Copy of Financial Mgmt

7/28/2019 Copy of Financial Mgmt

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Financial Management

Faculty: Gautam Negi


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Karma

Dharma

Moksha


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The Essence of Theory Lies in Practical

Application


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Objectives

Clarity on concepts

Ask questions reason..keep me on my toes.

Get attentive, interested and interactive

Peer learning

Stay disciplined and punctual

Love the subject.it will love you back


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There are no shortcuts in learning

We will create a glossary of 1000 financialwords in the next 3 months

Reference Books:

Prasanna Chandra

Van Horne

I M Pandey

Damodaran


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COURSE LAYOUT

INVESTMENT

FINANCING/WCMgmt

DIVIDEND VALUATION

Capex decisionsComplex decisionsCost of CapitalCash FlowRisk Analysis

Sources of Finance Capital Structure Deci Leveraging Inventory Mgmt Cash Mgmt

Dividend Relevance Dividend Irrelevance Value of firm

sential Tools:Time Value Of MoneyAnalysis Of Financial StatementsRisk Return Trade Off

Valuation concepts and Models(CAPM/APT)


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Contents

Introduction

Agency Costs

Time value of money

Valuation of Assets

Risk, Return, Portfolio

Beta Estimation

Financial Statements

FS Analysis

Capital Budgeting Decisions

Cost of Capital

Cash flow estimation

Risk Analysis in Capex

Operating and FinancialLeverage

Capital Structure

Introduction to Dividends

WC Management

Receivables Management

Inventory Management

Cash Management

WC finance


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Financial decisions can also be classified as

Long term

Short term

Functions of a Finance Manager Funds raising(Asset Mgmt-> Liability Mgmt-> Funds

Mgmt).

Funds Allocation

Profit Planning(Pricing/Cost/Volume Of Output)

Understanding the capital Markets


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The firm and its Objective..

Defining the Firm

Why a UNIQUE OBJECTIVE

Unique helps in harmony in decisioning Objective gives direction and must be SMART

Objective of the firm-> max value of

the firm-> Max Stock Price Managers are appointed by SHs. lenders can

protect themselves contractually


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Why Stock Price as the Objective

Most observable and updated constantly

Stock price reflects the long term effects ofthe firms decisions

Stockholders can liquidate and receive valuenow


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Agency Costs

MANAGERS

Shareholders

Society

Bondholders

FinancialMarkets

Firm positioned in an ideal world

Stockholders andManagers

Stockholders andBondholders

Firm and the Financial

Markets

Conflict betweenGroups


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Agency Costs between Groups

MANAGERS

Shareholders

Society

Bondholders

FinancialMarkets

Investing in badprojects

Overleveraging Overpaying on a

takeover Giving high dividends Resisting company

takeover

Overleveraging

Suppressing/delaying Info (eg.Satyam)


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Should stock price be taken as ameasure of Managerialperformance

Ability of the managers to suppress/delay info

Efficiency of the Capital Markets


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Ways to reduce Agency Costs

SHs and Managers

Disciplining the managers through an effectiveBoard/AGM

Making Managers think like SHs Threat of takeovers(Greenmail/Poison Pills/Golden

Parachute)

SHs and Bondholders

Bond Covenants(Affirmative/Negative)

Restricting investment policy/dividendpolicy/additional levarage.


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Ways to reduce Agency Costs

Firms and Financial Markets

Role of regulatory bodies(SEBI)

Making markets more efficient

Firms and Society

Corporate Citizen Behavior


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Other possible Objectives

Max of Profits

Window dressing/focus on the current only/ignorestime value of money

Max Market Share(Japan/China) Max Growth/Size/Revenues

Social Welfare Objectives..

conflict behind wealth maximization as an objective and Social welfare is the rhools have introduced Ethics in the curriculum


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Defense strategies against possibletakeover

Golden parachute

Greenmail

Poison Pills

Sell valuable portfolio(crown jewels)

Increase leverage Use up excess cash

Third party partnership with a break up fee.


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Introduction to FS

Suppliers of

funds:IndividualsCompanies

Govt

Demanders offunds:IndividualsCompanies

Govt

FinancialInstitutions

BanksInsurancecompanies

Mutual fundsProvident funds

Financial Markets

Funds

Funds

Deposits/shares

securiti

es

loans

Loancontract

securities

funds


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Time Value Of Money


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Time Value Of Money

Money has time valuewhy

Productivity

Why do you need to earn interest..

Presence of inflation

Preference to current consumption

How much return must you expect

Real rate

Inflation

The Fischers Effect


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Cont

Concept of compounding/discounting

Concept of SI/CI

FV of an amount being compounded Continuous compounding

Understanding the doubling rule

Rule of 72

.35+69/r

2=(1+r)n


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Time Value Formulae

PV of CF

FV of a CF

PV of an Annuity

FV of an Annuity

Finding Annuity given PV

Finding Annuity given FV

PV of a growing annuity

PV of a growing annuity to perpetuity

PV of a Perpetuity

Mathematically derive allthe formulae


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Uses of Time Value

In personal finance decisions

Amount to save annually

Annual deposit in sinking fund

Calculating annual growth

How long to wait

Determining periodic withdrawals

In Capex Decisions

NPV/IRR


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Teasers

A company currently has 1000 employees and thenumber is expected to grow at 20% perannum.How many employees will the companyhave 10 years from now.

ABC ltd had revenues of 100 lacs in 2000 whichincreased to 1000 lacs in 2010..What was thecompound growth rate in revenues.

Suppose you deposit Rs.50000/= per year in a fundwhich gives you an interest of 10%.What is the

value 20 years from now.


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Teasers

You want to buy a house after 5 years whenit is expected to cost 20 lacs. How muchshould you save annually if your savingsearn a compound return of 12%.

