FINANCIAL MANAGEMNT FORMULAS
CAPITAL STRUCTURE
1. Net Income Approach (NI)
According to this approach, 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.
This approach is based on the following Assumptions:
1. There are no corporate taxes
2. Cost of Equity(Ke) never changes
3. Kd is always less than Ke
Ke > Kd
Kd is the cost of debt and Ke is the cost of equity
V= S+B
V= Value of the Firm
S = Market value of equity
B = Market value of Debt
S = Net Income
Ke
The formula to calculate the average cost of capital or overall cost of capital is as
follows:
Ko = EBIT / V
Where: Ko is the average cost of capital
2. 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
Ko and Kd are constant for all levels of leverage.
FINANCIAL MANAGEMNT FORMULAS
According to this approach whether debenture increases or decreases in
both situations Ko will remain same or constant
Example: Following information is given for Polyplex corporation India
Limited:
Earning before Interest and tax (EBIT) Rs.6,00,000
12% Debentures Rs.8,00,000
Overall cost of capital is 16%
There are no corporate Taxes.
You are required to determine
1. Market Value of Equity under NOI approach
2. Market value of Firm
3. Costs of equity capital
Solution:
Particulars Rs.
EBIT( Earning before interest and tax) 600,000.00
Less: Interest on Debentures 96,000.00
5,04,000.0
Profit available to shareholders as no taxes exist 0
Market value of Firm (V) = EBIT / Ko
V = Rs.6,00,000 /16% = Rs.37,50,000
Market value of Equity
V = S +B
S= Rs.37,50,000 – Rs.8,00,000 = Rs.29,50,000
Costs of equity capital
Ke = 5,04,000 X 100 = 17.08%
29,50,000
LEVERAGE
3. Operating Leverage :
It is defined as the "firm's ability to use fixed operating costs
to magnify effects of changes in sales on its EBIT ". When
there is an increase or decrease in sales level the EBIT also
changes. The effect of changes in sales on the level EBIT is
measured by operating leverage.
Operating leverage
= % Change in EBIT / % Change in sales OR
= [Increase in EBIT/EBIT] / [Increase in sales/ sales]
Operating Leverage occurs when a firm has a fixed costs
which must be met regardless of volume of sales
FINANCIAL MANAGEMNT FORMULAS
A high operating leverage indicates high risky situations as it
consist a large fixed cost.
DEGREE OF OPERATING LEVERAGE:
= Contribution
EBIT
The operating Leverage is an attribute of the
business risk.
4. Financial Leverage :
It is defined as the ability of a firm to use fixed financial
charges to magnify the effects of changes in EBIT/Operating
profits, on the firm's earnings per share. The financial
leverage occurs when a firm's capital structure contains
obligation of fixed charges e.g. interest on debentures,
dividend on preference shares, etc. along with owner's equity
to enhance earnings of equity shareholders. The fixed
financial charges do not vary with the operating profits or
EBIT. They are fixed and are to be repaid irrespective of
level of operating profits or EBIT. The ordinary shareholders
of a firm are entitled to residual income i.e. earnings after
fixed financial charges. Thus, the effect of changes in
operating profit or EBIT on the level of EPS is measured by
financial leverage.
Financial leverage
= % change in EPS/% change in EBIT
or
= (Increase in EPS/EPS)/{Increase in EBIT/EBIT}
Degree of financial leverage:
= EBIT (EARNING BEFORE INTEREST & TAX)
Profit before tax
FINANCIAL MANAGEMNT FORMULAS
The Financial Leverage is an attribute of financial
risk.
5. Combined leverage :
Operating leverage explains operating risk and financial
leverage explains the financial risk of a firm. However, a firm
has to look into overall risk or total risk of the firm i.e.
operating risk as also financial risk. Hence, the combined
leverage is the result of a combination of operating and
financial leverage. The combined leverage measures the
effect of a % change in sales on % change in EPS.
Combined Leverage
= Operating leverage X Financial leverage OR
= % change in EBIT X % change in EPS OR
% change in sales) % change in EBIT
= % change in EPS/% change in sales
Degree of Combined leverage:
=
Contrbution
PBT
EXAMPLE:
In case of A Ltd. EBIT is Rs 5000 and interest on debentures is Rs 900,
When sales are Rs 20000 where as in case of B. Ltd. The EBIT is Rs
5000 and interest on debentures is Rs 100 when sales are Rs 20000.
