Financial Management I

The finance function is very important as

money forms the common fabric of all the
decisions made by managers. There is no
function or manager for whom money does not
matter.
Eg: R&D, Materials etc.
Objective: Maximizing the value of shareholders
by maximizing the value of the firm.

Why not maximization of profit? (Example)

Value of the firm=

What about other stakeholders?

Who are other stakeholders?

When value of the firm increases, it is not only

the shareholders who are benefited, but all
stakeholders, one can even say the objective is
maximizing stakeholders’ value
Relationship to accounting

Emphasis Role
Accounting: Develop & report Collecting & presenting
financial performa- financial data
ance of the firm on
accounting basis
Finance: Maintaining cash Decision making based on
flows to satisfy financial data
requirements
Role of the Financial Manager (FM)

FM

Mobilization of Deployment of Control of use Risk-Return

Funds Funds Of Funds Trade-Off
Other challenges:
 Short-term fund management (Treasury operations)
 Foreign exchange management
 Financial structuring
 Policies directed at maintaining share prices
 Policies aimed at ensuring management control
Interface between Finance with other
Functional areas
Marketing-Finance: Marketing get customers on
specific terms & conditions which will have impact on
profitability (delivery, credit, prices & discounts,
promotions & ads, product mix etc)
Production-Finance: Production get the products
made by utilizing the eqpt, inventory etc( cost of
prodn, inventory, make or buy, OHs, consumables)
HR-Finance: Increments, bonuses, stock options,
perquisites & benefits
Top Management-Finance: Strategic decisions
(investments, acquisitions, meeting with analysts &
media etc)
Environment of Corporate Finance
FM needs
- to understand the ext. envt.
- thorough understanding of regulatory
framework (ability to raise funds) not only of
India but also other countries Eg: Infosys
- to know the structure of the financial markets
-to know Tax legislation
Forms of business organization (Adv & Disadv)
 Sole proprietorship
 Partnership
 Companies (Diff between Pvt. Ltd & Pub. Ltd Presentation
by students))
 Financial System

Flow of funds

( Savings)
Seekers of funds
(mainly business Suppliers of funds
firms, financial (mainly households)
Flow of financial
Institutions & govt)
assets & services

Incomes & financial

claims
 The functions performed by a financial
system
Savings function
Liquidity function, the ability to convert a
financial asset into money
Payment function (cheques, credit cards, ECS
etc)
Risk function( insurance, portfolio or hedging
opportunities)
Policy function (regulatory & control
mechanisms by different bodies)
Financial Markets
A market where financial assets are created or
transferred. (What are financial assets?)
Can be divided into two: Money Markets &
Capital Markets
Money Market: A market that deals with short term
needs of funds ( call money markets, Govt. Securities
markets, commercial papers & certificate of deposits,
money market mutual funds)
Capital Market: Meets long-term needs of funds
(primary & secondary-students to make presentation)
Other Major Markets/Sub-Markets
Forex Market- where transactions in foreign
currencies happen; the need; the mechanism; physical
location largely absent as trading happens through
communication channels; open 24 hrs
Govt. Securities Market- Part of the money market-
where securities issued by Govt. or Govt. owned
bodies get transacted. Major players usually are banks
and financial institutions; dedicated MFs also play.
Derivatives Market: The word originates from
mathematics; refers to a variable which has been
derived from another variable; a financial derivative is a
product derived from the market of another product;
thus derivative markets have no existence without an
underlying asset. The price of the derivative instrument
is contingent on the value of its underlying asset
Business is subject to variety of risks. Many risks are
difficult to avoid, especially those arising from erratic
movements in markets. Such movements may adversely
affect or have severe impacts on revenues and costs
and may even threaten the viability of business.
Derivatives help in managing risks, arising from
movements in markets. Major participants are banks,
FIs, corporates, brokers and individuals.
Sources of Long-term Finance (Explain in detail
incl. advantages & disadvantages)
 Equity capital
 Preference capital
 Debenture capital
 Term loans & deferred credit
 Govt. subsidies
 Tax exemptions & holidays
 Leasing & Hire-purchase
 Foreign sources
 Venture capital
 Warrants
Methods to raise LT funds
IPO
Public issue by listed cos.
Rights Issues
Preferential issues
Private placements
Term loans
Venture capital
Time Value of Money
A rupee today is worth more than any time in the
future
Anybody would part with a rupee only if he
receives more than a rupee in exchange in
future. Why?
A Finance Manager dealing with money/cash
flows have to worry about time value.
FM must be familiar with Compounding,
Discounting and also applications of the same
including Perpetuities and Annuities.
(Problems to be done in the class: Ref)
Risk & Return
Investments are made with an intention of getting
returns, be it a firm or individual.
But, we know that different types of investments will
fetch you different types of returns.
For eg: List out various forms of investment
opportunities and their probable returns. The returns
vary.
Why?
How do the returns differ from one another?
(Fixed deposits with the banks, FDs with NBFCs,
Bonds/ Debentures, Preference Shares, Equity
Shares etc)
Components of Return
a. Periodic cash streams from the investment (interest,
dividends etc).
b. Appreciation ( depreciation) in the very price of the
asset (investment) itself- capital gains (loss)
Measuring return
The rate of return is the total return the investor receives
during the holding period stated as a percentage of the
amount of investment made at the beginning of the
holding period. The total return is the sum of interim
cash flows like interest or dividend and the price
differential of the asset from the date of purchase & date
of selling
The return equation can be
rt= Ct + Pt – Pt-1
Pt-1
where r= the rate of return
Ct= Cash flow received during time t
Pt= Price of the asset at time t
Pt-1= Price of the asset at time t-1, ie at the
beginning of the holding period or the
purchase price

