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BBA 222: FINANCIAL MANAGEMENT

Objective: The objective of the paper is to familiarize the students with principles and
practices
of financial management.
UNIT- I
Financial Management: Meaning, Scope and Objectives of Financial Management, Time
Value done
of Money- Compounding Techniques and Discounting Techniques, Risk and Return. Done
Capital Budgeting: Meaning, Types, Process, Techniques of Capital Budgeting - Payback
Period done
Method, Accounting Rate of Return, Net Present Value (NPV) Net Terminal Value Method,
Internal rate of Return (IRR), Profitability Index.

Cost of Capital: Determination of Cost of Capital, Components of Cost of Capital,

Computation
of Cost of Debt, Equity Capital, Preference Share Capital and Retained Earnings, Weighted
Average Cost of Capital (WACC) and Marginal Cost of Capital.
UNIT- II
Capital Structure, Meaning, Types of Leverage, Determinants of Capital Structure. EBIT-EPS
Analysis
Working Capital Management: Meaning, Types, Factors Affecting Working Capitals,
Working
Capital Planning and Management. Working Capital Forecasting, Methods of Estimating
Working Capital.
Dividend Policy- Relevance and Irrelevance Theories.
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Introduction

 Finance is essential for business success, big or small.

 Economic activities are driven by the need for profit, making finance crucial.

Meaning of Finance

 Finance is managing money, including services and tools.

 It ensures money is available and well-managed in business.

Definition of Finance

 Finance involves managing money, capital, and funds in business (Khan & Jain).
 It includes money circulation, credit, investments, and banking.

Definition of Business Finance

 Business finance focuses on acquiring and managing funds to meet business goals
(Wheeler).
 It involves planning, raising, and controlling funds for business.

Types of Finance

1. Private Finance
o Individual Finance: Managing personal money for savings, investments, and
budgeting.
o Business Finance: Funding and managing finances for businesses, including
capital investment, loans, and operational costs.
o Sources: Involves personal savings, private equity, bank loans, and venture
capital.
o Goal: To meet personal or business financial needs, growth, and stability.
o Example: A business using a bank loan for expansion.
2. Public Finance
o Government Revenue: Involves collecting taxes, fees, and other sources of
income for the government.
o Government Spending: Managing government expenditure for public
services like education, healthcare, and defense.
o Public Debt: Financing government activities through borrowing, such as
issuing bonds.
o Budgeting: Planning and allocating funds to various public sector needs.
o Example: Government spending on building infrastructure like roads or
schools.

Definition of Financial Management

 Financial management is about acquiring and using funds effectively (S.C. Kuchal).
 It combines general management with financial decisions.
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Scope of Financial Management

1. Economics: Applies economic concepts to business.

2. Accounting: Links financial management with accounting for decision-making.
3. Mathematics: Uses tools like time value of money and capital structure.
4. Production: Funds production needs to make profits.
5. Marketing: Allocates funds for effective product sales.
6. HR: Allocates funds for HR functions like salaries and bonuses.

Traditional Approach to Financial Management

1. Fund Raising
o Explanation: Bank loans, equity
2. Focus on Past Practices
o Explanation: Historical data reliance
3. Short-Term Focus
o Explanation: Daily operational needs
4. Limited Scope
o Explanation: Basic financial tasks
5. Conservative Financial Decisions
o Explanation: Low-risk investments

Modern Approach to Financial Management

1. Innovative Fund Raising
o Explanation: Diverse funding sources
2. Data-Driven Decisions
o Explanation: Analytics-based choices
3. Long-Term Focus
o Explanation: Sustainable growth emphasis
4. Broader Financial Scope
o Explanation: Includes risk management
5. Risk and Return Balance
o Explanation: Strategic investment balance
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Objectives of Financial Management