As such degree of financial leverage can be computed as
EBIT
______________
EBIT-Interest
A. Ltd B. Ltd
Financial Leverage Rs 5000 Rs 5000
= = ______________
Rs 5000- Rs 900 Rs 5000-Rs900
=1.22 = 1.02
FINANCIAL MANAGEMNT FORMULAS
High degree of financial leverage is supported by knowledge of fact
that in capital structure of A Ltd 90% is the debt capital component,
where as in case of B Ltd 10% is debt capital component.
It means that in case of A Ltd every 1% increase in EBIT will increase
EPS by 1.22% and vice versa.
As such, when EBIT is reduced from Rs 5000 to Rs 4000 (i.e. 20%
reduction), EPS of A Ltd, gets reduced from Rs 20.50 to Rs 15.50 (i.e.24.40 %
reduction) & EPS of B Ltd, gets reduced from Rs 2.72 to Rs 21.6 (i.e 20.40%
reduction)
Indications:-
(1) High Operating Leverage, High Financial Leverage:-
It indicates very risky situation as a slight decrease in sales and
contribution may affect EPS to great extant. So, this situation is should
be avoided.
(2) High Operating Leverage, Low Financial Leverage
it indicates that a slight decrease in sales and contribution may affect
EBIT to great extent due to existence of high fixed cost but this
possibility is already taken care by low proportion of debt capital in
overall capital structure.
(3) Low Operating Leverage, High Financial Leverage
It indicates decrease in sales/contribution will not affect EBIT to great
extent. This situation may be considered an ideal situation.
(4) Low Operating Leverage, Low Financial Leverage
It indicates decrease in sales/contribution will not affect EBIT to great
extent as the Component of fixed cost is negligible in overall cost
structure.
COST OF CAPITAL
7. The cost of capital may be put in the form of the following
equations
K= r0 +b + f
K means Cost of capital
r0 means Return at zero risk level
b means Premium for business risk
f means Premium for Financial risk
8. Irredeemable debentures
The formula for Computing the cost of long term debt at par is
FINANCIAL MANAGEMNT FORMULAS
Kd = (1-T) R
Example: Ranbaxy Limited Issued 10% Debentures at the tax
rate 60%. What will be the cost of debt?
Ans: Kd = (1-T) R
Kd = (1-.60) .10 = 4%
The formula for Computing the cost of long term debt at premium or
discount is
Kd = I (1-T)
NP
NP = Net proceed
I = Annual interest payment
9. Redeemable debentures
a) The formula for Computing the cost of long term Redeemable
debt
I + [P-NP] / N
Kd= -------------------------- X (1-T) X
100
[P +NP] /2
P = Par Value
NP = Net proceed
10. The following are the approaches to computation of cost
of equity capital:
Zero – Growth Dividends; it may be assumed that dividend will
remain constant and pegged at the current level for the assumed
perpetual life of the firm.
Ke = D1/ P0
FINANCIAL MANAGEMNT FORMULAS
D1 = Expected dividend at the end of year 1
P0 = Current market price of share
Ke = Cost of equity
D/P + Growth Rate Method : The method is comparatively more
realistic as
i) It considers future growth in dividends,
ii) It considers the capital appreciation.
This method is based on the assumption that the value of a share is
the present value of all anticipated dividends, which it will give over an
infinite time horizon.
The firm is here viewed as a going concern with an infinite life. Thus,
Ke = D1/ P0 + g (in case of existing shares)
Ke = D1/ NP + g (in case of Fresh issue of shares)
Where,
Po = current price of the equity share
D1 = per share dividend expected at the end of year 1
Ke = risk adjusted rate of return expected on equity shares.
g = constant annual rate of growth in dividends and earnings.
11. Cost of retained Earnings
Algebraically, the approach can be explained as:
Kr = Ke (1-T) (1-B)
where
Ke = Cost of equity capital based on dividend growth method
T = Shareholders’ Tax Rate
B = Percentage Brokerage cost
Example
A firm’s cost of equity capital is 12% and Tax rate of majority of
shareholders is 30%. Brokerage is 3%.