Returns can be ex-post (realized or historical) or

ex-ante (expected)
 Probabilities of returns
The expected returns from an investment may vary
based on the probable variations that affect the
returns.
Eg: Investors’ assessment of return on a share of ABC
Corp may vary according to three different scenarios
that could exist:

Scenario Chance Return %

1 0.25 36
2 0.50 26
3 0.25 12

What is the expected return from the company?

Generalizing,
Expected return r = p1r1+p2r2+-------+pnrn
n
or r = pi ri
i=1
Risk
We saw that the returns from various types of
investments vary. From our earlier example, we could
find that depending on the typical scenario prevailing
return can vary. Our expected return was 25 % but for
scenario 1, it is 36%, scenario 2, it is 26% and for
scenario 3, it is 12%.Thus there can be variations in
the returns from the expected one. And this is the risk
we have to take while investing. Risk is the chance
that the actual outcome from an investment will differ
from the expected outcome. The more variable the
possible outcomes that can occur, the greater the risk.
Since variability of returns indicates risk, risk can be
measured statistically by ascertaining how much the
actual return varies from the expected return.
A simple example:
There are two shares available to you for
investment, Share P and Share Q which
provided returns(%) as follows in the last 5
years.
Share P: 30, 28, 34, 32 and 31
Share Q: 26, 13, 48, 11 and 57
Suppose you want to invest only in one, which
will you choose? Why?
Sources of Risk
 Interest rate risk (affecting fixed income securities
more)
 Market risk – due to fluctuations in the securities
market
 Inflation risk (related to interest rates)
 Business risk ( due to tech changes, policy changes,
regulatory changes etc)
 Financial risk (when required to meet financial
commitments usually linked to debt called
leveraging)
 Liquidity risk (ease of transaction; all securities are
not equally liquid)
Variance or std deviation is used to measure variability of
the actual data from the mean of the data. Thus variance
or std. deviation can be used as a proxy for risk. Since
variance is expressed as a square, which makes
understanding difficult, std. deviation is commonly used to
measure risk.
Let’s try to find out about the risk of shares of ABC Corp
discussed above by finding out standard deviation