ABC ltd has an obligation to redeem Rs.500lacs bonds 6 years hence..how much shouldthe company deposit annually in a sinkingfund account wherein it earns 14% interest.


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Teasers

6. A finance company advertises that it will pay a lumpsum of Rs.8000 at the end of 6 years to investors whodeposit annually Rs.1000/= for 6 years..What interestrate is implicit in the offer?

7. You want to take up a trip to the moon which costsRs.10 lacs..You can save annually Rs.50,000 to fulfillyour desire..How long will you have to wait if yoursavings earn an interest of 12%.


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Teasers

9. Your father deposits Rs.3 lacs on retirementin a bank which pays 10% annual interest..howmuch can he withdraw annually for a period of10 years.

10. At the time of his retirement Mr.X is given achoice a) An annual pension of Rs.10000 for 15years b) a lump sum amount of Rs.50000todayAssuming an interest rate of 15%

which offer looks more attractive.


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Teasers

As a winner of the competition you can chooseone of the prizes:

Rs.5 lacs now

Rs.10 lacs at the end of 6 years

Rs.60000 a year forever

Rs.1 lac per year for 10 years

Rs.35,000 next year and rising thereafter by 5% peryear forever

If the interest rate is 10% which prize has thehighest PV.


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Teasers

You are 35 years old today and are considering your retirement needs. You expect to retire atage 65 and your actuarial table suggests that you will live to be 100you want to move toBahamas when you retire you estimate that it will cost you Rs.3, 00,000/= to make the moveon you 65th birthday and that your living expenses will be Rs.30000/= per year starting theend of 66th year and continuing through the end of year 100 after that

How much will you need to have saved by your retirement date to be able to afford this course of action

You already have Rs.50,000 in savings if you can invest money, tax free, at 8% a year, how much wouldyou need to save each year for the next 30 years to be able to afford this retirement plan

If you did not have any current savings and do not expect to be able to start saving money for the next 5yrs, how much would you have to set aside each yr after that to be able to afford this retirement plan


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Teasers

You are an investment advisor who has been approached by a client forhelp on his financial strategy.he has Rs.2, 50,000/= in savings in thebank..he is 55 years old and expects to work for 10 more years makingRs.1,00,000 per yearhe expects to make a return of 5% on his investmentfor the foreseeable future.

Once he retires 10 years from now, he would like to be able to withdraw Rs.80,000 ayear for the following 25 yearshis actuary tells him he will live to be 90 years

old..how much would he need in the bank 10 years from now to be able to do this.

How much of his income would he need to save each year for the next 10 years to beable to afford these planned withdrawals( Rs.80,000 a year after the tenth year)

Assume that the interest rate declines to 4% ,10 years from nowhow much, if any,would your client have to lower his annual withdrawal, assuming that he still plansto withdraw cash each year for the next 25 years.


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Teasers

A father is planning a savings program to put his daughter through college. His daughter is now 13years old. She plans to enroll at the University in 5 years and it should take her 4 years to complete hereducation. Currently the cost (for everythingfood, clothing, tuition, books) is Rs.12500 but a 5%annual inflation rate in these costs is forecasted. The daughter recently received Rs7500 from hergrandfather; this money which is invested in a bank account paying 8% interest compounded annuallywill be used to help meet the costs of the daughters education. The remaining costs will be met bymoney the father will deposit in the savings account. He will make 6 equal deposits to the account onedeposit in each year from now until his daughter starts college. These deposits will begin today and willalso earn 8 % interest compounded annually.

What will be the PV of the cost of 4 years of education at the time the daughter becomes 18? What will be the value of Rs.7500 that the daughter received from her grandfather when she starts college at age

18?

If the father is planning to make the first of 6 deposits today, how large must each deposit be for him to be able toput his daughter through college?


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Valuation.Bonds and

shares


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Concept of Valuation of assets

Assets

Real Assets

FinancialAssets(Bonds/Shares)

Concept of shares---> converting physical assets into financial instru

Principle of Valuation: Discounting all future CFs. Will depend on Certainty of CF Magnitude of CF Discounting Rate


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Cont

Concept of Value..

Book Value

Replacement value

Market Value

Going Concern Value

Liquidation Value

Present Value


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Understanding Bonds

What is a Bond(Par Value/Coupon/Maturity/Term)

Types of Bonds

Fixed Rate Bonds

Floating Rate Bonds

Call /Put Option Bonds

Zero Coupon Bonds

Secured/Unsecured Bonds

Perpetual Bonds

Convertible Bonds


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Cont

Interest rate on Bonds..

Coupon Rate

Current Yield

YTM: Bonds with Maturity/Perpetual ( PV= PV of Interest+ PV of

Maturity Value).

Relationship between Coupon Rate/YTM

Coupon Rate> Required Yield--> Bond Sells at Premium

Coupon Rate= Required Yield-- > Bond Sells at Par

Coupon Rate< Required Yield-- > Bond Sells at Discount


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Cont..

Valuation of Bonds

Bonds with Maturity

Perpetual Bonds

Deep Discount Bonds

Impact of changes in r on Bond Value

Valuation of Preference shares

Types of Preference Shares

Redeemable/non redeemable

Participative/non participative

Cumulative/ non Cumulative

Convertibles/non convertibles


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Cont

Bond Duration/Average Maturity

Volatility Of Bond

Impacted by Duration/Yield Valuation of bonds in the B/S

HTM

AFS AFT

Bond Rating Agencies..


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Cont

Valuation of Shares..

The Gordons Model

Assumptions:

The firm declares dividends

r > g

g is constant

Difficulty in valuation of shares.. Dividend declared is discretionary

Difficult to assess g


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Cont

Specific cases..

When the g is constant

When g is zero

When the firm pays no dividends Assume div is paid after n years

P/E Model

Relationship between Stock Price/Dividends

and Earnings g is a function of retained earnings and

ROE.