= 12% (1-0.30) (1-0.03)
= 8.15%
12. Weighted Average cost of capital
A calculation of a firm's cost of capital in which each category of
capital is proportionately weighted. All capital sources - common stock,
preferred stock, bonds and any other long-term debt - are included in a
WACC calculation.
WACC is calculated by multiplying the cost of each capital component
by its proportional weight and then summing:
FINANCIAL MANAGEMNT FORMULAS
Where:
Re = cost of equity
Rd = cost of debt
E = market value of the firm's equity
D = market value of the firm's debt
V=E+D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate
Broadly speaking, a company’s assets are financed by either debt or
equity. WACC is the average of the costs of these sources of financing,
each of which is weighted by its respective use in the given situation.
By taking a weighted average, we can see how much interest the
company has to pay for every dollar it finances.A firm's WACC is the
overall required return on the firm as a whole and, as such, it is often
used internally by company directors to determine the economic
feasibility of expansionary opportunities and mergers. It is the
appropriate discount rate to use for cash flows with risk that is similar
to that of the overall firm.
Once the component costs have been calculated, they are multiplied
by the weights of the various sources of capital to obtain a weighted
average cost of capital (WACC). The composite, or overall cost of
capital is the weighted average of the costs of various sources of
funds, weights being the proportion of each source of funds in the
capital structure. It should be remembered that it is the weighted
average concept, not the simple average.
The following steps are used to calculate the weighted average cost of
capital:
To calculate the cost of the specific sources of funds (i.e., cost of debt,
cost of equity, cost of preference capital etc.)
To multiply the cost of each source by its proportion in the capital
structure.
To add the weighted component costs to get the firm’s weighted
average cost of capital. In financial decision-making, the cost of capital
should be calculated on an after-tax basis. Therefore, the component
costs to be used to measure the weighted cost of capital should be the
after-tax costs.
MANAGEMENT OF INVENTORY
13. EOQ MODEL Inventory level can be managed by adopting the
Economic Order Quantity (EOQ) model. This model determines the
FINANCIAL MANAGEMNT FORMULAS
order size that will minimize the total inventory cost. According to this
model, three parameters are fixed for each item of the inventory:
1. Minimum level of that inventory to be kept after accounting
for usage rate of that item and time lag in procuring that item
and contingences.
2. The level at which next order for the item must be placed to
avoid possibility of a stock-out.
3. The quantity of the item for which the re-order must be
placed.
In addition to the determination of above parameters, the EOQ model
is based on the following assumptions:
• The total usage of that particular item for a given period is known
with certainty and the usage rate is even throughout the period.
• There is no time gap between placing an order and receiving
supply.
• The cost per order of an item is constant and the cost of carrying
inventory is also fixed and is given as a percentage of the average
value of inventory.
• There are only two costs associated with the inventory and these
are the cost of ordering and the cost of carrying the inventory.
Given the above assumptions, the optimum or economic order quantity
is represented as:
EOQ = √2AO/C
Where A = Total annual requirement for the item
O= Ordering cost per order of that item
C =Carrying cost per unit per annum
No. of orders per year = Demand per year ÷ EOQ size
Time interval between 2 orders = No of days/ month in a year
÷ No of orders
Total cost of inventory = Purchase + Total Ordering + Total
Carrying
Cost Cost Cost
Total cost of inventory = (A X C1) + (A/ EOQ X C0) + (1/2 X EOQ
X C)
C1 = Cost per item
C0 = Ordering cost per order
C = Carrying cost per unit
FINANCIAL MANAGEMNT FORMULAS
The below figure shows that the ordering cost for any
particular item is decreasing as the size per order is
increasing. This will happen because with the increase in size
of order, the total numbers of order for particular item will
decrease resulting in decrease in the total order cost. The total
annual carrying cost is increasing with the increase in order
size. This will happen because the firm would be keeping more
and more items in stores.
The relationship between order size and different component of cost is
given in the above graph. The total cost is low at the intersection point
of ordering cost and carrying cost. The order size at this intersection is
economic order quantity.
14. Stock-Levels
Re-order Level: The storekeeper starts to make the purchases when
the inventory in stores reaches this level. The re-order level is fixed
taking into consideration leadtime and unusual delays or interruptions.