1. Profit Maximization
o Focuses on increasing short-term profit.
2. Wealth Maximization
o Aims to increase long-term shareholder value.
3. Short-Term Focus
o Prioritizes quick financial gains.
4. Long-Term Focus
o Emphasizes sustainable growth.
5. Efficiency Improvement
o Enhances operational effectiveness to boost profit.
6. Risk and Time Consideration
o Weighs time and risk for better returns.
7. Revenue Growth
o Seeks quick increase in revenue.
8. Shareholder Wealth
o Focuses on growing investors' wealth.
9. Sustainability
o Prioritizes long-term business health over short-term profits.
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Types of Finance
1. Private Finance
o Personal Finance: Managing individual finances (savings, investments).
o Business Finance: Funding and managing business operations (loans,
capital).
o Sources: Personal savings, bank loans, venture capital.
o Goal: Financial growth and stability.
o Example: A business loan for expansion.
2. Public Finance
o Government Revenue: Tax collection and fees.
o Government Spending: Funding public services (education, healthcare).
o Public Debt: Borrowing through bonds and loans.
o Budgeting: Allocating funds for public needs.
o Example: Government spending on infrastructure.

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CHAPTER – 2 Time Value of Money (TVM)

 Concept: Money today is worth more than money in the future because it can earn
interest or returns.
 Purpose: TVM helps in making financial decisions, like evaluating investments, loans,
and savings, by considering inflation, interest rates, and opportunity costs.

Compounding Techniques
 Definition: Compounding means earning interest on both your original money and
the interest already earned.
 Formula: FV=P×(1+rn)ntFV = P \times (1 + \frac{r}{n})^{nt}
o PP = Principal, rr = Interest rate, tt = Time, nn = Compounding frequency.
 Effect: More frequent compounding results in higher returns over time.
 Example: Investing $1,000 at 10% interest compounded monthly will give you more
than simple interest over 5 years.

Discounting Techniques
 Definition: Discounting calculates the current value (PV) of money you’ll get in the
future.
 Formula: PV=FV(1+r)tPV = \frac{FV}{(1 + r)^t}
o FVFV = Future value, rr = Discount rate, tt = Time period.
 Purpose: Discounting adjusts future money to today's value.
 Example: A $1,000 payment in 5 years, discounted at 5%, is worth $783.53 today.

Risk and Return

 Risk: The chance of losing money or not earning the expected return. Higher risk
often leads to higher potential returns.
o Types:
 Systematic Risk: Affects the whole market.
 Unsystematic Risk: Affects specific investments.
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 Return: The profit or loss from an investment.

o Formula: Return=(EndingValue−BeginningValue)BeginningValue×100Return =
\frac{(Ending Value - Beginning Value)}{Beginning Value} \times 100
 Trade-Off: Higher returns often come with higher risks.

Risk-Return Trade-Off
 Principle: To get higher returns, you must take on more risk.
 Diversification: Spreading investments to reduce specific risks.
 Strategy: Balancing risk and return through smart investment choices.

Application in Financial Decisions

 Investments: Use compounding to calculate future value and discounting to calculate
present value.
 Loans: TVM helps calculate the total cost of loans, including interest.
 Savings: Helps plan how much to save today to meet future goals.

Real-World Implications of TVM

 Retirement: TVM helps determine how much to save now for future retirement.
 Business Decisions: TVM is used to evaluate investments and project profitability.
 Valuation: TVM helps calculate the value of businesses by considering future cash
flows.
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2.1 Introduction
Meaning:
The Time Value of Money (TVM) means that money today is worth more than money in
the future. This is because you can invest money now and earn a return over time.
Pointers:
1. TVM Concept: Money today is more valuable than in the future.
2. Why?: Money today can be invested to earn returns.
3. Important for: Investments, loans, and savings decisions.
4. TVM helps you make better financial choices.
5. Impact: TVM explains why you prefer money now over future payments.
Illustration:
Imagine you can either have Rs. 1,000 today or Rs. 1,000 next year. Which would you
choose?
 Why? Because you can invest Rs. 1,000 today and earn interest, making it worth
more in the future.