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Year BV EPS(10%)

DPS(40%)

RE(60%) EndingBV

1 100 10 4 6 106

2 106 10.6 4.24 6.36 112.36

3 112.36 11.24 4.49 6.74 119.10

4 119.1 11.91 4.76 7.15 126.25


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Risk & Return


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Introduction..

Concept of Return

On a single asset eg shares

Arithmetic Mean/Geometric Mean(CAGR)

Expected Return

Concept of Risk

Deviation from the average

Standard Deviation/Variance

S.D and Normal Distribution


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Understanding Portfolio..

What is a Portfolio

Return on a Portfolio

Rp=Rx * Wx + Ry*Wy Rp is a fn ( security returns/weights)

Risk in a Portfolio( why portfolio isless risky)

Economy Probabilit

y

Return

A(%)

Return

B(%)

Good .5 40 0

Bad .5 0 40


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Measuring for a two Asset case

The relationship

Influence of Covariance/Correlation

The relationship between Cov/Correlation Finding the min variance portfolio(=0)

Analysis:

=-1/0/1

Portfolio Risk for a n security case 1/n(Average Var) + (1-1/n)*(Av Covariance)

Impact of increasing n in the portfolio.


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Risk

Systematic

Unsystematic

R= SR+USR

No of Securities->

SR


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2 = 1/n (Av Var) + (1-1/n) (AvCovar)

USR SR-> cannot be diversified with n

Combining a risk free security and arisky security:Return Weights S.D

A 5% .5 0

B 15% .5 6


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Risk Return Models

CAPM

Establishes a relationship

Simple to understand

Used in estimating Kc and Valuation Models

Assumptions

Market Efficiency

Homogeneous expectations of risk and return Risk free rate

E(Ri) = Rf + i{ E(Rm) - Rf}


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Risk Return Models

Arbitrage Pricing Theory(APT)

What is Arbitrage(advantage of price differential)

The theory divides risk into twocomponents(predictable/unpredictable)

Predictable is Rf while Unpredictable can be firm specific(URs)/market specific(URm)

E(Ri) = Rf + (1F1+2F2+.nFn) + URs


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Teasers.

Share Beta InvestmentA .8 100000

B 1.25 100000

C 1 75000

D .6 125000

Given E(Rm) = 16% and Rf = 9% .what is the expected Return from thePortfolio.


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Beta Estimation..


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Revisiting the CAPM

Understanding the Betafor various values

Methods of Estimation

Direct Method..

The market modelregression on past data

Ri = + Rm ( Characteristic Line)

and are obtained by Normal Equations

The Normal Equations are Y = n + X

XY = n X + X2


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Beta Calculation by Excel

Year Stock Return Market Return

1 12 1

2 10 23

3 -10 -15

4 5 10

5 22 12

6 33 44

7 4 10

8 8 -10

9 -6 12

10 12 311 18 22

12 22 30


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Regression Statistics

Multiple R0.7307

8

R Square 0.53404Adjusted RSquare

0.487444

StandardError

8.63894

Observations 12

ANOVA

df SS MS FSignificanc

e F

Regression 1855.35

38855.35

3811.461

060.0069390

78

Residual 10746.31

2974.631

29

Total 11 1601.667

Coefficients SE t Stat P-value Lower 95%

Upper95%

Lower95.0%

Upper95.0%

Intercept4.5059

613.1164

821.4458

480.1788

22

-2.4379941

5511.44991

616

-2.437994

15511.44991

616

X Variable 10.5347

080.1579

443.3854

190.0069

390.1827857

670.886629

2750.182785

7670.886629

275


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Determinants of Beta Value(Covim /2m)

Nature of business( cyclicality of the business

leads to higher values of Beta). Operating leverage(use of FC)

Financial leverage (use of Debt)

Relation between Asset Beta and EquityBeta..


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Financial Statements


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What are financial statements

Indicates the financial position of a Firm

Perspective of Risk and Return

Answers the foll. Qs

How valuable are the Assets of the firm

How have these Assets been acquired

How profitable are these Assets

What is the Risk embedded in the Assets


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Financial Statements comprise

Balance Sheet

Income Statement

Statement of Changes in Financial Position Funds Flow Statement( WC )

Sources of WC( Liability(CL/SHE)

Uses of WC ( CA and FA)

Cash Flow Statement Cash flow from operating Activities

Cash Flow from Financing Activities

Cash Flow from Investing Activities


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Understanding the I/S

Income

Sales

Other income

Expenditure

Operating expenses

Depreciation

Interest Charges

EBT

Provision for Tax

PAT

P/L carried forward

Available for

Distribution Dividend

Tax on Dividend

Transfer to Reserves


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Understanding the B/S

Sources of Funds

Shareholders Equity

Share Premium

Reserves..

Long Term Debt

Total Capital Employed

Application of Funds

Fixed Assets

Gross Block

Accumulated Depn

Net FA

Investments

Minority(HTM/AFT/AFS)

Minority Active.

CA

Cash MS

Inventory

RM/WIP/FG

CL

Provisions..

Net CA(CA-CL)..

Net FA.


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Accounting profit Vs EconomicProfit

AP = Profit window dressing

Method of inventory valuation

Method of Depreciation

Goodwill valuation

Economic Profit = Net Cash Flow to firmand focuses on wealth creation


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The Funds Flow Statement

Current Assets

Cash/MS

Inventories

Debtors

Current Liabilities

Provisions

Creditors

Accounts PayableWC = CA -

CLThe funds flow statement depicts sources andapplications of WC. It is presented in 2 part:

sources and uses of WC Schedule of WC

There will be a WC only when there is a transaction between a current

account and aNon Current Account

Sources of WC cash flow from

operations Sale of non CA long term financing short term

Uses Of WC adjusted net loss from

operations purchase of Non CA repayment of Debt payment of Cash

Cash Flow statement Operating


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Cash Flow statementOperatingActivities

Cash from operating Activities

EBT..

