3. Modigliani and Millers dividend irrelevancy model 4. Capital asset pricing model
1.

1 5 6

Conti
1.

Dividend growth valuation model It assumes a constant level of growth in dividends in perpetuity. Equation: page no. 756 Example: 14.16

1 5 7

Conti
2. Walters share valuation model He argued that in the long run the share prices reflect only the present value of expected dividends, retentions influence stock price only through their effect on future dividends. Equation : page no. 757 Example: 14.17

1 5 8

Conti
3. Modigliani and Millers dividend irrelevancy model MM argue that dividend policy does not have a significant effect on a firms value or on its share price. It asserts that firms value is determined solely by its investment decisions and that the dividend payout ratio is mere detail. Equation: page no. 758 Example: 14.18

1 5 9

Conti
4. Capital asset pricing model It can be used to determine required rates of return on financial and physical assets. The model provides a strong analytical basis for evaluating risk-return relationship. Equation: page No. 759 Example: 14.19

1 6 0

Valuation based on companys fundamentals

It asserts the importance of companys

a. b. c. d. e. f.
1 6 1

fundamentals for its valuation. The type of valuation also called stand alone valuation. Revenue or sales multiple Operating profit multiple Operating free cash flow multiple Operating multiple Price/earning multiple Price/book value multiple

Conti
Revenue or sales multiple It reflects the value of the enterprise in relation to its revenues. It used to calculate both enterprise value and equity value.\
a.

Equation: page no. 760

1 6 2

Conti
b. Operating profit multiple An EBIDT multiple express the enterprise value in relation to cash flow as ascertained from the income statement. Equation: page no. 761

1 6 3

Conti
c. Operating free cash flow multiple In this method, operating free cash floe is considered in valuation of the enterprise. The operating free cash flow represents EBIDT as reduced by annual capital expenditure and extraordinary items. Equation: page no. 761.

1 6 4

Conti
d. Operating multiple It express the value of the company in relation to a specific operational activity. For example: for cement industry, multiplier is EV / Metric tonnes production. Equation: page no. 761

1 6 5

Conti
e. Price/earning multiple It expresses the value of the equity in relation to its earnings after tax. The stock prices of quoted companies are regularly described in terms of their p ? E ratio. Equation: page no. 761

1 6 6

Conti
f. Price/book value multiple It reflects the market value of equity in relation to the companys book value. Book value is the adjusted book value of total assets less adjusted value of liabilities. Equation: Page no. 761

1 6 7

Chapter 6

Analysis of Risk and Uncertainty

Risk
Is the variability in the actual returns in relation to the

estimated returns. The decision can be broken in to 3 types: 1. Uncertainty 2. Risk 3. Certainty Risk refers to a set of unique outcomes for a given event which can be assigned probabilities, while uncertainty refers to the outcomes of a given event which are too unsure to be assigned probabilities. In risks, decision make can assign probabilities to various outcomes when they have historical data in uncertainty decision maker has no historical data.

 Starting a new product will have more uncertain

returns than the one involving expansion of an existing one. Estimating of returns from cost reduction type of capital budgeting will be subject to a lower degree of risk, than revenue-expanding capital budgeting project. Risk with reference to capital budgeting, results from the variation between the estimated and the actual returns. The greater the variability between the two, the more risky is the project.

Sensitivity analysis

I.

Is a behavioral approach that uses a number of possible values for a given variable to assess its impact on a firm s returns. One measure which expresses risk in more precise terms is sensitivity analysis. It provides information as to how sensitive the estimated project parameters, namely, the expected cash flow, the discount rate and the project life are to estimation errors. It provides different cash flow estimates under three assumption: the worst , the expected and the best outcomes

Simulation
Is a statistically based behavioral approach used

in capital budgeting to get a feel for risk by applying predetermined probability distributions and random numbers to estimate risky outcomes.
Example no: 12.3

Standard deviation
Is the square root of the mean of the squared

deviation being the difference between an outcome and the expected mean value of all outcomes.

Risk adjusted discount rate

Is a method to incorporate risk in the discount

rate employed in computing the present values.

Certainty equivalents
Are risk adjusted factors that represent the

percent of estimated cash inflow that investors would be satisfied to receive for certain rather than the cash inflows that are possible/uncertain for each year.

Dependent cash flows

Are cash flows in period depend upon the cash

flows in the preceding periods.