2.2 Future Value (FV)

Meaning:
Future Value (FV) is the value of an investment at a future date, based on a certain rate of
interest or growth. It shows how much your investment today will grow over time.
Pointers:
1. Definition: FV tells you how much your money will be worth in the future.
2. Depends on: Interest rate and time period.
3. Formula for FV (Simple Interest):
FV=P×(1+r×t)FV = P \times (1 + r \times t)
4. Formula for FV (Compound Interest):
FV=P×(1+r)tFV = P \times (1 + r)^t
5. Effect: Higher interest and longer time increase future value.
Illustration:
You invest Rs. 1,000 at 10% interest for 1 year:
 Formula: FV=1,000×(1+0.10)1=1,100FV = 1,000 \times (1 + 0.10)^1 = 1,100
 Your Rs. 1,000 grows to Rs. 1,100 after 1 year.
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2.3 Calculation of Future Value

Meaning:
The calculation of FV can be done using either simple interest (interest on the principal only)
or compound interest (interest on both the principal and accumulated interest).
Pointers:
1. Lump Sum FV: One-time deposit growing over time.
2. Annuity FV: Regular payments over time (like savings or insurance).
3. Simple Interest: Interest calculated on the principal only.
4. Compound Interest: Interest calculated on both principal and accumulated interest.
5. Effect of Compounding: More frequent compounding results in a higher future value.
Illustration - Simple Interest:
 You invest Rs. 1,000 for 2 years at 5% simple interest:
 Formula: FV=1,000×(1+0.05×2)=1,100FV = 1,000 \times (1 + 0.05 \times 2) = 1,100
 Your Rs. 1,000 grows to Rs. 1,100.
Illustration - Compound Interest:
 You invest Rs. 1,000 for 2 years at 5% compound interest:
 Formula: FV=1,000×(1+0.05)2=1,102.5FV = 1,000 \times (1 + 0.05)^2 = 1,102.5
 Your Rs. 1,000 grows to Rs. 1,102.5.

2.4 Present Value (PV) vs. Future Value (FV)

Meaning:
Pointers:
1. PV: How much a future amount is worth today.
2. FV: How much money will be worth in the future.
3. Discounting: Adjusts for the fact that money in the future is worth less today.
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4. Formula for PV: PV=FV(1+r)tPV = \frac{FV}{(1 + r)^t}

5. Difference: FV is forward-looking, while PV brings future value into today’s terms.

Illustration:
You’ll receive Rs. 1,100 in 1 year. How much is it worth today with a 10% interest rate?
 Formula: PV=1,100(1+0.10)1=1,000PV = \frac{1,100}{(1 + 0.10)^1} = 1,000
 So, Rs. 1,100 in 1 year is worth Rs. 1,000 today.

2.5 Significance of Time Value of Money

Meaning:
TVM is crucial for understanding how time, interest, and inflation affect the value of money.
It helps in making financial decisions.
Pointers:
1. Helps Plan Investments: TVM helps determine how much to invest today for future
returns.
2. Evaluates Loans: It helps calculate loan repayments.
3. Project Profitability: TVM is used to assess if projects are profitable.
4. Business Valuation: TVM helps value businesses and assets.
5. Inflation Impact: It explains how inflation reduces the future value of money.
Illustration:
Suppose you need Rs. 5,000 in 3 years. If you invest Rs. 4,000 today at 6% annual interest,
 Formula: FV=4,000×(1+0.06)3=4,764.06FV = 4,000 \times (1 + 0.06)^3 = 4,764.06
 In 3 years, your Rs. 4,000 grows to Rs. 4,764.06, showing the effect of time and
interest on your savings.

2.6 Calculation of Time Value of Money

Meaning:
TVM can be calculated using formulas for both present value (PV) and future value (FV).
Compounding frequency and interest rates affect the calculations.
Pointers:
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1. Formula for PV: PV=FV(1+r)tPV = \frac{FV}{(1 + r)^t}

2. Formula for FV: FV=PV×(1+r)tFV = PV \times (1 + r)^t
3. Interest Rates: Higher rates lead to greater returns.
4. Compounding Frequency: More frequent compounding increases the future value.
5. Use Tools: Financial calculators or Excel can simplify TVM calculations.
Illustration:
You need Rs. 2,000 in 2 years. How much should you invest today at 8% interest?
 Formula: PV=2,000(1+0.08)2=1,714.29PV = \frac{2,000}{(1 + 0.08)^2} = 1,714.29
 You need to invest Rs. 1,714.29 today to get Rs. 2,000 in 2 years.