This is calculated as follows:
Re-order Level = Maximum consumption x Maximum Re-order
Period.
FINANCIAL MANAGEMNT FORMULAS
Minimum Level = Re-order Level - (Normal consumption x
Normal Re-order Period)
Maximum Level = Re-order Level + (Re-order quantity) -
(Minimum consumption x Minimum Re-order Period)
Danger Level: This level is fixed even below the minimum level as a
disastrous signal when the inventory level touches this level. This has
to be solved by exercising greater efforts in purchasing to bring the
inventory to the required level.
Danger Level = Average Consumption X Lead Time for
Emergency Purchases
Re-order point = Safety stock + (Average consumption x lead
time.)
DIVIDEND POLICY DECISIONS
15. The following is the Walter’s formula to determine the
market price (P) per share:
P= [D+ r/Ke (E-D)]
Ke
P is the prevailing market price per share
D is the dividend per share
E is the earning per share
R is return on investment
1. When the ROI is greater than the cost of capital, the optimum
dividend pay out ratio is 0%. In such a situation dividend price
and share price are inversely related.
2. When the ROI is less than the cost of capital, the optimum
dividend pay out ratio is 100%.
3. When the ROI is equal to cost of capital, there is no such
optimum dividend policy.
16. According to the Gordon’s model, the market value of a firm’s
share will be equal to the present value of future stream of dividends
payable for that share. Accordingly, the value of share can be obtained
by the following equation:
P= EPS (I – b)
Ke – br
Where,
P = share price
FINANCIAL MANAGEMNT FORMULAS
E = Earning per share
b = Retention ratio
(1 – b ) = Dividend pay-out ratio
Ke = Cost of equity capital (Cost of capital of the firm)
br = Growth rate (g) in the rate of return on investment
g = Growth rate of earnings
17. M.M’s irrelevance hypothesis.
Modigliani and Miller (M–M) proposed an interesting model which
concludes that dividend policy does not affect the firm’s value. The
firm’s value, according to them, hinges only on its earnings which
result from its investment policy. Given the investment policy, decision
of retention and pay-out, they hold, will not affect the firm’s value M-
M’s model is based on the following assumption:
• The capital markets are perfect, investors behave rationally,
information is available freely, and transaction and floatation
costs do not exist.
• Either taxes do not exist, or they are same on both dividend
income and capital gains so that investors do not prefer one over
other.
• The firm has a fixed investment policy.
• The risk, will not increase with futurity. The investors can
forecast future prices and dividends with certainty, and one
discount rate is appropriate for all securities and all time periods.
Based on these assumptions and using the process of arbitrage Miller
and Modigliani have explained the irrelevance of the dividend policy.
The process of arbitrage balances or completely offsets two
transactions, which are entered into simultaneously. Arbitrage can be
applied to the investments function of the firm. As mentioned earlier,
firms have two options for utilizing its after tax profits (i) to retain the
earnings and plough back for investment purposes (ii) distribute the
earnings as cash dividends. If the firm selects the second option and
declares dividend then it will have to raise capital for financing its
investment decisions by selling new shares. Here, the arbitrage
process will neutralize the increase in the share value due to the cash
dividends by the issue of additional shares.
Symbolically the Model is given as
In the first step the market price of the shares is equal to the sum of
the present values of the dividend paid and the market price at the
end of the period.
Po = ___1___ (D1 + P1)
FINANCIAL MANAGEMNT FORMULAS
(1 + ke)
Where,
Po = Current market price of the share
P1 = Market price of the share at the end of the period. ( t = 1)
D1 = Dividends to be paid at the end of the period ( t = 1)
Ke = Cost of equity capital.
Firms will have to raise additional capital to fund their investment
requirements, if its investment requirements are more than its
retained earnings, additional equity capital (n 1 P1) after utilizing its
retained earnings is as follows:
n1 P1 = I - ( E - n D1 )
Where,
I = Total Investments required
nD1 = Total dividend paid
E = Earnings during the period (E - nD1)
Simplifying the above equation we get,
n1 P1 = I - E + n D1
Substituting this value of the new shares in the equation we get,
nP0 = (n + n 1 ) P1 – I + E
(1 + ke)