Add Depreciation

Less Int Income received

Less Div Income

Less Gain on Asset Sale

Add loss on Asset Sale

Operating Profit before WCChanges

Adjustments for

CA( an in the value of a CA will imply

outflow of Cash, will imply inflow)

CL ( an in the value of a CL will implyinflow of cash, will imply outflow)

Cash generated fromOps..

Taxes Paid

CF from Operations..


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CF from Investing & Financing

CF from Investing Activities:

Sale of FA

Less purchase of FA

Sale of Investments

Purchase of Investments Interest recd from Investments

Dividend received

Net Cash used inInvesting

CF from financing Activities:

Dividends paid

Tax on Dividends

Interest paid on Debt Interest on short loans

Repayment of debt

Add New Debt

Add New Issue

Net Cash used in FinancingActivities


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Net Cash Flow to the firm

NCF= Cash Flow from OperatingActivities + Cash Flow from InvestingActivities

+ Cash Flow from Financing Activities

The Cash with the Firm Comprises: Cash on Hand Cash with Bank Cheques on hand


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Financial Statement

Analysis


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Analysis: Risk and Profitability

Users of financial analysis and their perspective ofanalysis.

Trade creditors-> liquidity position

Debt suppliers-> Solvency

Investors-> profitability

Management-> overall performance( risk/profitability)

Trade analysts/Academicians/Students/Researchers

Employees

Public

Government


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Financial Statement Analysis Comparative Analysis

Common Size Analysis

Trend Analysis CVP Analysis

Ratio Analysis

Liquidity Ratios

Leverage Ratios Turnover Ratios

Profitability Ratios

Valuation Ratios


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Liquidity Ratios: Current Ratio/Quick Ratio/Cash Ratio

Interval Measure->(CA-Inv) / Av daily Op Expenses

Leverage Ratios: Capital Structure

Total Debt/Capital Employed

Debt to Equity Ratio

Debt/ Capital Employed

Solvency

Interest coverage

Debt service coverage ratio


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Turnover Ratios(indicates the efficiency withwhich a firm utilizes its Assets/ the rate at whichAssets are being converted to Sales)

Inventory T/O

DIH(Days of Inventory Holding)

Debtors T/O

ACP(Average Collection Period)

Ageing Schedule of Debtors

NA Turnover Ratio

Total Assets Turnover Ratio

CA Turnover Ratio


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Profitability Ratios(Sales/Investment) Gross Profit Margin/ Net Profit Margin

ROCE/ROA/ROE

Valuation Ratios EPS

DPS

Dividend Yield

Earning Yield

P/E Ratio

MV to BV of Share


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Evaluating a firms Earning Power:

Du Pont Analysis

ROE= ROA(1+ D/E)

For No Debt Firm, ROE= ROA

ROE= NPM * Assets Turnover * Equity Multiplier


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Capital Budgeting

Decisions


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What is Capex.Allocationwhy

Features of Capex

Exchange of current funds for future benefits

Funds invested in long term assets

Objectives of Capex.Value

Types of Capex

Expansion/diversification/replacement/modernization/contingent


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Importance of Capex

Long term investment/large investments/highrisks/generally irreversible/strategicdecisions/complex

Steps involved in evaluation of investment

Determination of Cash flows

Estimation of required return/cost of capital

Application of decision rule


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Characteristics of a good decisionrule

Assist in wealth maximization

Must work well for both revenuegenerating and cost reduction projects


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Capex Evaluations

NPV IRR

Profitability Index

Payback Period

DiscountedPayback Period

ARR

DCF Criteria Non DCFCriteria


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NPV

It is the PV of all discounted CFs( I and O).

Steps(Determine CFs and r)

Decision Rule.accept/reject

Why is NPV important(. A firm has cash 1 lac) Features

It recognizes time value

Measures true profitability since it considers CFs

Value Additive.valuation of Corporate


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IRR

Measures yieldrate which equates current CFto all future CFs

Relationship between IRR/NPV

Stepscalculating CFs Decision ruleaccept (IRR> Cost of Capital)

Features

Popular since it uses %

It recognizes time value

Measures true profitability since it considers CFs

No value additivity

P fi bili I d


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Profitability Index

Ratio of PV of all CFs to InitialOutflow

Steps(measuring CFs and r)

Decision rule.PI > 1 Accept

P b k P i d


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Payback Period

Time required to recover initial investment

Steps ( determine CFs each year)

Decision rule..accept with shortest PB

Features

Simplicity/risk shield/focus on liquidity

Limitations

Ignores CF after PB period/ inconsistent with ourobjective of SH wealth maximization/not a measureof true profitability

Di t d PB i d


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Discounted PB period..

No. of years required to recover theinitial investment on a PV basis.

Uses discounted CFs in calculatingPBP.

ARR


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ARR..

Ratio of Average EBIT(1-t) to averageinvestment.

Decision rule..Accept(ARR> required return)

Features Uses accounting Data

Easy to understand and calculate

Demerits

Does not use CFs

Ignores time value of money

NPV/IRR


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NPV/IRR

Project C0 C1 C2 C3 NPV(9%)

IRR

A -1680 1400 700 400 301 23%

B -1680 140 840 1510 321 17%

NPV and IRR will give conflicting results in foll. Cases

project has a non conventional CF

Initial investments are differentProjects have different livesTiming of CFs is different.


