FINANCIAL MANAGEMENT

BY: A.ARULDOSS VITHAKAN

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 FINANCIAL MANAGEMENT
o The term "finance" in our simple understanding it is perceived
as equivalent to 'Money‘. But finance exactly is not money, it
is the source of providing funds for a particular activity.
o Finance refers to assessing the requirements of funds, identify
sources , sourcing, deployment and evaluating the results of
such investment with a view to improve performance in the
future.
 NATURE AND OBJECTIVE:
 Common thread running through all desisions taken by
various managers is money.
 Objective of the finance manager is to maximise the
wealth of the owners through effective financial
management.

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 FINANCIAL MANAGEMENT-MEANING

 Financial Management is that specialised function of general

management which is related to the procurement of finance
and its effective utilisation for the achievement of common
goal of the organisation.
It includes each and every aspect of financial activity in the
business. Financial Management has been defined differently
by different scholars. A few of the definitions are being
reproduced below:-
“Financial Management is an area of financial decision
making harmonizing individual motives and enterprise
goals.”- Weston and Brigam.

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 Financial Management is the operational activity
of a business that is responsible for obtaining and
effectively, utilizing the funds necessary for
efficient operations.”- Joseph and Massie.
From the above definitions, it is clear that
financial management is that specialised activity
which is responsible for obtaining and effectively
utilizing the funds for the efficient functioning of
the business and, therefore, it includes financial
planning, financial administration and financial
control
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 FUNDAMENTL PRINCIPLE OF FINANCE

 Before making a decision one has to ask the

question whether the investment decision will raise
the market value of the firm.
 A business proposal –regardless of whether it is
new or acquiring an existing business –raises the
value of the firm only if the present value of the
future stream of net cash benefits expected from the
proposal is greater than the total cash outlay
required initially for the project.
 RISK-RETURN TRADE OFF

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FUNDAMENTL PRINCIPLE OF FINANCE –CASH
ALONE MATTERS

INVESTORS PROVIDE
INITIAL CAPITAL

INVESTORS
THE BUSINESS
SHAREHOLDERS
PROPOSAL
LENDESRS

TO FINANCE THE
BUSINESS PROPOSAL

PROPOSAL GENERATES CASH RETUNS

TO INVESTORS 6
DECISIONS, RETURNS, RISK AND MARKET
VALUE

MARKET
VALUE OF
THE FIRM

RETURN RISK

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 EMERGING ROLE OF THE FINANCIAL
MANAGER IN INDIA
 Investment planning.
 Financial structure.
 Mergers, acquisitions and restructuring.
 Working capital management.
 Performance management.
 Risk management.
 Corporate governance.
 Investor relations.

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FINANCE FUNCTIONS -Definition & Scope
CHIEF FINANCIAL OFFICER

TREASURER

CAPITAL FUND
CASH CREDIT
BUDGETING RAISING
MANAGER MANAGER
MANAGER MANAGER

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 GOALS OF FINANCIAL MANAGEMENT
 Maximize wealth of current shareholders.
 In market based economy which recognizes the right to
private property, the only social responsibility is to do business
legally, ethically and with sincerity..
 It is a profound error to view company’s value enhancement
is only for shareholders.
 The question is whether a company should maximise
employees welfare, value addition to customers, or maximise
contribution to society at large..
 maxi,mising contribution to society is through enhancing
value of the firm.

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 ALTERNATIVE GOALS:
 Maximisation of profit- Limitations:- (a) Profit in absolute
terms is not a proper guide unless it is expressed in terms
of profit per share basis or in relation to investment.; (b)no
guide for comparing profit now, profit in past and profit in
future; ( c) if profits are uncertain and described buy a
profitability distribution, the meaning profit maximisation
is not clear.
 Maximising earnings per share and Maximisation of
return on equity do not suffer from the above limitations.

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 Maximisation of current market price.
 Shareholders’ orientation in India:
1. Foreign exposure
2. Greater dependence on capital market.
3. Abolition of wealth tax on financial assets.
Chairman of Reliance Industries Limited state in 1993
Annual Report “in everything that we do, we have only
one supreme goal,, that is to maximise your wealth a
members of India’s largest investors family”
A similar view has been expressed by Mr Anand Mahindra.

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 TIME VALUE OF MONEY

 Money has time value. A rupee today is more

valuable than a rupee a year hence. Why? There
are several reasons:
a) Individuals prefer current income / consumption
than future income/ consumption.
b) Capital can be employed productively to generate
income. A rupee today can grow to (1+r) a year
hence where r is the return earned on the
investment.
c) In a inflationary period a rupee value today is
greater than a rupee on a later date.
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 FUTURE VALUE/PRESENT VALUE

 ANNUITY- an equal annual cash flow whether

‘in’ or ‘0ut’
 FVIF- Future Value of Interest Factor.
 FVIFA- Future Value of Interest Factor Annuity.
 PVIF- Present Value of Interest Factor
 PVIFA- Present Value of Interest Factor Annuity.

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 PRESENT VALUE OR DISCOUNT

 The concept of present value is opposite of

compounding.
 While money value increases in compounding due
to addition of compound interest, in case of
present value of a future cash vlue is less since
compound interest is lost. Thus the present value
of a rupees is less when received on future date
 This is commonly called discounting.
 Let us work out some examples.
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 Investment And Types of Investments
 1. In finance, the purchase of a financial product or other item of
value with an expectation of favorable future returns. In general terms
, investment means the use money in the hope of making more money.
2. In business, the purchase by a producer of a physical good, such as
durable equipment or inventory, in the hope of improving future
business.
Types of common investments
– Cash
– Cash equivalents (CDs, Treasury bills)
– Bonds
– Stocks
– Mutual funds
– Retirement accounts
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 Risks of investing
– Investment risk
– Market risk
– Liquidity risk
– Interest rate risk
– Credit risk
– Inflation risk

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 FINANCIAL DECISIONS AND CONCEPTS
 CAPITAL BUDGETING DECISIONS of firms are of
strategic importance for the overall growth of an economy as
such decisions commit it’s limited productive resources to it’s
production system and also for firms as they strengthen and
renew their resources.
 They consist of allocation of a firm’s resources with plans for
recouping the initial investment plus adequate profits (or other
returns) from cash flows (or other benefits) generated during
the economic life of an investment. economic life of an
investment.
 Such decisions are hard to reverse without severely disturbing
an organization economically and otherwise.
 CAPITAL STRUCTURE DECISIONS
 WORKING CPITAL DECISIONS
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 MARKETS
 The financial markets can be divided into different subtypes:
 Capital Market which consist of:
– Stock Market, which provide financing through the issuance
of shares or Common Stock, and enable the subsequent
trading thereof.
– Bond Markets, which provide financing through the issuance
of bonds and enable the subsequent trading thereof.
 Commodity markets, which facilitate the trading of
commodities.
 Money Markets, which provide short term debt financing and
investment.

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 Derivatives Markets, which provide
instruments for the management of financial
risk.
– Future Market, which provide standardized
forward contracts for trading products at some
future date; see also Forward contract.
 Insurance Markets, which facilitate the
redistribution of various risks.
 Foreign Exchange Markets, which facilitate
the trading of foreign exchange
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 The capital market is the market for securities, where
companies and governments can raise long-term funds.
 Selling stock and selling bonds are two ways to generate
capital and long term funds.
 Thus bond markets and stock markets are considered
capital markets.
 The capital markets consist of the primary market, where
new issues are distributed to investors, and the secondary
market, where existing securities are traded.