Scen Chance Return%

ario
1 0.25 36

2 0.50 26
r =25
3 0.25 12
Going back to our example of shares P and Q,
std. deviation of P is and std. deviation of
Q is .Hence we can say that share is
times riskier than share .
Portfolios & Risk
Investing the entire money in one asset can be highly
risky as if something happens to the company, all your
investment will be reduced to nought. So it is
advisable to divide your investible funds into two or
more assets.
“Don’t put all your eggs into one basket” is the oft
heard advice. A portfolio is a set of assets that is
owned by an investor. The purpose of creating a
portfolio is to achieve a reduction of risk through a
process known as diversification. Diversification can
be achieved within an asset class or across asset
classes.
Let’s see how it works:
Let’s look at a simple scenario of a portfolio of two
securities, our ABC Corp & XYZ Ltd.
Investors’ assessment of returns on shares of the
companies are as follows:

Scenario Chance Return

ABC XYZ

1 0.25 36 22

2 0.50 26 16

3 0.25 12 14

Let’s assume that an investor puts 60% of funds in

ABC and balance in XYZ.What would be the expected
return & risk of the portfolio?
Expected return from ABC=

Expected return from XYZ=

Expected return from the portfolio

=
Calculating portfolio risk from first principles

Return % Portfolio Deviation Chance X

Scenario Chance Return Deviation Deviation
Squared
ABC XYZ Squared

1 0.25 36 22 30.4 8.60 73.96 18.49

2 0.50 26 16 22.0 0.20 0.04 0.02

3 0.25 12 14 12.8 -9.0 81.00 20.25

E ABC=25 , E XYZ =17,E P =21.80 Portfolio Variance= 38.76

Variance of portfolio return =38.76

Std. Deviation of the portfolio = 6.23%
Covariance between returns of ABC and XYZ

Chance *
Scen- Chance Return Return Deviation Deviation Product of
Product of
ario p ABC XYZ RABC-EABC RXYZ-EXYZ deviations Deviations

1 0.25 36 22 11 5 55 13.75

2 0.5 26 16 1 -1 -1 -0.50

3 0.25 12 14 -13 -3 39 9.75

EABC=25 E xyz= 17 Covariance = 23

Risk of the portfolio = 6.23%

Covariance = 23
The Correlation Coefficient measures how
large the co-variance is in relation to the
variability in the individual returns
x, y
Correlation Coefficient x, y =
x y

In our example, x, y = 23, x = 8.54

and
y = 3 and so the correlation coefficient
is 0.90, which tells us that the two shares are
expected to move in the same direction (as
is positive) but not exactly in step with each
other (as is less than 1)
Correlation Coefficient (CC)
 Ranges from -1 to +1
 If two returns move exactly opposite to each other, the
CC is -1;if they move exactly in step with each other,
the CC is +1; if they are entirely unrelated to each
other, it is 0.
 Positive correlation less than +1, indicates that the two
returns have a tendency to move in the same
direction, but not always in exact step with each other.
(as in our example)
 Imperfect +ve correlation is most commonly observed
as two different securities of two different firms can
hardly be expected to move in perfect harmony with
each other as various factors affect the companies in
different ways.
Diversifiable & non-diversifiable risk:
 Diversifiable risk or unsystematic risk is risk arising from
firm specific factors like demand for the company’s
products, higher costs incurred by the company due to
lack of control, labour problem in the company, poor
management etc etc.
An investor can reduce the impact of these risk factors by
buying into shares of companies where one or many of
such risks don’t exist.
 Non-diversifiable or systematic risks are those which
affect all the companies more or less alike. Eg: Increase
in Corporate Tax rates, changes in the Govt’s economic
policy, an industrial recession, increase in inflation rates,
fluctuations across the market as reflected in the changes
in market indices etc etc. Since they affect the entire
market, also called
market risk.
Number of securities in the portfolio
The aim of any portfolio is risk reduction. So, if you are
talking about an equity portfolio, how many shares will
be needed to achieve an almost total elimination of
diversifiable risks?
While addition of shares in the initial stages will result
in rapid decline of risk, the percentage of decline of
risk reduces as we go on adding more and more
shares. It has been observed that as the number of
shares in the portfolio reaches around 20, the risk
reduction rate declines and tapers off.
R
I Diver-