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The Cost Of Capital


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Required return = cost of Capital

Concept of WACC (debt/equity/Preference)

Significance of Kc

Used in investment evaluation(NPV/IRR)

Designing debt policy

Performance appraisal of management/CFO

Opportunity Cost of Capital Cost of Capital

Historical cost / Marginal Cost


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Determining the WACC of Firm

Cost of Debt

Cost of Preference

Cost Of Equity

The cost of capital of the firm will bethe weighted average of thecomponent costs


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Cost of Debt

Debt issued at Par ( Kd = Coupon Rate)

Debt issued at Premium/Discount

After tax cost of debt = Kd(1-t)

Cost of Preference

Irredeemable (Div/Issue price)

Redeemable

enerally Kp > Kd since interest on Debt is Tax deductible

C t f E it


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Cost of Equity

Equity( external/retained earnings)

Is equity free of Cost

Methods of calculating Ke The dividend growth model

E/P ratio

CAPM


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Practical calculation of Ke

Dividend G Model

Ke = Div1/P + g

g can be calculated by ( retention ratio * ROE)or by EPS growth of the last 10 years.

CAPM

E(Ri) = Rf + i [ E(Rm) Rf ]

Beta can be found by regression.


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Determining CF for

Investment Analysis.


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CF vs Profit( FCF = EBIT(1-t) + Dep WC Capex)

FCF for Capex decisions and is the

cash available to lenders andshareholders.

Basic principles of CF estimation


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Basic principles of CF estimation

Separation principle( investment CF and financing CFare to be treated separately)

Incremental principle

CF from project = CF with implementation of project CF w/o

implementation of project Incidental effects be considered( cannibalization)

Ignore sunk costs

Include opportunity cost

Post Tax principle( consider tax impact) Consistency principle( CF must be consistent with

investor group).


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Risk Analysis in

Investment Decisions


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Every investment decision is based onforecasted CFs.

The forecasted CFs are influenced by

Economic factors

Industry factors

Company factors

Risk Measurement --> Variance

Reducing risk through the concept of ExpectedNCF( CFi x Pi) where i= 1,2n


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Conventional techniques of riskanalysis

Payback period

Risk adjusted discount rate(k = kf + kp )

Certainty equivalent (0< < 1). Choiceof is an indicator of the confidence

level of the CFs being realized asforecasted.


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Other methods of risk analysis Sensitivity analysis -> identifying variables that impact

revenues/ sales and thus CFs

DCF break even analysis

Scenario analysis

Simulation analysis

Decision tree analysis

1 2 3 4

S.P 15 15 15 15

V.C 6.5 6.5 6.5 6.5

If Project Cost = Rs.1000, V(15-6.5) x PVIFA(r,4yrs) = 1000


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Financial Leverage &

Operating Leverage


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Relationship between investmentdecision and financing decision

Defining capital structure( Capex ->

need to raise funds -> capitalstructure decision(D/E).purpose isKc and V

Defining FL

ROI > cost of debt


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Measuring FL Debt ratio( D/D+E)

Debt to Equity Ratio

Interest coverage = EBIT/ Interest Charges Analyzing impact of FL

ROI>Kd -> Increase in SH returns-> EPS/ROE

ROI< Kd -> Decrease in SH returns-> EPS/ROD


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How does FL impact EPS & ROE

Eg a project requires an investment of 5lacs. The return on investment expected

is 24% and the cost of debt is 15%.Which of these two alternatives shouldthe firm take.

Raise 5 lacs through equity( 50,000 x Rs.10)

Raise 2.5 lacs through equity (25,000 x Rs.10)and Rs. 2.5 lacs through debt.


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All equity 50% Debt

EBIT

Interest

EBT

Tax(50%)

PAT

No. of shares

EPS

ROE

ROI > Cost of debt


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All equity 50% Debt

EBIT 120000 120000

Interest 0 37500

EBT 120000 82500

Tax(50%) 60000 41250

PAT 60000 41250

No. of shares 50000 25000EPS 1.2 1.65

ROE 12% 16.5%

Return to investors 60000 78750

The gain from FL = Rs.18750.This is the interest tax shield enjoyed by the company since interest chargesare tax deductableThis is equivalent to ( Interest x Tax rate)

If ROI is 12% < Cost of debt,15%


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All equity 50% Debt

EBIT 60000 60000

Interest 0 37500

EBT 60000 22500

Tax(50%) 30000 11250

PAT 30000 11250

No. of shares 50000 25000EPS 0.6 0.45

ROE 6% 4.5%

Return to investors 30000 48750

The impact on EPS and ROE is negative.

Impact of FL on varying EBIT

N D bt I t t 5 l t f d bt


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No Debt Investment = 5 lacs, cost of debt=15%, ROI = -5%, 10%,

EBIT -25 50 75 120 160 300

Interest 0 0 0 0 0 0

EBT -25 50 75 120 160 300

PAT -12.5 25 37.5 60 80 150

#shares

50 50 50 50 50 50

EPS -.25 0.5 0.75 1.2 16 30

ROE -2.5% 5% 7.5% 12% 16% 30%

50% Debt

EBIT -25 50 75 120 160 300

Interest 37.5 37.5 37.5 37.5 37.5 37.5EBT -62.5 12.5 37.5 82.5 122.5 262.5

PAT -31.25 6.25 18.75 41.25 61.25 131.25

#shares

25 25 25 25 25 25

EPS -1.25 .25 .75 1.65 2.45 5.25

Impact of FL on varying EBIT

75% Debt


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75% Debt

EBIT -25 50 75 120 160 300

Interest 56.25 56.25 56.25 56.25 56.25 56.25

EBT -81.25 -6.25 18.75 63.75 103.75 243.75

PAT -40.62 -3.13 9.38 31.88 51.88 121.88

#shares

12.5 12.5 12.5 12.5 12.5 12.5

EPS -3.25 -2.5 .75 2.55 4.15 9.75ROE -32.5% -2.5% 7.5% 2.55% 41.5% 97.5%

Impact of FL on varying EBITInvestment = 5 lacs, cost of debt= 15%, ROI = -5%, 10%,