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 FINANCIAL MARKETS
 MONEY MARKET-
 1. Call money market-mostly surplus funds of banks
are traded with maturity period of 1-15 days. If for one
day it is called ‘call money’ more than 1 day ‘notice
money’. Purpose is-1.To meet temporary gap or 2. To
meet crr or 3.To meet sudden demand funds. Located
in commercial centres. Prticpants are banks, icici, rbi
etc.
 2. Commercial paper(cp) are s.T. Unsecured
promissory notes at a discount of face value issued by
well known compamiesas per rbi guidelines. Issue
expenses include stamp duty (based on period),
broker’s feesrating agencies fees(crisil)

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 SECURITIES

 A financial security is some type of financial instrument that is

negotiable and has a recognized financial worth. Usually referred to
simply as securities, the financial security can take on several forms.
Generally, a financial security will have the potential to generate
some additional return above face value for either the holder of the
issuer of the security.
 Government Securities- G-Secs are issued by the Reserve Bank of
India on behalf of the Government of India. Normally the dated
Government Securities have a period of 1 year to 30 years. These
are sovereign instruments generally bearing a fixed interest rate
with interests payable semi-annually or otherwise and principal as
per schedule. For shorter term RBI issues Treasury Bills which are
discounted papers. At present T-Bills are issued for 91 days, 182
days & 364 days. G-Secs provide risk free return to investors
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 Common stock is a form of corporate equity ownership, a type of
security. It is called "common" to distinguish it from preferred
stock. In the event of bankruptcy, common stock investors receive
their funds after preferred stock holders, bondholders, creditors, etc.
On the other hand, common shares on average perform better than
preferred shares or bonds over time.
 Common stock is usually voting shares, though not always. Holders
of common stock are able to influence the corporation through votes
on establishing corporate objectives and policy, stock splits, and
electing the company's board of directors. Some holders of common
stock also receive preemptive rights, which enable them to retain
their proportional ownership in a company should it issue another
stock offering.
 Additional benefits from common stock include earning dividends
and capital applications 24
 Preferred stock, also called preferred shares, preference shares, or
simply preferred, is a special equity security that resembles
properties of both an equity and a debt instrument and generally
considered a hybrid instrument. Preferred are senior (i.e. higher
ranking) to common stock, but are subordinate to bonds
 Preferred stock usually carries no voting rights but may carry priority
over common stock in the payment of dividends and upon liquidation.
Preferred stock may carry a dividend that is paid out prior to any
dividends being paid to common stock holders. Preferred stock may
have a convertibility feature into common stock. Terms of the
preferred stock are stated in a "Certificate of Designation".
 Similar to bonds, preferred stocks are rated by the major credit rating
companies. The rating for preferred is generally lower since preferred
dividends do not carry the same guarantees as interest payments from
bonds and they are junior to all creditors
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 Corporate Bonds- Corporate Bonds are issued by public sector
undertakings and private corporations for a wide range of tenors
normally up to 15 years although some corporate have also issued
perpetual bonds. Compared to government bonds, corporate bonds
generally have a higher risk of default.
 This risk depends, of course, upon the particular corporation issuing
the bond, the current market conditions, the industry in which it is
operating and the rating of the company.
 Corporate bond holders are compensated for this risk by receiving a
higher yield than government bonds.

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 Certificate of Deposit- CDs are negotiable money market
instrument issued in demat form or as a Usance Promissory Notes.
 CDs issued by banks should have a maturity of not less than seven
days and not more than one year. Financial Institutions are allowed
to issue CDs for a period between 1 year and up to 3 years.
 CDs normally give a higher return than Bank term deposit. CDs are
rated by approved rating agencies(e.g. CARE, ICRA, CRISIL,
FITCH) which considerably enhances their tradability in secondary
market.
 CDs are issued in denominations of Rs.1 Lac and in the multiples of
Rs. 1 Lac thereafter

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 Commercial Papers- A CP is a short term security (7 days to 365
days) issued by a corporate entity (other than a bank), at a
discount to the face value.
 One can invest in CPs starting from a minimum of 5 lacs (face
value) and multiples thereof. CPs are rated by approved rating
agencies (e.g. CARE, ICRA, CRISIL, FITCH). .
 CPs normally give a higher return than fixed deposits & CDs. We
deal in investment grade CPs only.
 CPs can be traded in the secondary market, depending upon
demand. An element of credit risk is attached to CPs.

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 Valuation of Securities
 The concept of a cost of equity
 The cost of equity is the cost to the company of providing equity
holders with the return they require on their investment.
 The primary financial objective is to maximize the return to equity
shareholders. This return is as the future dividend yield and capital
growth.
 Until new shareholders become members of the company, the
objective above is concerned with existing shareholders. Company
management will need to offer new shareholders the minimum
acceptable future return on the funds they put into the company,
thereby retaining as much benefit as possible for existing
shareholders.

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 Anticipated rate of return on existing equity
 The anticipated rate of return on a share acquired in the market
consists of two components:
 Component I - Dividends paid until share sold
 Component 2 - Price when sold
 In order to make a purchase decision, the shareholder must
believe the price is below the value of the receipts, i.e, -
 Current price, Po <   Dividends to sale + Sale price
                                    Discounted at rate i
 Algebraically, if the share is held for n years then sold at a price
Pn and annual dividends to year n are D1, D2, D3, ... Dn
 Then:
   
 Po < D1/(1+i)¹  + D2/(1+i)²  + D3/(1+i)³ + (Dn + Pn)/(1+i)ⁿ
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 Limitations of the above valuation model
 It is important to appreciate that there are a number of problems and
specific assumptions in this model.
 (a) Anticipated values for dividends and prices - all of the
dividends and prices used in the model are the investor's estimates of
the future.
 (b) Assumption of investor rationality - the model assumes
investors act rationally and make their decisions about share
transactions on the basis of financial evaluation.
 (c) Application of discounting - it assumes that the conventional
compound interest approach equates cash flows at different points in
time.
 (d) Share prices are ex div
 (e) Dividends are paid annually with the next dividend payable in
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one year.
 Dividend Valuation Model
 To value a stock, first find the present discounted value of the
expected cash flows.
 •         P0  =  Div1/(1 + ke)  + P1/(1 + ke) where
 –        P0  = the current price of the stock
 –        Div = the dividend paid at the end of year 1
 –        ke   = required return on equity investments
 –        P1   = the price at the end of period one
 •         P0  =  Div1/(1 + ke)  + P1/(1 + ke)
 Let ke = 0.12, Div = 0.16, and P1 = Rs.60.
 •         P0  =  0.16/1.12 +  Rs.60/1.12
 •         P0  =  Rs.0.14285 + Rs.53.57
 •         P0  =  Rs.53.71

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 Generalized Dividend Valuation Model
 The one period model can be extended to any number of periods.
 P0 = D1/(1+ke)1 + D2/(1+ke)2 +…+ Dn/(1+ke)n + Pn/(1+ke)n
 If Pn is far in the future, it will not affect P0. Therefore, the
model can be rewritten as:
 P0  =  S Dt/(1 + ke)t
 The model says that the price of a stock is determined only by the
present value of the dividends.
 If a stock does not currently pay dividends, it is assumed that it
will someday after the rapid growth phase of its life cycle is
over.
 Computing the present value of an infinite stream of dividends
can be  difficult. Simplified models have been developed to make
the calculations easier.
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 The Gordon Growth Model

 P0 = D0(1+g)1  +  D0(1+g)2 +…..+  D0(1+g)∞

 (1+ke)1 (1+ke)2      (1+ke)∞
 where
 D0 = the most recent dividend paid
  g   = the expected growth rate in dividends
  ke  = the required return on equity investments
 The model can be simplified algebraically to read:
 P0 = D0(1 + g)           D1
         (ke - g)      (ke – g)

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 Assumptions:
 Dividends continue to grow at a constant rate for an
extended period of time.
 The growth rate is assumed to be less than the required
return on equity, ke.
 Gordon demonstrated that if this were not so, in the
long run the firm would grow impossibly large.
 Find the current price of Coca Cola stock assuming
dividends grow at a constant rate of 10.95%, D0 = Rs.1.00,
and ke is 13%.
 –        P0 = D0(1 + g)/ke – g
 –        P0 = Rs.1.00(1.1095)/0.13 - 0.1095 =
 –        P0 = Rs.1.1095/0.0205 =  Rs.54.12
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 Price Earnings Valuation Method
 Gordon Model: Conclusions
 •         Theoretically, the best method of stock valuation is the dividend
valuation approach.
 •         But, if a firm is not paying dividends or has an erratic growth
rate, the approach will not work.
 •         Consequently, other methods are required.
 Price Earnings Valuation Method
 •         The price earning ratio (PE) is a widely watched measure of
how much the market is willing to pay for Rs.1 of earnings from a
firm. A high PE has two interpretations:
 –        A higher than average PE may mean that the market expects
earnings to rise in the future.
 –        A high PE may indicate that the market thinks the firm's
earnings are very low risk and is therefore willing to pay a premium
for them.
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 36
 Cost of preference shares By definition preference shares
have a constant dividend
  kp  =  D/MV(ex div)
  where D = constant annual dividend 
 If you have cumulative preference shares, the MV is increased
by the outstanding amount to be paid. Preference dividends are
normally quoted as a percentage, eg 10% preference shares.
This means that the annual dividend will be 10% of the
nominal value, not the market value..
 Share prices change, often dramatically, on a daily basis.  The
dividend valuation model will not predict this, but will give an
estimate of the underlying value of the shares.