Independent cash flows

Are cash flows not affected by cash flows in the

proceeding or following years.

Chapter 7

Business Restructuring and Industrial sickness

Decision tree
Is a pictorial representation in tree form which

indicates the magnitude probability and interrelationships of all possible outcomes.

Chapter 8

Designing Capital Structure

Financial distress
Includes a broad spectrum of problems ranging

from minor liquidity shortages to bankruptcy.

EBIT-EPS analysis/approach
Is an approach for selecting capital structure that

maximizes earnings per share (EPS) over the expected range of earnings before interest and taxes.

Coverage ratio
Measures the size of interest payments relative to

the EBIT and the adequacy of EBIT to meet payment obligations.

Cash flow analysis

Evaluates the risk of financial distress.

Debt capacity
Relates to how much debt can be comfortably

serviced.
Example no 20.1

manoeuverability
Implies the ability to adjust source of funds in

response to change in the need for funds.

flexibility
As to financing is important when future external

financing will be necessary.

CAPITAL STRUCTURE PRACTICES IN INDIA

Indian corporates employ substantial amount of debt in their

capital structure in terms of the debt-equity ratio as well as total debt to total assets ratio.Nonetheless.the foreign controlled companies in India use less debt than the domestic companies.The dependence of the Indian corporate sector on debt as a source of finance has over the years declined particularly since the mid-nineties. The corporate enterprises in India seem to prefer long-term borrowings over short-term borrowings. Over the years,they seem to have substituted short-term debt for long-term debt. The foreign controlled companies use more long-term loans relatively to the domestic companies. As a result of debt-dominated capital,structure,the Indian corporates are exposed to a very high degree of total risk as reflected in high degree of operating and financial leverage and,consequently,are subject to a high cost of financial distress which includes a broad spectrum of problems ranging from relatively minor liquidity shortages to extreme cases of bankruptcy. The foreign companies, however, are exposed to lower overall risk as well as financial risk.

CAPITAL STRUCTURE PRACTICES IN INDIA

The debt service capacity of the a sizeable segment of the

corporate borrower as measured by (i) interest coverage ratio and (ii) debt service coverage ratio is inadequate and unsets-factory. Retained earnings are the most favoured source of finance.There is significant difference in the use of internally generated funds by the highly profitable corporates relative to the low profitable firms.the low profitable firms use different form of debt funds more than the highly profitable firms. Loan from financial institutions and private placement of debt are the next most widely used source of finance The large firms are more likely to issue bonds in the market than small corporates. The hybrid securities is the least popular of finance amongst corporate India.They are more likely to be used by low growth firms.preference shares are used more by public sectors units and low growth corporates. Equity capital as a source of funds is not preferred across

Summary
A host of factors both quantitative and qualitative,including subjective judgment of financial managers have. a bearing on the determination of an optional capital structure of a firm They are not only highly complex but also conflicting in nature and,therefore cannot fit entirely into a theoretical framework moreover the weights assigned to various factors also vary widely,according to conditions in the economy, the industry and the company itself. Therefore, a corporate should attempt to evolve an appropriate capital structure, given the facts of a particular case. The key factors relevant to designing an appropriate capital structure are; (i) profitability (ii) liquidity (iii) control, (iv) leverage ratios in industry, (v) nature of industry, (vi) consultation with investment banks/lenders, (vii) commercial strategy, (ix) company characteristics and (x) tax planning. Given the objective of financial management to maximise the shareholders wealth a corporate should carry out profitability analysis in terms of determining the amount of EBIT (indifference point) at which its MPS is identical under two proposed financial plans. In general, the higher the level of EBIT than the indifference point and the lower the probability of its downward fluctuation the greater is the amount of debt that can be employed by a corporate.Coverage ratio can also be used to judge the adequacy of EBIT to meet the firms obligations to pay financial charges,interest on loan preference dividend and repayment of principal. A higher ratio implies that firm can go for lager proportion of debt in its capital structure. Liquidity position of a firm is

Chapter 9

Operating Financial and Combined Leverage

Leverage
Is the employment of an asset/source of finance

for finance for which firm pays fixed cost/ fixed return.

Operating leverage
Is caused due to fixed operating expenses in a

firm.

Operating risk
Risk of not able to cover fixed operating costs by

firm.