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No Debt

EBIT -25 50 75 120 160 300

EPS -.25 0.5 0.75 1.2 16 30ROE -2.5% 5% 7.5% 12% 16% 30%

50% Debt

EPS -1.25 .25 .75 1.65 2.45 5.25

ROE 12.5% 2.5% 7.5% 16.5% 24.5% 52.5%

75% Debt

EPS -3.25 -2.5 .75 2.55 4.15 9.75

ROE -32.5% -2.5% 7.5% 2.55% 41.5% 97.5%

S increases with increased EBIT for all financial plans

works both ways. It depresses EPS/ROE under unfavorable economic conditionincreases EPS/ROE under favorable conditions.

gher the FL , wider is the range in which the EPS fluctuates with varying EBIT.


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Relationship between EBIT,EPS

EPS = PAT/N = [(EBIT-Interest)x (1-t)] / N= (1-t)/N [ EBIT Interest ]

This can be rearranged as > -(1-t)/N xInterest + (1-t)/N x EBIT

This shows EPS is a linear function of EBIT

with EPS= a + b x EBIT From the above formula, EPS for varying

levels of EBIT can be worked out.


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Calculating the level of EBIT for whichEPS would be same under diff financialplans.

All equity firm, EPS1 = EBIT(1-t)/ N1 Debt firm , EPS2 = (EBIT- Interest) x (1-t) /

N2

The indifference point can be calculated byequating EPS1 and EPS2.


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Combining OL and FL

OL affects EBIT while FL affects PAT/EPS

DOL = % EBIT/ % Sales = Q(s-v)/Q(s-v)-F

DFL = % EPS/ % EBIT = Q(s-v)-F /Q(s-v)-F-Int

DCL = % EPS/ % Sales = Q(s-v)/ Q(s-v)-F-Int


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Capital Structure


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Meaning of Capital Structure

Advantages of Debt

Tax benefit( Tax rate x Interest)

Disciplining effect


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Disadvantages of Debt Expected bankruptcy

CF < Obligations

High SD of CFs

When a firm approaches bankruptcy there are twoassociated costs

Direct Costs ( borne by lender)

Indirect Costs( borne by firm)

Customers stop buying

Suppliers stop supplying Firm fails in raising fresh capital

The cost is high for durable products, products requiringregular maintence, high value goods.


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Disadvantages of debt

Loss of flexibility(Covenants:Affirmative/Negative)

Agency Costs


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Debt taken by a Company is influenced by High tax will encourage debt

Companies with low depreciation will prefer debt

Generally as taxes go up, the D/E of Companiesgoes up

Level of efficiency of Debt / Equity markets

Level of variability of a Cos CFs.


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Is there a relationship betweenCapital Structure and Value of a firm..

Traditional View(Net Income and NOI

Approach) Capital structure impacts value

Miller & Modigliani View

Capital Structure is irrelevant

Net Income approach

Ke and Kd are constant for a firm. The K0 of the firm


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Ke and Kd are constant for a firm. The K0 of the firmdeclines as debt is taken

Value of firm = V of Equity + V of Debt = NI/Ke +Interest/Kd

K0 = Ke (Ke-Kd)xD/Vas D increases ,the value ofK0 will decrease and will be minimum when D/V =1.

Value of firm = EBIT/K0 K0 is minimum at Debt100% and hence maximum value of firm is whenDebt is 100% of the structure.

Cost

D/

KeK0

Kd

Net Operating Income Approach


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Kd and K0 for the firm is constant.

As debt increases , Ke will increase Ke = K0 + (K0- Kd) x D/E.as D increases ,

Ke increases

K0 for the firm remains constant because thesubstitution of cheap debt is compensated bythe increase in cost of equity.

D/

E

Cost

Ke

K0

K

d


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MM Approach The value of a firm is independent of Capital

structure and only depends on earnings andrisk.

Assumptions of perfect capital markets , notransaction costs and no taxes.


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MM Proposition 1

> V1 = V2 = EBIT/K ( assuming K1= K2)

In MM view the way in which the firms arestructured only changes the way in which theearnings are distributed ( SH and Debt holders)

EBITK1

EBITK2

Levered Firm Unlevered Firm

Why should Proposition1work


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EBIT 150000 150000

Debt 500000 0

Kd 12%

Ke 16% 15%

Interest 60000

Equity Earnings 90000 150000

MV of Equity 562500 1000000

MV of Debt 500000 0

Value of Firm 1062500 1000000

Assume you own 10% shares of the levered firm. Your investment of

Rs.56250Gives you a return of Rs.9000 in the levered firm.

MM argue that if two firms have the same EBIT, their values must besame. If not thenThis will encourage arbitrage .

A rational investor will do the foll.

Sell 10% equity in L 56250


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Investor invests Rs.100000 in U (10%)

His old income was Rs.9000 . His new income is as below

The customer make an income of Rs.6250 keeping his earningsconstant.

The arbitrage will continue till the value of the firms equal.

Borrow 10% at rate 12% 50000

Total money 106250

Income from 10% stake inU

Rs.15000

Less interest on Rs.50,000@12%

Rs.6000

His net income Rs.9000


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MM proposition 2 Higher the financial risk greater will be

the required return of the investors and

higher will be the cost of equity. K0 = Ke( E/D+E) + Kd (D/D+E)

Ke = K0 + (K0 Kd) D/E


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The value of a firm increases with leverageand is theoretically max when D= 100%

Debt avoided on account of dangers of financialdistress.

The pecking order theory

Internal equity

Debt External equity

Enhancing firm value through DebtBook


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how will the Company value be impacted if ittakes a debt of Rs.75,000 @ 10% and buys backits shares from the market ? Assume tax rate of30%.