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 INVESTMENT DECISIONS
 Features of investment:
a. Exchange of current funds for future benefits.
b. Funds are invested in long term assets.
c. Future benefits will occur to the firm over a series of years
 Importance of investment decision:
i. Influence the firm's growth in the long run.(GROWTH)
ii. They affect the risk of the firm. (RISK)
iii. They involve commitment of large amount of funds.
(FUNDING)
iv. They are irreversible or reversible with substantial cost/ loss
(IRREVERSIBILITY)
v. They are among the most difficult decagon to
make( (COMPLEXITY)
(
 INVESTMENT CRITERIA

INVESTMENT
CRITERIA

DI SCO U N TI NG N O N -D IS CO U N TIN G
CRITERIA CRI TERI A

BENEFIT INTERNAL
NET PRESENT COST RATE OF PAY BACK ACCOUNTING

VALUE RATIO RETURN METHOD

RATEOF
RETURN

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 PROJECT CASH FLOWS
 Elements of cash flow stream:
i. Initial investment (cash out floe)
ii. Operating cash inflows
iii. Terminal cash inflow.
 Time horizon for analysis:
i. Physical life of the plant
ii. Technological life of the plant
iii. Product market life of the plant.
iv. Investment planning horizon of the firm

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 Incremental principle- project cash flow for year 1= project cash
flow for year 1 with the project- project cash flow for year 1
without the project-
 Consider all incidental effects-effect of complimentary relationship
of new product with existing product- product cannibalization.
Loss of sales on product cannibalization treated will depend on
whether the competitor will introduce a close substitute
 Ignore sunk costs
 Include opportunity cost
 Question allocation of overhead costs.
 Estimate working capital properly.

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 Basic principles of cash flow estimation.
 Separation principle;-Financing side and investment side to
be separated. The important point to be noted is that in
defining cash flows on the investment side financing cost
should not be considered since they will be reflected in cost of
capital figure against which the rate of return figure will be
evaluated
 Operationally the above means that interest t of debt is to be
ignored while calculating profits and taxes thereon
PROJECT
Financing Side Investment side
Time Cash flow Time Cash flow
0 +1000 0 -1000
1 -1150 1 +1200
Cost of capital =15% Rate of Return 20% 42
 Post tax principle- tax rate
 Treatment of losses
Scenario Project Firm Action
1 Incurs losses Incur losses Defer tax savings
2 Incurs losses Makes profit Take tax savings in the year of loss

3 Makes profit Incur losses Defer tax unitil the firm makes profit
4 Makes profit Makes profit Consider tax in the year of profit
Stand Incur losses Defer tax savings until the firm
alone makes profit

 Effect of non cash charges can have an impact on tax liabilty like in
case of depreciation.
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 CAPITAL MARKET

PRIMARY PLAYERS SECONDARY

COMPANY
QUANTUM OF COST OF SETTLEMENT
METHOD OF ISSUE BROKERS LISTING TRADING
ISSUE ISSUE CLEARING
PUBLIC

PUBLIC

RIGHT

BONUS

PRIVATE
PLACEMENT

BOUGHT OUT
DEALS
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 Therefore,
 a Capital Budgeting Decision needs systematic and careful analysis.
But, such analysis is a many-sided activity which includes among
others the estimation and forecasting of current and future cash
flows and the economic evaluation of alternative projects. Since in
reality the cash flows estimation complex interplay of takes place in
a non-deterministic environment, full of conflicting forces, an exact
description about cash flows is virtually impossible
 Therefore, a firm has to take such decisions in fuzzy environment
and this work makes an attempt to develop procedures and
techniques so as to equip decision analyst to achieve a meaningful
economic evaluation of projects
 work makes an attempt to develop procedures and techniques so as
to equip
 decision analyst to achieve a meaningful economic evaluation of
projects. 45
 Capital Budgeting Tools

 • Payback Period

 • Accounting Rate of Return

 • Net Present Value

 • Internal Rate of Return

 • Profitability Index

46
 Sensitivity Analysis
 Sensitivity analysis is used to determine how “sensitive” a
model is to changes in the value of the parameters of the
model and to changes in the structure of the model.
 Sensitivity analysis helps to build confidence in the model
by studying the uncertainties that are often associated with
parameters in models. Many parameters in system dynamics
models represent quantities that are very difficult, or even
impossible to measure to a great deal of accuracy in the real
world.
 Also, some parameter values change in the real world.
 Sensitivity analysis allows him to determine what level of
accuracy is necessary for a parameter to make the model
sufficiently useful and valid.
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 Risk-Return Paradigm
 finance executives today face a challenging shift
 in the risk management paradigm: how can they
effectively assess the future without relying on
measuring what’s happened in the past?
 As the quest for profitable growth dominates corporate
decision making, companies look for ways to create and
capture value by launching new, innovative products or
growth businesses—and to the extent possible, to try to
bring some degree of certainty and predictability extent
possible, to try to bring some degree of certainty and
predictability
48
 The manifestation of returns is partially driven by
thoughtful and calculated risk-taking.
 The concept of underlying risk exposure factors has
become increasingly important, especially during the
recent economic crisis.
 The relationship of various asset classes to each other
has influenced the actual returns of each asset class,
with global equities generally losing value across the
board as a result of what at first appeared to be isolated
problems in the U.S. sub-prime debt market. As the
crisis unfolded, linkages across the various asset
classes became stronger, exacerbating the risk to the
entire financial market. 49
 Risk budgeting techniques attempt to identify and
quantify risks within a policy portfolio framework. Risk
budgeting policies are carefully designed to allocate
risks across the choice of asset classes in an effort to
maximize returns on a suitable risk-adjusted basis
without breaching the risk budget.
 Ideally, the return per unit of risk justifies the
expenditure of risk
 The spectrum of risk covers wide ranging factors that
could impact the outcome of portfolio decisions such as
counterparty risk and the soundness of the financial
stability of potential and existing counterparties.
50
 In addition, a key portfolio risk that is front and
foremost today is idiosyncratic risk associated with
specific alternative asset classes that are difficult to
quantify or predict.
 Increasingly compliance managers are the new risk
officers, while risk managers are becoming partners to
the asset class managers and CIOs in structuring risk
aware portfolios.
 In addition, qualitative judgment is becoming more
complementary to an established reliance on
quantitative
analysis as what-if scenarios and stress-testing portfolios
move to the head of the queue. 51
 Capital Structure Decisions
 Capital Structure Decisions
 Introduction: The two principal sources of finance for a
company are equity and debt. What should be the proportion of
equity and debt in the capital structure of the firm? One of the
key issues in the capital structure decision is the relationship
between the capital structure and the value of the firm. There
are several views on how this decision affects the value of the
firm.
 Capital structure theories:
 Basic assumptions:
 There are only two kinds of funds used by a firm i.e. debt and
equity.

52
 Taxes are not considered.

 The payout ratio is 100%

 The firm’s total financing remains constant

 Business risk is constant over time

 The firm has perpetual life.

53
 Net Income Approach (NI)
 According to this approach, the cost of debt and the cost of
equity do not change with a change in the leverage ratio. As a
result the average cost of capital declines as the leverage ratio
increases. This is because when the leverage ratio increases,
the cost of debt, which is lower than the cost of equity, gets a
higher weightage in the calculation of the cost of capital.
 The formula to calculate the average cost of capital is as
follows:

54
 Ko = Kd (B/ (B+S)) + Ke (S/(B+S))
 Where:
 Ko is the average cost of capital
 Kd is the cost of debt
 B is the market value of debt
 S is the market value of equity
 Ke is the cost of equity

55
 Net Operating income Approach (NOI)
 According to this approach:
 The overall capitalisation rate remains constant for all levels
of financial leverage
The cost of debt also remains constant for all levels of
financial leverage
The cost of equity increases linearly with financial leverage
The formula to calculate the cost of capital is
Ko=Kd(B/(B+S))+Ke(S/(B+S))
 Ko and Kd are constant for all levels of leverage. Given this,
the cost of equity can be expressed as follows:
 Ke =Ko+(Ko-Kd)(B/S)

56
 Traditional or Intermediate Approach

 This approach is midway between the NI and the NOI approach.

The main propositions of this approach are:
 The cost of debt remains almost constant up to a certain degree
of leverage but rises thereafter at an increasing rate.
 The cost of equity remains more or less constant or rises
gradually up to a certain degree of leverage and rises sharply
thereafter.
 The cost of capital due to the behaviour of the cost of debt and
cost of equity
– Decreases up to a certain point
– Remains more or less constant for moderate increases in
leverage thereafter
– Rises beyond that level at an increasing rate.
57
 MM Approach
 According to this approach, the capital structure decision of a
firm is irrelevant. This approach supports the NOI approach and
provides a behavioural justification for it
 Additional assumptions of this approach include:
 Capital markets are perfect. All information is freely available
and there are no transaction costs
 All investors are rational
 Firms can be grouped into ‘Equivalent risk classes’ on the basis
of their business risk
 There are no taxes
 This approach indicates that the capital structure is irrelevant
because of the arbitrage process which will correct any imbalance
i.e. expectations will change and a stage will be reached where
further arbitrage is not possible.
58
 MM Approach-Assumptions
 Information is available at free of cost.
 The same information is available to all investors.
 Securities are infinitely divisible.
 Investor are free to buy or sell securities.
 There is no transaction cost.
 Investor can borrow without any restrictions at the same term
as company can borrow.
 There are no bankruptcy costs.
 Dividend payout ratio is 100%
 EBIT is not affected by use of debt.