2.7 Financial Decisions - Time Value of Money

Meaning:
TVM is used in financial analysis to evaluate investment opportunities, financing options,
and loan decisions.
Pointers:
1. Discounted Cash Flow (DCF): TVM is used to evaluate whether investments meet
profitability goals.
2. Financing Decisions: Helps in choosing the right mix of debt and equity.
3. Investment Decisions: Assesses whether an investment will generate enough returns
based on present value.
4. Loan Evaluation: Helps calculate the cost of loans considering interest rates and time.
5. Savings Planning: Helps determine how much to save today for future financial goals.
Illustration:
You are deciding between Rs. 5,000 today or Rs. 5,500 in 1 year at a 10% interest rate:
 Formula for Option 2: PV=5,500(1+0.10)1=5,000PV = \frac{5,500}{(1 + 0.10)^1} =
5,000
 Both options have the same value today, but if you need money now, Option 1 is
better.

.
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CHAPTER – 3 CAPITAL BUDGETING

Introduction:
Capital budgeting helps businesses decide where to invest for long-term growth. It’s a way of
planning how to spend money on assets that will bring benefits over time.
Meaning:
Capital budgeting is the process of deciding which long-term investments, like buying new
equipment or expanding a business, are worth pursuing.
Definition:
It’s the process of evaluating projects or assets to see if they will generate enough profit to
cover their costs. The goal is to choose investments that give a good return.
"Principles of Corporate Finance" by Richard A. Brealey

Here’s a simplified breakdown of each point, each explained in four words:

1. Traditional Methods
Evaluates investments without considering time value of money, affecting profitability
assessment.

A. Pay-back Period Method

Explanation:

1. Calculates recovery time using cash inflows.

2. Simple estimate of recovery time.
3. Ignores future inflows or money's time value.

Formula:
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Payback Period=Cash OutlayAnnual Cash Inflow\text{Payback Period} = \frac{\text{Cash

Outlay}}{\text{Annual Cash Inflow}}

Merits:
1. Easy to understand.
2. No computation costs.
3. Useful in small businesses.
4. Uses available data.
5. Quick investment recovery estimate.

Demerits:

1. Ignores future cash inflows.

2. Ignores time value of money.
3. Does not consider inflation.
4. Does not maximize wealth.
5. Ignores future cash timings.

B. Average Rate of Return (ARR)

Explanation:

1. Calculates average annual profit.

2. Measures expected return yearly.
3. Ignores cash flows and time value.

Formula:

ARR=Average Net Income After TaxesAverage Investment×100ARR = \frac{\text{Average

Net Income After Taxes}}{\text{Average Investment}} \times 100

Merits:

1. Simple to calculate.
2. Uses accounting data.
3. Includes entire earnings stream.
4. Helps prioritize investments.
5. Easy to compare projects.

Demerits:

1. Ignores actual cash flows.

2. Does not maximize shareholder wealth.
3. Ignores project lifespan.
4. Ignores profit reinvestment.
5. Uses accounting data, not real finances.

2. Discounted Cash Flow (DCF) Methods

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Evaluates profitability using present value of future inflows, considering time value of
money.

A. Net Present Value (NPV)

Explanation:
1. Calculates difference between inflows and investment.
2. Discounts future cash flows to present.
3. Positive NPV indicates a good investment.
Formula:
NPV=∑Ct(1+k)t−InvestmentNPV = \sum \frac{C_t}{(1+k)^t} - \text{Investment}
Merits:
1. Accounts for time value.
2. Considers all cash inflows.
3. Maximizes shareholder wealth.
4. Easy to interpret.
5. Clear decision criteria.
Demerits:
1. Complex with fluctuating cash flows.
2. Relies on accurate cost estimation.
3. Not ideal for large investments.
4. Doesn’t solve limited funds issue.
5. Sensitive to assumptions made.

B. Internal Rate of Return (IRR)

Explanation:
1. Finds rate making NPV zero.
2. Break-even rate between inflows and outflows.
3. Can give multiple rates for irregular projects.
Formula:

Trial and error to find:

NPV=0NPV = 0

Merits:
1. Accounts for time value.
2. Comprehensive with all cash flows.
3. Popular for investors.
4. Wealth maximizing with high IRR.
5. Easy for decision-making.
6.
Demerits:
1. Complex, prone to errors.
2. Multiple IRRs for irregular projects.
3. Assumes reinvestment at same rate.
4. Hard for unusual cash flows.
5. Misleading with multiple IRRs.