S sifiable Risk

K Non-diversifiable Market Risk

20

NO. OF STOCKS
Risk of a portfolio
In a well diversified portfolio, all the unsystematic
(diversifiable) risk must have been eliminated and only
that risk which can’t be diversified away is applicable.
How do we measure the non-diversifiable risk? For
this one has to know by how much the returns on the
portfolio varies for a 1% change in the returns of the
market portfolio. This relative risk can be used as an
effective proxy for the non-diversifiable risk as market
portfolio represents the most diversified portfolio of
risky assets an investor could buy. It gives us an idea
of the vulnerability of a portfolio’s return to market
risk. This vulnerability is measured by the sensitivity of
the return of the portfolio vis-à-vis the market return
and is indicated by (Greek letter Beta)
A beta of 2 means when the market return
increases by 10%, security (portfolio) return
increases by 20%.A beta of 0.5 means that if
the market return increases by 10%, security
(portfolio) return increases by 5%.A beta of 1
means that the security (portfolio) return moves
in tandem with the market return. By default,
the market portfolio has a beta of____ ?
Estimating Beta
We can use regression method using periodic (daily,
weekly, monthly etc) returns from the security
(portfolio) and returns from the market.
The methodology
Plot the returns from the market along the X-axis and
those from a share/portfolio corresponding to those
market returns on the Y-axis. You may get a scattered
diagram. Using the method of regression, we can find
the best-fitting line and can be expressed as
k j = α j+ β j k m + e j
There may be a return from the share/portfolio when
the market return is zero. This is represented by the Y-
intercept and is referred to as α (Alpha); ej is error
The β j in the equation represents the slope of the
fitted line and measures the responsiveness of the
security/portfolio to the general market .It is defined as
the ratio of the security’s covariance of return with
the market to the variance of the market.

Or β j = Cov ( k j, km)
Var (km)
∑ p (k j - k j )( km – k m )
=
∑p (km – km)2
Capital Asset Pricing Model
Investors always have access and option to invest in
certain types of instruments which offer risk free
returns. For example, when one puts his money in a
fixed deposit of a bank or in a treasury bill, he is
assured of the contracted interest returns, or we say
that these instruments represent the risk-free
category. The returns from them can be considered to
be risk-free. So, whenever he invests in a risky
security or portfolio, he expects to get a premium on
returns to compensate for the risk. Or he demands a
risk premium.
Or, he needs
Return from the risky security/portfolio = Risk-free
return + Risk premium corresponding to the risk.
Or
Risk premium = Return from the security - Risk Free
return.
In a competitive market, the diversifiable risks can be
eliminated and hence only market risk has to be
considered, represented by the Beta of the
security/portfolio.
In the 1960s, Sharpe, Lintner and Mossin evolved this
into a model, which came to be called the Capital
Asset Pricing Model (CAPM). According to this,
Expected Risk premium on stock/portfolio
=
Beta Expected risk premium on market
or R – R f = β ( R m – Rf)
 Assumptions underlying CAPM
 While investing in a portfolio, investors are concerned only
about risk & return.
 Purchase or sale of a security can be undertaken in
infinitely divisible units.
 Short selling without limit can be resorted to.
 Market is efficient. All information that could possibly
affect the prices becomes available to all investors quickly
and more or less simultaneously.
 There are no transaction costs or taxes.
 Investors can borrow and lend any amount at the risk free
rate.
 Investors have homogenous expectations w r t the
decision period.
Dividend Capitalization Model
This is another model investors use when they
investing in stocks. It works on the premise that the
price of any share is based on the benefits the holders
of the share expect to receive in future in the form of
dividends or the present value of future dividends,
computed at an appropriate discount rate. The return
from holding the share is received in the form of
dividends or capital appreciation at the time of selling.
The risk part is reflected in the discount rate selected.
The methodology used is known as fundamental
analysis of investments and form the basis of Value
Based Investing. Decisions regarding purchase or sale
will be made based on the difference between the
fundamental value and the market value.
Example:
We expect to receive dividends of Rs.20, Rs.30
and Rs.40 respectively at the end of 1st, 2nd and
3rd year respectively. If you desire to earn a
return of 25% p.a. on your investment, how
much shall I pay for the share now?