59
 Basic Propositions in MM Approach
 I. The overall cost of Capital (Ko ) and the value of the firm ( V)
are independent of capital structure. In other words (Ko ) and V
are constant for any proportions of debt and equity. The total value
is given by capitalizing the expected net operating income by
discount rate appropriate to its risk class. THROUGH
ARBITRAGE PROCESS
 V =E+ D =NOI/ Ko
 II. The cost of equity Capital (Ke ) to capitalisation rate of the
equity plus premium for the financial risk. The cost of equity
Capital (Ke) increase with the use of more debt in capital
structure.. The increase in Ke exactly offset by the use less
expensive source of funds represented by debt.
 III. The cut rate for investment purpose s is completely 60
 Steps in working out Arbitrage Process
 Step-1:Investors current position
 Step-2.calculation of savings in investment by moving from
levered firm to unlevered firm..
 Step-3. Calculation of increased income
 Limitations of MM Approach
 Investors inability to borrow funds on ame conditions of
corporate
 Personal leverage will not substitute corporate leverage.
 Existence of transaction costs

61
62
 WORKING CAPITAL MANAGEMENT
 Meaning: Working capital means the funds (i.e.; capital)
available and used for day to day operations (i.e.; working) of an
enterprise. It consists broadly of that portion of assets of a
business which are used in or related to its current operations. It
refers to funds which are used during an accounting period to
generate a current income of a type which is consistent with major
purpose of a firm existence.
 Objectives of working capital:
Every business needs some amount of working capital. It is
needed for following purposes-
• For the purchase of raw materials, components and spares.
• To pay wages and salaries.
• To incur day to day expenses and overhead costs such as fuel,
power, and office expenses etc.
• To provide credit facilities to customers etc.
63
 Factors that determine working capital:

The working capital requirement of a concern depend upon a

large number of factors such as
? Size of business
? Nature of character of business.
? Seasonal variations working capital cycle
? Operating efficiency
? Profit level.
? Other factors.

64
 Sources of working capital

 :
The working capital requirements should be met both from
short term as well as long term sources of funds.

? Financing of working capital through short term sources

of funds has the benefits of lower cost and establishing
close relationship with banks.

? Financing of working capital through long term sources

provides the benefits of reduces risk and increases liquidity

65
 CORPORATE OBJECTIVES
 Corporate Objectives

 Corporate objectives are statements of intent that provide the

basic direction for the activities of an organization in pursuit of its
mission.

In many organizations there is overlapping and confusion between

the terms objectives and goals. This is easy to avoid if you think
of objectives as statements of intent and goals as quantifiable
targets. For more about goals and objectives,

Generally speaking, an objective is a broad statement of an

intention to do and/or achieve something.
66
 CORPORATE OBJECTIVES
 Profit maximization
 Wealth Maximization
 Market share
 Share price
 Technology leadership
 Customer satisfaction
 Ethical issues
 Efficiency
 Social issues
 Long-term survival
 Image and reputation

67
HOW DO YOU ASSESS PROJECT ECONNMIC
VIABILITY?
 PROJECT CALLS FOR HUGE INITIAL
INVESTMENT AND WHEN COMPLETED GIVES
ANNUAL YIELD OVER THE PROJECT PERIOD.
 IF THE PRESENT VALUE (AT A DESIRED RATE OF
INTEREST) OF TOTAL YIELD OF THE PROJECT
IS MORE THAN THE INITIAL INVESTMENT
THEN THE PROJECT IS CONSIDERED VIABLE.

68
WHYSHOULD TMONEY HAVE TIME VALUE?
 MONEY CAN BE EMPLOYED PRODUCTIVELY TO
GENERATE INCOME.
 IN A INFLATIONARY TREND MONEY HAVE
BETTER PURCHASING POWER TODAY THAN
TOMORROW.
 PROCESS OF COMPOUNDING: HERE THE
COMPARISON WILL BE BETWEEN HE FUTURE
VALUE OF THE INITIAL OUTFLOW AT THE END
OF THE PROJECT PERIOD WITH THE SUM OF
THE FUTURE VALUES PF THE YEARLYCASH IN
FLOWS 69
 TYPES OF INVESTMENTS

 Cash
– Simple interest vs. compound interest
Which would you rather choose?
Investment Rs.1,000
Time 20 years
Interest rate 7%
Rs.2,330.00 after 20
Simple interest account
years
Compound interest Rs.3,616.53 after 20
account years

70
 TYPES OF INVESTMENTS

 Cash equivalents
– Certificates of deposit
– Treasury bills
– Money market accounts
 Bonds
– Corporate bonds
– Municipal bonds
– Government bonds
71
 RISK MANAGEMENT

 Simple ways to minimize risk

– Diversification
– Asset allocation
– Rebalancing

72
 Capital Markets
 The Indian Equity Markets and the Indian Debt
markets together form the Indian Capital markets
The Indian Equity Market depends mainly on
monsoons, global funds flowing into equities and the
performance of various companies. The Indian Equity
Market is almost wholly dominated by two major
stock exchanges -National Stock Exchange of India
Ltd. (NSE) and The Bombay Stock Exchange (BSE).

73
 Capital Markets
 The benchmark indices of the two exchanges - Nifty
of NSE and Sensex of BSE are closely followed.
 The two exchanges also have an F&O (Futures and
options) segment for trading in equity derivatives
including the indices.
 The major players in the Indian Equity Market are
Mutual Funds, Financial Institutions and FIIs
representing mainly Venture Capital Funds and
Private Equity Funds.

74
 Capital Markets
 Indian Equity Market at present is a lucrative field for
investors. Indian stocks are profitable not only for
long and medium-term investors but also the position
traders, short-term swing traders and also very short
term intra-day traders.
 In India as on December 30 2007, market
capitalisation (BSE 500) at USRs. 1638 billion was
150 per cent of GDP, matching well with other
emerging economies and selected matured markets.

75
 Capital Markets
 How do the debt markets impact the economy?
1. Increased funds for implementation of government development
plans. The government can raise funds at lower costs by issuing
government securities.
 2. Conducive to implementation of a monetary policy.
 3. Less risk compared to the equity markets, encouraging low-risk
investments. This leads to inflow of funds into the economy.
 4. Higher liquidity and control over credit.
 5. Opportunity for investors to diversify their investment portfolio.
 6. Better corporate governance.
 7. Improved transparency because of stringent disclosure norms and
auditing requirements.

76
 Cost of Debt
 The coupon rate gives the gross rate of interest received by
debenture-holders.
 The coupon rate is based on the nominal value of the debentures.
 MV is normally quoted as the MV of a block of Rs.100 nominal
value. For example 10% debentures quoted at Rs.95 means that a
Rs.100 block is selling for Rs.95 and annual interest is Rs.10 per
Rs.100 block. Irredeemable.  
 Using the same logic as for dividends and looking at the cash
flows from the investor's point of view.
 MV (ex interest) =  present value of future interest payments
discounted at the debenture-holder's required rate of return.

77
 For irredeemable debentures interest is a constant
perpetuity. 
 MV (ex int)  =  I/r where  I =  annual interest received  r 
=  return required by debenture holder 
 r  = I/MV = Interest yield 
 The company gets tax relief on the debenture interest it
pays, which reduces the cost of debentures to the company.

78
 Convertible debentures
 Convertible debentures or loan stock allow the investor to choose
between redeeming the debentures at some future date or
converting them into a pre-determined number of ordinary shares
in the company.   In order to find the cost of debt of convertibles it
is necessary to be able to determine which option the investor will
exercise and at what date.  
 This will normally involve the following stages:
 Step 1
 Calculate the value of the conversion option
 Step 2
 Compare the conversion option with the redemption option. As
investors are rational it can be assumed that they will all choose
the option with the higher value.
  2.  79
 Step 3
 Calculate the IRR of the cash flows as for redeemable
debentures using either the conversion value or redemption
value as determined in Step2
 Example:
 A company has in issue some 8% convertible loan stock
currently quoted at Rs.85 ex interest. The loan stock is
redeemable at a 5% premium in five years time, or can be
converted into 40 ordinary shares at that date. The current ex
div market value of the shares is Rs.2 per share and dividend
growth is expected at 7% per annum. Corporation tax is 33%.
 What is the cost to the company of the convertible loan stock?