BookValue

Equity 1,50,000 Assets 1,50,000

Debt 0

TotalCapital

1,50,000 TotalAssets

1,50,000

MarketValue

Equity 8,00,000 Assets 8,00,000

Debt 0

TotalCapital

8,00,000 8,00,000


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Current tax structure: Corporate tax rate (30% + 3% education cess)

Personal taxes(10% - 30%)

Tax is 10% on Capital gains(investment


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Introduction to Dividend

Theory..


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What are dividends

Objective of the dividend policy..( balance between funds for growth

and distribution to SHs. Concept of Payout ratio/ retention

ratio/dividend yield

The dividend decision is impacted bythe investment decisions of a firm.

Impact of dividend payoutsHigh payout firm (80%)

Year Equity Earnings@2 Dividend RE


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Year Equity Earnings@20%

Dividend RE

1 100 20 16 42 104 20.8 16.64 4.16

3 108.16 21.63 17.31 4.32

10 142.33 28.47 22.77 5.69

15 173.17 34.63 27.71 6.92

20 210.68 42.14 33.71 8.43

Low payout firm (20%)

1 100 20 4 16

2 116 23.2 4.64 18.56

3 134.56 26.91 5.38 21.5310 380.30 76.06 15.21 60.85

15 798.75 159.75 31.95 127.80

20 1677.65 335.53 67.11 268.42Post 15th year low payout firm has a higher dividend.the growth for the

two firms has been


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Dividend theories Walters Model

Gordon Model

Walters Model:

P = PV of an infinite stream of dividends + PV of an infinitestream of Capital gains

P = Div/k + r(EPS-DPS)/k / k

Assumptions:

Constant r, k, EPS and DPS

100% payout or 100% retention

The firm has an infinite life

Demonstration of Walters Model

Consider three firms(growth firm/normal firm andd li i fi ) S 0


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declining firm).Assume EPS = Rs.10

Retain all earnings when r>k

Distribute all earnings when r


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Gordons ModelThe price of a share is the PV of an

infinite stream of dividends expected to

grow @ g

P=Div1 / k-g = EPS1( 1-b) / k r.b

Mathematically derive the formula..

Demonstration of Gordons Model

Consider three firms(growth firm/normal firm anddeclining firm) Assume EPS = Rs 10


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declining firm).Assume EPS = Rs.10

When r > k, keep low payout

When r < k, payout should be maximum

When r =k, the dividend decision has no impact on the value of the firm.

Assumptions in the model

Constant k and r. Both models have the same conclusions THE DIVIDEND DECISION OF A FIRM

HAS AN IMPACT ON ITS VALUE

Growthfirm(r=15%,k= 10%)

Normalfirm( r=10%,k=10%)

Decliningfirm( r=10%, k =15%)

Payout = 40%,b=0.6

P=400 P = 100 P = 77

Payout = 60%, b =0.4

P = 150 P = 100 P = 88

Payout = 90% ,b =0.1

P= 106 P = 100 P = 98


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Factors that influence the dividendpolicy of a firm

Current available investment

opportunities Stage of firm(introduction/growth/maturity/decline)

Thumb rule(r > k)

Expectation of the shareholders

Clientele effect( identifying the investors)

Constraints on paying dividends

Legal restrictions-> dividend to paid out of


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Legal restrictions > dividend to paid out ofprofits only

Liquidity constraints Borrowing capacity

Access to capital markets

Restriction in loan agreements Control

Forms of dividends

Cash Dividends

Bonus Shares

Shares Buyback

Bonus shares.. Eg a 2:1 bonus issue

Equity( 1 lac 10,00,

Equity( 1.5 15,00,000


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Bonus issue is only a recapitalization..(E/R)

Advantages of bonus:

It is an indication of higher future profits

Psychological value

Company conserves cash

Ideal for a company when in a financial crunch

Share price brought in the trading range

Equity( 1 lacshares @Rs10)

10,00,000

Reserves 20,00,000

Total NW 30,00,000

Equity( 1.5lac shares@ Rs10)

15,00,000

Reserves 15,00,000

Total NW 30,00,000

Share Splitreverse splitEquity( 1 lac 10,00,

Equity( 2 10,00,000


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Reasons for share split

Bring price of stock in trading range

Indication of companys higher earning infuture

Increased expected dividend to theshareholders

Equity( 1 lacshares @Rs10)

10,00,000

Reserves 10,00,000

Total NW 20,00,000

Equity( 2lac shares@ Rs 5)

10,00,000

Reserves 10,00,000

Total NW 20,00,000


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Shares buyback.. Rationalize capital structure

Pop up the share price

When company has idle cash

Manas Corp expects to earn Rs.66 lacs for the current yearand it plans to distribute 50% of this amount to itsshareholders. There are 11 lac outstanding shares and themarket price per share is Rs.30. The Co. believes that it canpay a cash dividend of Rs. 3 per share or buyback 1 lacshares at an offer price of Rs.33. what is the impact if theshares are brought at less than Rs.33 or greater thanRs.33.


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WC Management..


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Assets Management: Fixed Assets Management

CA Management

Concept of WC Gross WC

Net WC

Why is investment in CA required The concept of Operating Cycle

Operating cycle of a firm


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Order stock Cash FG Cash

Placed arrives Paid sold received

AP AR

Inventory period

Cash Cycle

Operating Cycle

perating Cycle is a function of Inventory period and AR.