As you were firming your decision to purchase

the share, information came about the
probability of the company not meeting its
projected financials. If you want to incorporate
this new information (involving risk &
uncertainty), how would you do it?
 Valuation of Securities
The concept of valuation in investments
Methods of Valuation:
 Book value: based on accounting concept; recorded at
historical costs and depreciated over years.
 Replacement value: the amount the company would be
required to spend if it were to replace its existing assets
in the current condition.
 Liquidation value: the amount the company can realize if
it sells its assets after having terminated its business
 Going concern value: the amount the company can
realize if it sells its business as an ongoing, operating
one
 Market value : the current price at which the asset or the
security is being sold or bought in the market
Calculating growth rate of dividends:Explain
Valuation of Bonds: Govts or companies can
raise money through issue of bonds. A bond is a LT
debt. When one owns a bond, he/she receives a set of
cash flows in the form interest payments( at
predetermined intervals) and get back the value of
bond on maturity (completion of term)
Terminologies: Face Value; Coupon Rate;
Maturity; Redemption Value; Market Value

Eg: You want to invest in a bond carrying 8% coupon

rate and face Value of Rs.1000 today maturing in
2013.How much should you pay for it now if similar
treasury bonds currently offered 9%. What will you pay
if the interest rate in the market (a) falls to 5% or )b)
increases to 12% ?
Yield to maturity: In our example quoted
above, suppose we buy the bond at Rs.
and hold the same till maturity, what return
could be expected by investors? . This rate is
called the bond’s yield to maturity (YTM)
(H/W)
Bond prices and compounding
intervals : Coupon payments may be made
at more frequent intervals (semiannually,
quarterly etc). In such cases the PV formula will
need changes in the values of “r” and the
coupon payments.
Warrants and Convertibles:
A warrant is an option which gives the holder the
right to buy a stated number of shares on/during
a specified date/period in future. The number of
shares and the price at which the option can be
exercised and the expiry date are stated at the
time of issue. Warrant holders normally have no
rights as shareholders.
A Convertible is any financial instrument that can
be converted into a different security (usually
equity). A convertible debenture is a debenture
which is convertible (partly or fully) into equity
shares. The conversion is either optional or
compulsory.
The exercise price is what the holder must pay to
purchase the share.
Valuation depends on the premium the investor
can get at the time of exercise. Usually the
premium associated with the warrant
decreases as the expiry date approaches.
Value of a Convertible:

n
∑ C + Pn Conversion Ratio
t=1 (1+r)t (1+r)n
Where C=coupon amount
r= reqd rate of return
Pn = exp. Price of equity share on
conversion
n = no of years to maturity
Equity Evaluation
Dividend Model/Dividend Capitalization Model
We have already seen that the price we are prepared
to pay for a share is nothing but the present value of
the dividends we expect to receive on the share and
the price at which we expect to sell it in the future.
Abstracting from our example, if the investment
horizon is one year, the present value or the
fundamental value of the share today will be
P(0)= D(1)+P(1) (Eq 1)
(1+k)
where D(1) is the expected dividend at the end of the
year
P(1) is the expected price at the end of the year, and
k is the appropriate rate of return for the share.
 What is the diff between P(1) and P(0)?
Applying the same procedure to find the price at the
end of the first year P(1) w r t to price at the end of the
second year,P(2),
P(1) = D(2)+ P(2) where (Eq. 2)
(1+k)
D(2) is the expected dividend at the end of the second
year,
P(2) is the expected price of the share at the end of
the second year.
Substitute the value of P(1) from Eq 2 in Eq 1.
The process can be repeated to any number of
years. If we do the process indefinitely (without
an intention of selling), the P(0) would be
nothing but the discounted value of the
expected future dividends.
Or,P(0)= D(1) + D(2) + D(3) + -----
(1+k) (1+k)2 (1+k)3
If the company is expected to pay a uniform
dividend of D, or D(1)=D(2)=D(3)=……=D,
then P(0) will be D + D + D + ……
(1+k) (1+k)2 (1+k)3
Or P(0)= D/k (ref Annuity formula)
Valuation under dividend growth
Assume that the dividend grows at a
compounded rate of g per annum. If dividend at
the end of first period is D(1), then dividend at
the end of second year is D(1)(1+g) and that at
the end of third year is D(1)(1+g)2 and so on.
Then
P(0) = D(1) + D(1)(1+g) + D(1)(1+g)2 +……..
(1+k) (1+k)2 (1+k)3
This expression gets simplified into
P(0) = D(1) when g is less than k
(k –g)
Cost of Capital
Is the rate of return a firm must earn on its
investments for the market value of the firm to
remain unaffected. Thus, COC can be regarded
as the rate of return required by investors on
capital provided by them.
Why needed?
1.For analyzing cap. inv. decision COC is required.
2.Other decisions like leasing, long-term financing, and
working capital policy requires estimate of COC
3.For maximizing the value of the firm, the costs of all
inputs, including the capital input, must be minimized
and hence the need to measure the COC.
Capital components
Only LT capital considered
1. Long-term debt capital (Debenture, Term-
Loan)
2.Preference capital
3. Equity (PUC + Retained Earnings)
1.Cost of Debt capital
a. Cost of Debenture: is defined as the discount rate
which equates the net proceeds from issue of
debentures to the expected cash outflows in the form
of interest payments and principal repayment
 n
Or P = C(1-T) + F