80
 Solution:
 First we need to decide whether the loan stock will be
converted or not in five years.  To do this we compare the
expected value of 40 shares in five years' time with the cash
alternative.
 We assume that the MV of shares will grow at the same rate as
the dividends.
 MV/share in five years =  2(1.07)5 = Rs.2.81 
 ∴  MV of 40 shares × Rs.2.81 =  Rs.112.40
 Cash alternative =  Rs.105
  Therefore all loan stock-holders will choose the share
conversion. To find the cost to the company, find the IRR of
the post-tax flows.

81
 Discount Discount
Time Cash flow PV PV
factor factor@10%

0 (85) 1 (85) 1 (85)

1-5 8(1-0.33) 4.329 23.2 3.791 20.32

5 112.4 0.784 88.12 0.621 69.80

NPV 26.32
Therefore the cost to the company = 11.2% 5.12
IRR = 5 + 26.32/(26.32-512) x (10-5) = 11.2%

IRR = 5 + 26.32/(26.32-512) x (10-5) = 11.2%

Therefore the cost to the company = 11.2% 82
P/E RATIO EPS MARKET MARKET STATUS
PRICE VALUE
8 20 140 160 Over valued

6 20 140 120 Undervalued

83
 DISTINCTION AMONG VALUATION
CONCEPTS
 Liquidation value versus going concern value: while in case of
liquidation assets are separately sold to realize cash but in case of
going concern the value is for a going concern as an entity.
Generally security valuation is done as going concern concept
 Book value versus market value.
 Market value versus intrinsic value

84
Bond value = Present value of interest + Present value of maturity
value
n
INTt Bn
B0   
t 1 (1  kd ) (1  kd ) n
t

The yield-to-maturity (YTM) is the measure of a bond’s

rate of return that considers both the interest income and
any capital gain or loss. YTM is bond’s internal rate of
return.
(1  kd )t kd t 1
B0   
n 
INT INT
85
 Bond Value and Amortisation of Principal
A bond (debenture) may be amortised every year, i.e., repayment
of principal every year rather at maturity.
The formula for determining the value of a bond or debenture that
is amortised every year, can be written as follows:

Note that cash flow, CF, includes both the

interest and repayment of the principal.

CFt n
B0  
t 1 (1  k d )
t
86
 Pure Discount Bonds
 Pure discount bond do not carry an explicit rate of interest. It
provides for the payment of a lump sum amount at a future date in
exchange for the current price of the bond. The difference between the
face value of the bond and its purchase price gives the return or YTM
to the investor.
 Example: A company may issue a pure discount bond of Rs 1,000
face value for Rs 520 today for a period of five years. The rate of
interest can be calculated as follows:
1, 0 0 0
520 
1  Y T M 
5

1, 0 0 0
1  
5
YTM   1 .9 2 3 1
520
i  1 . 9 2 3 1 1 / 5  1  0 . 1 4 o r 1 4 87%
 Perpetual Bonds
Suppose that a 10 per cent Rs 1,000 bond will pay
Rs 100 annual interest into perpetuity. What would
be its value of the bond if the market yield or
interest rate were 15 per cent?
The value of the bond is determined as follows:

INT 100
B0    Rs 667
kd 0.15
88
 The Expectation Theory
 The expectation theory supports the upward sloping
yield curve since investors always expect the short-
term rates to increase in the future.
 This implies that the long-term rates will be higher
than the short-term rates.
 But in the present value terms, the return from
investing in a long-term security will equal to the
return from investing in a series of a short-term
security.

89
 The expectation theory assumes
– capital markets are efficient
– there are no transaction costs and
– investors’ sole purpose is to maximize their returns
 The long-term rates are geometric average of current and
expected short-term rates.
 A significant implication of the expectation theory is that
given their investment horizon, investors will earn the
same average expected returns on all maturity
combinations.
 Hence, a firm will not be able to lower its interest cost in
the long-run by the maturity structure of its debt.

90
 The Liquidity Premium Theory

 Long-term bonds are more sensitive than the

prices of the short-term bonds to the changes in
the market rates of interest.
 Hence, investors prefer short-term bonds to the
long-term bonds.
 The investors will be compensated for this risk by
offering higher returns on long-term bonds.
 This extra return, which is called liquidity
premium, gives the yield curve its upward bias.

91
 The liquidity premium theory means that rates on
long-term bonds will be higher than on the short-
term bonds.
 From a firm’s point of view, the liquidity premium
theory suggests that as the cost of short-term debt
is less, the firm could minimize the cost of its
borrowings by continuously refinancing its short-
term debt rather taking on long-term debt.

92
 The Segmented Markets Theory

 The segmented markets theory assumes that the

debt market is divided into several segments based
on the maturity of debt.
 In each segment, the yield of debt depends on the
demand and supply.
 Investors’ preferences of each segment arise
because they want to match the maturities of
assets and liabilities to reduce the susceptibility to
interest rate changes.
93
 Valuation of Shares

 A company may issue two types of shares:

– ordinary shares and
– preference shares

 Features of Preference and Ordinary Shares

– Claims 
– Dividend 
– Redemption
– Conversion 

94
Value of a Preference Share-Example

Suppose an investor is considering the purchase of a 12-year, 10% Rs 100 par value preference share. The
redemption value of the preference share on maturity is Rs 120. The investor’s required rate of return is
10.5 percent. What should she be willing to pay for the share now? The investor would expect to receive
Rs 10 as preference dividend each year for 12 years and Rs 110 on maturity (i.e ., at the end of 12 years).
We can use the present value annuity factor to value the constant stream of preference dividends and the
present value factor to value the redemption payment.
 1 1  120
P0  10    12 
 0. 105 0. 105  (1 .105)  (1. 105)12
 10  6.506  120  0.302  65.06  36.24  Rs101.30

Note that the present value of Rs 101.30 is a composite of the present value of dividends, Rs 65.06 and
the present value of the redemption value, Rs 36.24.The Rs 100 preference share is worth Rs 101.3 today
at 10.5 percent required rate of return. The investor would be better off by purchasing the share for Rs 100
today.

95
 Valuation of Ordinary Shares

 The valuation of ordinary or equity shares is

relatively more difficult.
– The rate of dividend on equity shares is not
known; also, the payment of equity dividend is
discretionary.
– The earnings and dividends on equity shares are
generally expected to grow, unlike the interest on
bonds and preference dividend.

96
 Dividend Capitalisation
The value of an ordinary share is determined by
capitalising the future dividend stream at the
opportunity cost of capital
DIV1  P1
Single Period Valuation P0 
1  ke
If the share price is expected to grow at g per cent,
then P1: P 1  P (1  g )
0
We obtain a simple formula for the share

DIV1
valuation as follows:

P0 
ke  g
97
 Multi-period Valuation
If the final period is n, we can write the general formula for share
value as follows:

n
DIVt Pn
P0   
t 1 (1  ke )t (1  ke ) n
Growth in Dividends

Growth = Retention ratio  Return on equity

g  b  ROE
Normal Growth
DIV1
P0 
ke  g

Share value  PV of dividends during finite super-normal growth period

 PV of dividends during indefinite normal growth period
98
For firms for which dividends are expected
to grow at a constant rate indefinitely and
the current market price is given

DIV1
ke  g
P0

99
 Price-Earnings (P/E) Ratio: How
Significant?
 P/E ratio is calculated as the price of a share
divided by earning per share.
 Some people use P/E multiplier to value the shares
of companies.
 Alternatively, you could find the share value by
dividing EPS by E/P ratio, which is the reciprocal
of P/E ratio.

100
 Price-Earnings (P/E) Ratio: How
Significant?
The share price is also given by the following formula:

EPS1
P0   Vg
ke
The earnings price ratio can be derived as follows:

EPS1  Vg 
 ke 1  
Po  Po 
101
 Price-Earnings (P/E) Ratio: How
Significant?
 Cautions:
– E/P ratio will be equal to the capitalisation rate only if
the value of growth opportunities is zero.
– A high P/E ratio is considered good but it could be high
not because the share price is high but because the
earnings per share are quite low.
– The interpretation of P/E ratio becomes meaningless
because of the measurement problems of EPS.

102
 CAPITAL BUDGETING
 Capital budgeting decisions pertain to fixed/long term assets
-refer to assets which are in operation and yield return or revenue
generating assets
 This is a critical and important financial decision as it – has an it
has influence on the firm’s profitability; has a definite bearing on
competitive position of the enterprise as it decides the earning
capacity of the firm; has a long term impact; decision canot be
easily reversed; it involves cost.
 Difficulties: 1. benefits are received in future period which is
uncertain. 2.costs incurred and benefits derived are from capital
budgeting decisions are in different time periods. 3.it it is not
possible to estimate accurate return in the future.