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Factors influencing WC requirements.. Nature of business ( OC/retailers)

Seasonality of operations

Production policy

Market conditions

Conditions of supply/ supplier credit

Credit policy of Co

Operating efficiency

WC management is a trade off between liquidity andprofitability


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Cost of liquidity

Low returns, inventory wear off, carrying cost

Cost of illiquidity Unable to meet short term obligations

Borrowing at high cost ,production shortage

A B C

Sales 15,00.000 15,00,000 15,00,000

EBIT 1,50,000 1,50,000 1,50,000

FA 500000 500000 500000

CA 500000 400000 300000

TA 10,00,000 9,00,000 8,00,000ROI 15% 16.67% 18.75%


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Estimation of WC needs CA holding period cost

RM holding cost + WIP cost + FG holding cost +Debtors holding credit allowed

WC as a % of sales

WC as a % to fixed investment


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Receivables Management

and Factoring..


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How are receivables created-> CreditSales

Receivables involve an element of risk

It implies futurity

Measuring receivables

Net Credit Sales per day x Average collectionperiod

NCS is a function of sales

ACP is a function of the cos credit policy


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Why do companies grant credit

Competition

Buyers requirements

Companys bargaining power

Relationship with dealers

Marketing tool

Industry practice

the purpose of all is to enhance sales.

Receivables is a function of theCredit Policy


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Credit Policy Credit Standards

Credit Terms

Collection Effort

Goals of the credit policy Increasing sales

( Benefits > Costs)Increased Sales Bad Debt losses

Credit Administration and supervision

Collection Costs

Credit Standards and evaluation:

Individual:


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( Character/Capacity/Cash/Collatoral/Condition

) -> intention and the ability Company -> Financials and ratios

Evaluation and analysis of credit

Traditional approach

Numerical credit scoring

Discriminant analysisFactor

wt 5 4 3 2 1 Score

Past

p

.3

NPM .2

CR .1

D/E .4

CR

RO


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Credit Terms Rate of cash discount

Cash discount period

Net credit period

Eg. 2/10, net 30.

Monitoring receivables

ACP -> 360/ Debtors Turnover


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ACP 360/ Debtors Turnover

Ageing Schedule Collection Experience Matrix

O/Sdays

Amount

%

0-25 200000

20%

26-35

300000

30%

36-45

400000

40%

>45

100000

10%

Month

J F M A M

Sales 100 250 375 400 570Rec(%)

J 80%

F 60% 78%

M 20% 50% 90%

A 10% 40% 60%

M 10% 10% 70%

Factoring


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seller buyer

factor

1

4

2

3

56

7

1: buyer places order, 2: factor fixes buyer limit, 3: seller supplies goods to thBuyer , 4: seller raises invoice to the factor, 5: factor pays a portion upfront6: factor follows up with buyer for payment7: buyer makes the payment to the factor.


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Inventory Management

Types of inventory( RM/WIP/FG)


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Types of inventory( RM/WIP/FG)

Why hold inventory Transaction Motive

Precautionary Motive( D/S fluctuation)

Speculative Motive

Objectives of inventory management

Efficient and smooth production

Maintain optimum level

Costs associated with inventory management

Ordering cost Carrying cost

Inventory management seeks to answer

How much should be ordered ?


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At what level should the order be placed ?

How much to order->TC = ordering cost + Carrying Cost = (Annual

usage/Q ) x Per order cost + (Averageinventory) x carrying cost per unit

EOQ = Q = Sq root( 2UF/c)

When to order->

Reorder Point = Average Usage x Lead time

if safety stock is being maintained, its value isadded to the reorder point.


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Inventory control systems ABC Analysis

Just in Time

FSN ( fast moving, slow moving, nonmoving )

Computerized inventory controls.


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Cash Management


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Cash management concerns managing Cash flow into and out of the firm

Cash flow within the firm

Cash balances with the firm

Motives for holding cash

Transaction motive

Precautionary motive

Speculative motive


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Cash Management covers Cash planning

Managing the cash flows

Optimum level of cash Investing surplus cash


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Cash planning Forecasting

Short term: Receipts and disbursements

Long term: Cash flows generated through P/L

Managing the cash flows

Minimizing deviation between projectedand actual CFs. it includes

Accelerating cash collections

Controlling disbursements


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Speeding cash collections

Minimizing floats

Disbursement float: cheque issued and not debited

Collection float: cheques received and not credited

Net Float = Disbursement float + Collection float

Customer mails cheque co receives co deposits cheque cash available

Mailing time Processing Availability delay


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Maintaining Optimum Cash level

Under certainty: when the firm is able to

forecast cash needs with certainty

Baumols Model

Under uncertainty

The Miller Orr Model

Baumols Model

Total Cost = Holding Cost + Transaction


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Total Cost Holding Cost + Transaction

CostTC = (average cash balance) x k +

(Number of transactions) x cost pertransaction

TC = C/2 x k + (T/C) x Ct = sqroot( 2TCt/k)

C= starting cash balance, k = opportunity cost, T =

total cash requirement in the year, T/C = totalnumber of transactions, Ct = cost per transaction.

Cash

balance

tim

e

Miller Orr Model

UL


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3 limits are specified( upper limit, return point,

lower limit)

RP = 3 Sq root( 3b 2/4I) + LL

UL = 3RP 2LL

b= fixed cost per order for converting MS-> cash 2 = variance of daily changes in expected cash balance

I = interest rate (daily) earned on MS

cash

time

LL

R

P


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Investing surplus cash Factors considered: risk/return/liquidity

Types of short term investments

T Bills

Commercial Paper

Certificates of Deposit

Bank Deposits

Inter Corporate Deposits/ Call Money

Working Capital Finance

Trade Credit eas


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Trade Credit: easy

availability/flexibility( 3/15,net 45).implicitinterest rate

Deferred Income

Bank Finance OD, CC limit

Bills discounting

Letter of credit

WC loan

Commercial Paper.( conditions: NW > 5 Cr,Co. should be listed, CR > 1.33, Crisil rated .


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All The Best

Documents

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