t=1 (1+kd)t (1+kd)n

where P= net amount realized on debt issue

C= annual interest payable
T= tax applicable to the firm
F= redemption price
n= maturity period of debt
Please note that the annual interest cost is multiplied
by (1-T) to reflect that interest is a tax deductible
expense. Or tax deductible interest expense of C
brings a tax-shield of CT. (See example below)
 Co A Co B
Earnings before Interest & Taxes (EBIT) 100 100
Interest (I) -- 60
Profit Before Tax (PBT) 100 40
Tax (T) 50 20
Profit After Tax (PAT) 50 20

It is evident that an interest payment of 60 in Co B

brings a tax shield of 30 which means that the post tax
cost of the interest payment of 60 is only 30 or net of
tax, the cost of interest is only 30.
 An Approximate method of calculating cost of
debt

K d = C (1-T) + (F-P)/n
(P+F)
2
If interest is payable half yearly, the COC will
k d in 2n
P= C(1-T)/2 + F
t= 1 (1+kd)t (1+Kd)2n
 b. Cost of Term Loans from FIs.
COC= Interest rate(1-T)
c. Cost of preference capital
Fixed dividend, payable at the discretion of the BOD
but Cos intend to pay and shareholders
expect to receive dividends regularly
Thus cost of Pref. Cap. Is K p in
n

P= D + F where
t=1 (1+kp)t (1+Kp)n
P = net amount realized per pref. share
D=Pref. Div. per share payable annually
F=Redemption price
n= maturity period
 An approximation

K p = D+ (F-P)/n
(P+F)
2
∞
Cost of Perpetual pref. cap: P= D
t=1 (1+kp)t
Cost of Equity Capital
The rate of return reqd by the suppliers of debt capital
and preference capital can be ascertained easily
because the benefits expected by them can be
defined with near certainty. The estimation of the rate
of return required by the equity shareholders is difficult
as benefits expected by them can’t be ascertained
easily. To overcome this problem, different
approaches have been proposed: dividend
capitalization, CAPM, realized yield, bond-yield plus
premium, and earnings –price approaches.
 Dividend capitalization approach:
We know that
P0 = D1 + D2 +----------+ D∞
(1+ks) (1+Ks)2 (1+Ks)∞