103
 CAPITAL BUDGETING
 RATIONALE: the rationale underlying the capital budgeting
decision is efficiency. Thus afirm must replace old and obsolete
equipments, introduce state of art technology,, new products or
services,, make strategic investment decisions
 Investment decisions affecting revenues
 Investment decisions reducing costs.
 Ca[pital budgeting decisions involves:-
 Accept or reject decision
 Mutually exclusive project decisions- acceptance of one will
exclude acceptance of another.
 Capital rationing decision

104
 CAPITAL BUDGETING
 Data Requirement: Identifying relevant cash flows.
 Cash flows vs Accounting profit- primary difference is
inclusion non-non-cash expenses like Depreciation. Therefore
accounting profit is to be adjusted withsuch non cash
expenses.
 Cash flow estimates-
 Tax effects- cash flow for capital budgeting decision is to be
net of taxes.
 Effect on other projects
 Effect of indirect expense
 Effect of depreciation
 Working capital effect.

105
 EVALUATING CAPITAL BUDGETING
DECISIONS
 Evaluation of NPV Method- provides most acceptable
investment rule for the following reasons:
i. Time value
ii. Measure of true profitability since it uses all cash flows of the
project.
iii. Value additively- the discounting process facilitates measuring
cash flows in terms of present value,, that is, in terms of
equivalent current rupees.
iv. Shareholders value- NPV method is always consistent with
the objective of the shareholders.

106
 Limitations in using NPV Rule:
i. Cash flow estimation
ii. Discount rate
iii. Mutually exclusive projects.
iv. Ranking of projects
INTERNAL RATE OF RETURN: The rate which equates
Present value of future cash flows to initial cash outflow, that
is NPV=0
IRR measures the profitability as percentage which can be easily
compared with opportunity cost while evaluation a project.
Hence it is popular.

107
 PROFITABILITY INDEX/BENEFIT COST RATIO
 Benefit cost Ratio = PV of Future cash flows /investment
 NBCR = BCR-1
 Like NPV and IRR PI is also a sound method of project
evaluation
 It is variation of NPV method and requires NPV calculation.
 Merits:
i. It recognizes time value
ii. It is consistent with shareholders value maximisation
principle.
iii. Since PV of future cash flows divided by initial cash outflow
it is a relative measure of profitability

108
 Maris of IRR:
i. Time value.
ii. Profitability measure
iii. Acceptance rule- same as NPV
iv. Shareholders value
 Limitations:
i. Multiple rates- A project can have multiple crate . It may not
have a unique rate.
ii. Mutually exclusive projects.
iii. Value additively- unlike in NPV value additively principle
dose not hold under IRR method.

109
 RISK ANALYSIS IN CAPITAL BUDGETING-
SENSITIVITY ANALYSIS

 Expected revenue is function of sales volume and selling price.

 Sales volume depends on the market and the firm’s market share.
 Costs include variable costs which depend on sales volume and
unit variable cost and fixed cost.
 NPV or IRR depends on the after tax cash flows and discount
rate.
 It is therefore difficult to arrive at accurate and unbiased forecast
of each variable.
 The reliability of NPV or IRR depends on the reliability of the
forecast.

110
 RISK ANALYSIS IN CAPITAL UDGETING-
SENSITIVITY ANALYSIS

 We can change each of the forecast one at a time to at least

three variable- pessimistic, expected and optimistic
 We can then recalculate the NPV OR IRR under these
 different assumptions.

111
 Calculation of NPV in different assumptions

Sl.No Variale 0 1 2 3 4 5 6 7
1 Investment -10000
2 Revenue 15000 15000 15000 15000 15000 15000 15000
3 Variale cost 6750 6750 6750 6750 6750 6750 6750
4 fixed cost 4000 4000 4000 4000 4000 4000 4000
5 Depreciation 2500 1875 1406 1055 791 593 1347
6 EIT(2-3-4-5) 1750 2375 2844 3195 3459 3657 2903
7 Tax 613 831 995 1118 1211 1280 1016
8 PAT(6-7) 1138 1544 1849 2077 2248 2377 1887
9 NCF(1+5+8) -10000 3638 3419 3255 3132 3039 2970 3234
10 Pv Factor 0.893 0.797 0.712 0.636 0.567 0.507 0.452
11 PV(8*9) 3248 2725 2317 1992 1723 1506 1462 14973
112
12 NPV ( 4973
 PESSIMISTIC-VOLUME CHANGE to 750 UNITS

Sl.No Variable 0 1 2 3 4 5 6 7
-
1Investment 10000
2Revenue 11250 11250 11250 11250 11250 11250 11250
Variable
3 cost 5063 5063 5063 5063 5063 5063 5063
4fixed cost 4000 4000 4000 4000 4000 4000 4000
Depreciatio
5n 2500 1875 1406 1055 791 593 1347
EIT(2-3-4-
6 5) -313 313 782 1133 1397 1595 841
7Tax -109 109 274 396 489 558 294
8PAT(6-7) -203 203 508 736 908 1036 546
NCF(1+5+8 -
9) 10000 2297 2078 1914 1791 1699 1629 1893
10Pv Factor 0.893 0.797 0.712 0.636 0.567 0.507 0.452
11PV(8*9) 2051 1656 1363 1139 963 826 856 8854
12NPV ( -1146
113
 OPTIMISTIC VOLUME CHANGE TO 1250 UNITS
Sl.No Variable 0 1 2 3 4 5 6 7

-
1Investment 10000

2Revenue 18750 18750 18750 18750 18750 18750 18750

3Variable cost 8438 8438 8438 8438 8438 8438 8438

4fixed cost 4000 4000 4000 4000 4000 4000 4000

5Depreciation 2500 1875 1406 1055 791 593 1347

6EIT(2-3-4-5) 3813 4438 4907 5258 5522 5720 4966

7Tax 1334 1553 1717 1840 1933 2002 1738

8PAT(6-7) 2478 2884 3189 3417 3589 3718 3228

-
9NCF(1+5+8) 10000 4978 4759 4595 4472 4380 4311 4575

10Pv Factor 0.893 0.797 0.712 0.636 0.567 0.507 0.452

11PV(8*9) 4445 3793 3272 2844 2483 2186 2068 21092

114
12NPV ( 11092
 Risk & Return-Capital Market Theory
 In studying the capital market theory we deal with issues like
the role of the capital markets, the major capital markets, the
initial public offerings and the role of the venture capital in
capital markets, financial innovation and markets in derivative
instruments, the role of securities and the exchange commission,
the role of the federal reserve system, role of the SEBI and the
regulatory requirements on the capital market.
 The market where investment funds like bonds, equities and
mortgages are traded is known as the capital market . The
financial instruments that have short or medium term maturity
periods are dealt in the money market whereas the financial
instruments that have long maturity periods are dealt in the
capital market.

115
 Role of the Capital Market

 The main function of the capital market is

 to channelize investments from the investors who have surplus
funds to the investors who have deficit funds.
 The different types of financial instruments that are traded in the
capital markets are equity instruments, credit market
instruments, insurance instruments, foreign exchange
instruments, hybrid instruments and derivative instruments.
 The money market instruments that are traded in the capital
market are Treasury Bills, federal agency securities, federal
funds, negotiable certificates of deposits, commercial paper,
bankers' acceptance, repurchase agreements, Eurocurrency
deposits, Eurocurrency loans, futures and options.

116
 Initial Public Offering and the role of Venture Capital
in the capital market
 The companies raise their long term capital through the
issue of shares that are floated in the capital market in the
form of Initial Public Offering. The venture capital are the
funds that are raised in the capital market via the
specialized operators. This is also a very important source
of finance for the innovative companies.

117
 Markets in Derivatives
 The derivatives like the options, futures, credit derivatives etc
are traded in the capital markets.
 Return Measures
 Total return = dividend income capital gain/loss
 = Divt+1+Pt+1􀀀Pt
 note that this formula assumes a single holding period;
otherwise we must consider the time value of money
 example: suppose you bought a share of Widget Corp. at the
beginning of January 2004 when its price was Rs.19.75 per
share. By the end of the year the price of the stock had
appreciated to Rs.27.50. In addition, the rm paid a dividend of
Rs.1.50 per share.
 What is your total return?
118
 percentage return:
 Rt+1 = total dollar return / Pt
 = Divt+1+(Pt+1􀀀Pt) / Pt
 this formula also assumes a single holding period, and it gives
the return on an investment of Rs.1
 example: what was the percentage return for Widget Corp.'s
stock?
 percentage return is preferred since it is independent of the
amount of money invested

119
 Markowitz Portfolio Theory
 Modern portfolio theory (MPT) is a theory of investment which
tries to maximize return and minimize risk by carefully choosing
different assets. Although MPT is widely used in practice in the
financial industry and several of its creators won a Nobel prize for
the theory, in recent years the basic assumptions of MPT have been
widely challenged by fields such as behavioral economics.
 More technically, MPT models an asset's return as a
normally distributed random variable, defines risk as the
standard deviation of return, and models a portfolio as a weighted
combination of assets so that the return of a portfolio is the
weighted combination of the assets' returns. By combining different
assets whose returns are not correlated, MPT seeks to reduce the
total variance of the portfolio. MPT also assumes that investors are
rational and markets are efficient.
120
121
 MPT was developed in the 1950s through the early 1970s and
was considered an important advance in the mathematical
modeling of finance. Since then, much theoretical and
practical criticism has been leveled against it. These include
the fact that financial returns do not follow a
Gaussian distribution and that correlations between asset
classes are not fixed but can vary depending on external events
(especially in crises). Further, there is growing evidence that
investors are not rational and markets are not efficient
 Risk and return

122
 MPT assumes that investors are risk averse, meaning that
given two assets that offer the same expected return,
investors will prefer the less risky one. Thus, an investor
will take on increased risk only if compensated by higher
expected returns. Conversely, an investor who wants
higher returns must accept more risk. The exact trade-off
will differ by investor based on individual risk aversion
characteristics. The implication is that a rational investor
will not invest in a portfolio if a second portfolio exists
with a more favorable risk-return profile – i.e., if for that
level of risk an alternative portfolio exists which has better
expected returns.
123
 MPT further assumes that the investor's risk / reward preference can be
described via a quadratic utility function. The effect of this assumption is
that only the expected return and the volatility (i.e., mean return and
standard deviation) matter to the investor. The investor is indifferent to
other characteristics of the distribution of returns, such as its skew
(measures the level of asymmetry in the distribution) or kurtosis (measure
of the thickness or so-called "fat tail").
 Note that the theory uses a parameter, volatility, as a proxy for risk, while
return is an expectation on the future. This is in line with the
efficient market hypothesis and most of the classical findings in finance.
There are problems with this, see criticism.
 Under the model:
 Portfolio return is the proportion-weighted combination of the constituent
assets' returns.
 Portfolio volatility is a function of the correlation ρ of the component
assets. The change in volatility is non-linear as the weighting of the
component assets changes. 124
 Diversification
 An investor can reduce portfolio risk simply by holding combinations of
instruments which are not perfectly positively correlated (
correlation coefficient -1<(r)<1)). In other words, investors can reduce their
exposure to individual asset risk by holding a diversified portfolio of assets.
Diversification will allow for the same portfolio return with reduced risk.
 If all the assets of a portfolio have a correlation of +1, i.e., perfect positive
correlation, the portfolio volatility (standard deviation) will be equal to the
weighted sum of the individual asset volatilities. Hence the portfolio variance
will be equal to the square of the total weighted sum of the individual asset
volatilities.[2]
 If all the assets have a correlation of 0, i.e., perfectly uncorrelated, the portfolio
variance is the sum of the individual asset weights squared times the individual
asset variance (and the standard deviation is the square root of this sum).
 If correlation coefficient is less than zero (r=0), i.e., the assets are inversely
correlated, the portfolio variance and hence volatility will be less than if the
correlation coefficient is 0.
125
 Markowitz model -Assumptions
 The individual investor estimates risk on the basis of variability of
returns-variance of returns
 Investment decision is entirely based on expected returns and its
variance.
 For a given level of risk investor prefer higher return.
 Alternatively for given level of return investor prefers
 lower level of risk.
 THE CONCEPT-Markowitz had given up single stock portfolio
and introduced diversification.

126
 Capital market line
 When the market portfolio is combined with the risk-free asset,
the result is the Capital Market Line. All points along the CML
have superior risk-return profiles to any portfolio on the efficient
frontier. Just the special case of the market portfolio with zero
cash weighting is on the efficient frontier. Additions of cash or
leverage with the risk-free asset in combination with the market
portfolio are on the Capital Market Line. All of these portfolios
represent the highest possible Sharpe ratio. The CML is
illustrated above, with return μp on the y-axis, and risk σp on the
x-axis.
 CML is an efficient set of risk free and risky securities. And it
shows the risk-return in the market equilibrium.

127
 RISK-RETURN RELATIONSHIP FOR PORTFOLIO OF RISK FREE
AND RSKY SECURITIES
14

12 D
EXPECTED RETURN

10 C

8
B

6 Series 3
A
4

2
6.0
RISK FREE RATE
0
1.8 3.6 5.4 7.2 9
STANDARD DEVIATION

128
 Observation that the construction of a diversified portfolio of
risk-free investments and those with varying degree of risk is
unaffected by the investor's personal preferences. That is, an
investor makes choices on the basis of the net present value of
the projected returns and not on his or her level of
risk tolerance. Since this behavior separates the decision about
the type of investments from the decision about the acceptable
level of risk, it is named portfolio separation theorem. Its
implication is that a company's choice of debt-equity ratio is
inconsequential. Also called Fisher's Separation Theory after
its proposer, the U.S. economist Irving Fisher (1876-1947).

129
CAPITAL ASSET PRICING MODEL (CAPM
 In finance, the capital asset pricing model (CAPM) is used to
determine a theoretically appropriate required rate of return of an
asset, if that asset is to be added to an already well-diversified
portfolio, given that asset's non-diversifiable risk. The model takes
into account the asset's sensitivity to non-diversifiable risk (also
known as systematic risk or market risk), often represented by the
quantity beta (β) in the financial industry, as well as the
expected return of the market and the expected return of a
theoretical risk-free asset.

130
 The model was introduced by Jack Treynor (1961, 1962),[1]
William Sharpe (1964), John Lintner (1965a,b) and Jan
Mossin (1966) independently, building on the earlier work
of Harry Markowitz on diversification and
modern portfolio theory. Sharpe, Markowitz and
Merton Miller jointly received the
Nobel Memorial Prize in Economics for this contribution
to the field of financial economics.

131
 The CAPM is a model for pricing an individual security or a
portfolio. For individual securities, we make use of the
security market line (SML) and its relation to expected return
and systematic risk (beta) to show how the market must price
individual securities in relation to their security risk class. The
SML enables us to calculate the reward-to-risk ratio for any
security in relation to that of the overall market. Therefore,
when the expected rate of return for any security is deflated by
its beta coefficient, the reward-to-risk ratio for any individual
security in the market is equal to the market reward-to-risk
ratio, thus:

132
 E(R i) = Rf + β i ( E ( R m -Rf )
 E(R i) is the expected excess return on the capital asset
 Rf is the risk-free rate of interest such as interest arising
from government bonds
 β I (the beta coefficient) is the sensitivity of the expected
excess asset returns to the expected excess market returns
 E (R m) is the expected excess return of the market

133
 Arbitrage pricing theory (APT
 Arbitrage pricing theory (APT), in finance, is a general
theory of asset pricing, that has become influential in the
pricing of stocks.
 APT holds that the expected return of a financial asset can be
modeled as a linear function of various macro-economic
factors or theoretical market indices, where sensitivity to
changes in each factor is represented by a factor-specific
beta coefficient. The model-derived rate of return will then be
used to price the asset correctly - the asset price should equal
the expected end of period price discounted at the rate implied
by model. If the price diverges, arbitrage should bring it back
into line.

134
 Since it is unlikely that market inefficient for extended period
of time, financial economists started looking for alternate risk-
return models beyond CAPM.
 APT developed by Stephen Ross which is reasonably
intuitive,, require only limited assumptions and allows for m
ultiple risk factors
 Arbitrage pricing theory (APT) is a valuation model.
Compared to CAPM, it uses fewer assumptions but is harder
to use.
 The basis of arbitrage pricing theory is the idea that the price
of a security is driven by a number of factors. These can be
divided into two groups: macro factors, and company specific
factors.
135
 The name of the theory comes from the fact that this division,
together with the no arbitrage assumption can be used to
derive the following formula:
 r = rf + β1f1 + β2f2 + β3f3 + ⋅⋅⋅ where r is the expected return
on the security,
rf is the risk free rate,
Each f is a separate factor and
each β is a measure of the relationship between the security
price and that factor.
 This is a recognizably similar formula to CAPM.
 .

136
 The difference between CAPM and arbitrage pricing theory is that
CAPM has a single non-company factor and a single beta, whereas
arbitrage pricing theory separates out non-company factors into as
many as proves necessary. Each of these requires a separate beta.
The beta of each factor is the sensitivity of the price of the security
to that factor.
 Arbitrage pricing theory does not rely on measuring the
performance of the market. Instead, APT directly relates the price of
the security to the fundamental factors driving it. The problem with
this is that the theory in itself provides no indication of what these
factors are, so they need to be empirically determined. Obvious
factors include economic growth and interest rates. For companies
in some sectors other factors are obviously relevant as well - such as
consumer spending for retailers.
137
 The potentially large number of factors means more betas
to be calculated. There is also no guarantee that all the
relevant factors have been identified. This added
complexity is the reason arbitrage pricing theory is far less
widely used than CAPM.