where P0=current mkt. price of the equity share

D t=Div. expected at the end of the year t
Ks=equity shareholders’ reqd. rate of return
If shareholders expect constant dividend every
year, then
ks= D
P
If they expect the dividend to grow annually at
the rate of g per cent forever, then
P0 = D1 + D1(1+g) + D1(1+g)2 + -----
(1+ks) (1+ks)2 (1+ks)3
P0 = D1 or k s= D1 + g
ks-g P0
Realized Yield Approach
According to this, the yield (rate of return)
realized by equity shareholders historically is
regarded as a proxy for the rate of return
required by them. The yield is calculated as
Yt = Dt + Pt - 1
Pt-1
where Yt = yield for year t
Dt = dividend per share for year t payable at the end
of year t
Pt = price per share at the end of year t
Pt-1 = price per share at the end of the year t-1 or at
the beginning of the year t
Dt + Pt is referred to as the wealth ratio, Wt
Pt-1
For an n-period, the yield is
(W1×W2×W3×……×W n)1/n – 1
where W1 = D1 + P1
P0
W2 = D2 + P2
P1
:
:
Wn = Dn + Pn
Pn-1
Capital Asset Pricing Model
According to CAPM,
ki = rf + β ( km-rf)
Where ki = rate of return reqd on security i
rf = risk-free rate of return
βi = Beta of security I
km = the return on the market portfolio
Hence we need estimates of rf, km, and β
While elegant and rigorous in theory, approach is based on
assumptions on which CAPM is based. It is true only for
a diversified portfolio; β varies over time; even risk-
free returns vary over time. But in a perfectly functioning
market, the CAPM approach can be the best proxy for
the reqd rate of return as it considers both rf and km.
Bond Yield Plus Risk Premium Approach
According to this, the required rate of return is equal to
Yield on the long-term bonds of the firm + risk premium
Logic: Investors require a return higher than the bond
holders as they are subject to higher risks.
Difficulty: What is the risk premium to be charged? This is
subjective.
Earnings Price Ratio Approach
according to this, the rate of return required by equity
investors is equated to
E1/ P0 where
E1 = the expected EPS for the next year
P0 = current market price per share
E1 may be estimated as
Current EPS * (1+growth rate in EPS)
Suitable when
a. the EPS are expected to remain constant
and the payout ratio is 100%
b. retained earnings if any are expected to earn
a rate of return equal to the rate of return
required by equity investors.
Cost of External Equity
a. Dividend cap. Approach when div is expected to
grow at a constant rate
ks = D1/ P0 + g where P0 is the share price But
the price issued and realized may be different from P0
as there may be underpricing when new shares are
issued and also there may be issue expenses which
have to be deducted from the issue price. Then the
cost of external equity will stand modified as
ks = D1/ P0(1-f) + g
where f is the fraction of P0 that accounts for
underpricing and issue expenses.
Cost of Retained Earnings
Two approaches:
1.Tax-adjusted rate of return approach:
The retained earnings can be contributing to the
strength of the value of the company. Or it will be
reflected in the price of the co’s stock in the market.
Any price increase of the stock can result in capital
gains for the stockholder. Hence, the company’s return
must take care of the capital gains tax that may
become incidental on the shareholder. But shareholder
themselves may be tax payers at the individual level
and thus he will be content with a return that is adjusted
for his personal income tax.
or k r = k s (1-t p)
(1-tg)
Where k r= cost of retained earnings
ks = rate of return required by equity investors
tp = ordinary personal IT rate
tg = personal long-term capital gains tax rate
Pitfalls: a. The IT rate may vary across the
shareholders
b. Alternative investment opportunities are not
considered.
2.External yield approach: The premise is that the co
should evaluate the possibility of buying shares of
other companies with similar risk characteristics by
using retained earnings. Hence the cost of retained
earnings is deemed equal to the rate return that can
be earned on such investment.
Average COC
A firm’s COC is the weighted arithmetic average of the
post tax cost of various sources of long- term finance
used by it.
Or, if a firm uses n different sources of finance it’s
COC is
n
ka = ∑ wi ki
i=1
Where ka = av. coc
wi = proportion or weight of the ith source
of finance
ki = cost of the ith source of finance
Determination of weights
The weights or proportions may be based on
Book values
Financing plan (proposed for a new project)
Market values
The best is supposed to be the market value-
based.
Weighted Marginal Cost of Capital Schedule
The weighted av. COC will not remain same
irrespective of the magnitude of financing. It will
change and COC tends to rise as the firm
seeks more capital. This is because the supply
schedule is typically upward sloping- as
suppliers provide more capital, the rate of
return required by them tends to increase. The
weighted marginal cost of capital schedule is
the graphical relationship between additional
financing and the weighted average cost of
capital.