138
 Operating Leverage
 Operating leverage present any time in a firm when it has
operating(fixed) cost regardless of the level of performance.
 Fixed costs do not vary with reference to sale up to a particular
(established capacity) level of production.
 Variable cost varies according to volume of production or units
of production.
 Semi variable costs do not vary up to a point and the n vary
according to volume or units of production.
 Degree of operating leverage can be defined as the percentage
change in operating profit (EBIT) for a given change in
percentage of sales revenue.

139
 If more than I year data is given
 DOL = % Change in EBIT/% Change in sales ,
 If Only one year data is given, then
 OL = contribution / EBIT(operating Profit)

140
 Financial Leverage
 For long term investments like expansion, diversification etc
the firm needs long term funds.
 Required funds may be sourced through equity share or from
debt.
 Use of fixed charges fund such as debt or preference share
capital along with equity funds in capital structure is called
financial leverage.
 Financial leverage is the ability of the firm touse fixed
financial charge to magnify the effect of changes in EBIT or
on the firm’s EPS
 In other words the payment of fixed rate of interest for the use
of fixed interest bearing securities to magnify the rate of return
on equity shares.
141
 Financial leverage is also known as ‘Trading on Equity’
 Hence financial leverage results from the existence of fixed
financial charges in the income statement of the firm.
 Financial leverage associated with financing decision /
activities
 Fixed charges do not vary with firm’ EBIT. They must be paid
regardless of he firm’s EBIT.
 Ordinary shareholders are entitled to residual income – after
paying fixed charges such a interest on debt and dividend on
preference capital.

142
 The financial leverage employed by the company is to earn
more return on the fixed charges funds than their costs
 The surplus or deficit will increase or decrease owners return.
 Financial Leverage ( FL) =EBIT/EBT
 Degree of Financial leverage = % change in EPS / %
change in EBIT.

143
 Efficient Market Theory
 Efficient market is where the value of a security is unbiased
intrinsic value
 Market efficiency does not imply that the market price of a
security equals the intrinsic value at every point in time.
 All that it says is that errors in market price is unbiased.
 This means the market price deviates from intrinsic value but
the deviations are random and uncorrected with any
observable variable.
 If the deviations in the market price to intrinsic value are
random it is not possible to consistently identify over/ under
valued securities.

144
 Market efficiency is defined in relation to, information that is
reflected in security prices.
 Eugene Fama suggested that it is useful to distinguish three
levels of market efficiency:
1. Weak form efficiency- Prices reflect all information found in
the record of past prices and volumes.
2. Semi- strong efficiency form- here in addition to i(1) above it
all reflect all publicly available information.
3. Strong form efficiency-prices reflect all available information
both public and private.

145
 Misconception about Efficient Market Theory
Misconception Answer
EMT implies that market has perfect EMT merely implies that it takes all available
forecasting abilities' information but it does not mean it has perfect
forecasting abilities.

As prices tend to fluctuate, they would not Unless prices fluctuate, they would not reflect
reflect the value value. Since future is uncertain, prices reflect
the surprises sseen by the market continually.

Inability of portfolio managers to achieve Market efficiency exists because portfolio

superior investment performance implies lack managers do their job effectively. But in an
of competence. efficient market it is not possible to achieve
superior performance results.

Random movement of stock prices suggest Randomness and irrationality are two
that stock market is irrational. different matters.
If investors are rational and competitive ,
prices are bound to be random.
146
 Bankruptcy Costs
 Within the theory of corporate finance, bankruptcy costs of debt
are the increased costs of financing with debt instead of equity that
result from a higher probability of bankruptcy. The fact that
bankruptcy is generally a costly process in itself and not only a
transfer of ownership implies that these costs negatively affect the
total value of the firm. These costs can be thought of as a financial
cost, in the sense that the cost of financing increases because the
probability of bankruptcy increases. One way to understand this is
to realize that when a firm goes bankrupt investors holding its debt
are likely to lose part or all of their investment, and therefore
investors require a higher rate of return when investing in bonds of
a firm that can easily go bankrupt. This implies that an increase in
debt which ends up increasing a firm's bankruptcy probability
causes an increase in these bankruptcy costs of debt.
147
 A theory stating that the costs of bankruptcy offset or
exceed the benefits a company receives from a great deal
of leverage. Followers of this view recommend companies
maintain less than 100% leverage.

148
 Agency Costs
 An agency cost is an economic concept that relates to the cost
incurred by an entity (such as organizations) associated with
problems such as divergent management-shareholder objectives and
information asymmetry. The costs consist of two main sources:
 The costs inherently associated with using an agent (e.g., the risk
that agents will use organizational resource for their own benefit)
and
 The costs of techniques used to mitigate the problems associated
with using an agent (e.g., the costs of producing financial statements
or the use of stock options to align executive interests to shareholder
interests).
 Though effects of agency cost are present in any agency relationship,
the term is most used in business contexts.
149
 The information asymmetry that exists between shareholders
and the Chief Executive Officer is generally considered to be a
classic example of a principal-agent problem. The agent (the
manager) is working on behalf of the principal (the
shareholders), who does not observe the actions of the agent.
This information asymmetry causes the agency problems of
moral hazard and adverse selection.
 Agency costs mainly arise due to divergence of control,
separation of ownership and control and the different
objectives (rather than shareholder maximization) the
managers.

150
 According to Michael and Westerfield (Corporate Finance,
7th edition): when a firm has debt, conflicts of interest
arise between stockholders and bondholders. Because of
this, stockholders are tempted to pursue selfish strategies,
imposing agency costs on the firm. These strategies are
costly, because they lower the market value of the whole
firm.
 There are various actors in the field and various objectives
that can incur costly correctional behaviour. The various
actors are mentioned and their objectives are given below.

151
 Dividend Payout Decision
 Why firms pay dividends?
 Plausible reasons:-
I. Investor preference for return in the form of dividends.
II. Self control and dividends- individuals lack self ccontrol in
every walk of life including in financial management. so they
would like to retain principal and spend dividends.
III. Aversion to regret and dividends- you get dividend of
Rs.30000 and buy a Tv
You sell your Shares for Rs.30000 and buy a TV

152
 Information signaling- by paying higher dividends the firm
signals higher prospects in their projects . This way the firm
ensure that others can not easily Imitate
 Clientele effect- Some investors prefer dividend, others may
prefer dividends plus capital gains and some others may prefer
capital gains. Generally inventors move to companies which
match their preferences.
 Agency Costs
 Dubious reasons for paying dividends:
 Bird-in-hand fallacy
 Temporary excess cash.

153
 Dimensions Of Dividend Policy
 There are tow important dimension s of firm’s dividend policy:
1. Payout ratio and
2. Stability
 Payout ratio- coniderations
I. Funds requirement
II. Liquidity
III. Access to external sources of financing
IV. Shareholder preference
V. Difference in cost of extternal equity and retained earnings
VI. Control
VII. Taxes

154
 Stability:
1. Stable dividend payout ratio
2. Stable dividends or steadily changing dividends.
 Rationale for dividend stability:
i. Investors dependence on dividend income.
ii. Dividend decision of of the firm is regarded as an important means
by which the firm communicates the prospects of its projects.
iii. Institutional investors consider this as a pre-requisite for investment
in equity or debt of the firm.

155
 Types of Dividend Policies
 Constant dividend per share
 Constant payout ratio
 Stable rupee dividend plus extra dividend
Advantages of stable dividend policy:
1. Builds confidence among investors.
2. Current income to investors
3. Information about firm profitability
4. Institutional investor requirement.
5. Raising additional finances.
6. Stability in market price of shares.
7. Easy availabilty of debt funds.

156
 Limitations of stable dividend policy:-
1. Difficult to change.
2. Adverse effect on market price of share
3. Long run effect on the company if dividend ar paid out of
borrowed funds for long period of time.
Factors influencing dividend policy:
4. Nature of earnings.
5. Age of company.
6. Liquidity of the company.
7. Equity shareholders preference.
8. Requirement of institutional investors.
9. Legal rules- capital impairment rule to protect creditors and
lenders 157
 Net profits- dividend to be within net profits after providing
for depreciation.
 Insolvency rule
7. Contractual requirement primarily of lenders.
8. Financial needs of the company.
9. Access to, the capital market external sources.
10. Control objective
11. Inflation
12. Dividend policy of competitors
13. Past dividend rate of the company.

158