C. Probability Index (PI)

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Explanation:
1. Modifies NPV, comparing inflows to outflows.
2. Useful for projects needing varying investments.
3. Values above 1 indicate profitable projects.

Formula:

PI=Present Value of Cash InflowsInvestmentPI = \frac{\text{Present Value of Cash

Inflows}}{\text{Investment}}

Merits:
1. Simpler than IRR.
2. Ranks projects by profitability.
3. Better for different investment sizes.
4. Considers full cash flow stream.
5. Clear rule: Accept PI > 1.
Demerits:

1. Can be hard to interpret.

2. Limited by cash flow assumptions.
3. Relative measure may be limiting.
4. Complex for varying project sizes.
5. Assumes equal risk for investments.

Net Terminal Value (NTV) Method

The Net Terminal Value (NTV) method calculates a project's value at the end of its life,
considering its residual value (like resale value of assets).

Formula:
NTV = Future Value of Cash Flows - Residual Value of the Asset

Merits:
1. Residual Value: Accounts for asset's end-of-life value.
2. Long-term Projects: Useful for projects with significant final value.
3. Comprehensive Valuation: Adds terminal value to overall project worth.
4. Informed Decisions: Assists in better investment choices.
5. Supports NPV: Works well with NPV for clearer insights.

Demerits:
1. Difficult to Estimate: Hard to predict terminal value accurately.
2. Overestimates Value: Assumes asset will have value at the end.
3. Ignores Market Changes: Doesn’t consider market shifts.
4. Prediction-based: Relies on forecasts which may be wrong.
5. Limited Use: Not applicable for projects with little residual value
CHAPTER – 3 COST OF CAPITAL
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Introduction:
Cost of capital is the minimum return a firm must earn on its investments. It helps in
evaluating investment proposals and capital projects. It’s also known as the required rate of
return.

Meaning: It is the required rate of return on investments from equity, debt, and retained
earnings, essential for the firm’s financial health and wealth maximization.

Definition: According to the definition of Solomon Ezra, “Cost of capital is the minimum
required rate of earnings or the cut-off rate of capital expenditure”.

Importance of Cost of Capital:

 Capital Budgeting Decisions:

Used for investment proposals (e.g., NPV).
 Capital Structure Decisions:
Designs optimal structure (e.g., debt vs equity).
 Evaluation of Financial Performance:
Compares profitability (e.g., ROI).
 Other Financial Decisions:
Aids in dividends and shares (e.g., bonus shares).

Classification of Cost of Capital:

 Historical vs Future Cost:

o Past costs (e.g., old loan rates) vs future projections (e.g., expected interest
rates).
o Helps in comparing actual vs estimated financial performance.
 Specific vs Composite Cost:
o Cost of individual source (e.g., debt) vs combined cost of all sources (e.g.,
WACC).
o Useful for deciding funding strategies and capital budgeting.
 Explicit vs Implicit Cost:
o Direct costs (e.g., interest payments) vs opportunity costs (e.g., returns lost by
using retained earnings).
o Aids in evaluating actual vs potential returns.
 Average vs Marginal Cost:
o Overall cost of all capital (e.g., weighted average) vs cost of additional funds
(e.g., new debt).
o Helps in investment decisions for expanding or raising more capital.

Determination of Cost of Capital:

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As stated already, cost of capital plays a very important role in making decisions relating to
financial management. It involves the following problems:

Problems in Determination of Cost of Capital:

 Capital Structure Controversy:

Disagreement on cost and structure.
 Historic vs Future Costs:
Debate on past vs future costs.
 Equity Cost Calculation:
Difficult to quantify shareholder expectations.
 Retained Earnings Opportunity Cost:
Varying reinvestment opportunities for shareholders.
 Book Value vs Market Value:
Choosing between book or market values for WACC.

Computation of Cost of Capital:

 Cost of Specific Sources: Calculate costs for debt, equity, preference capital, and
retained earnings.
 Weighted Average Cost of Capital (WACC): Compute combined cost of all capital
sources.

Cost of Debt (Kd):

Cost of debt is the effective rate a company pays on borrowed funds, including interest,
calculated before and after tax.

Types of Debt:

 Perpetual Debt (Irredeemable):

Debt with no maturity, repaid at the company’s discretion. Cost calculated based on
interest and net proceeds.

Formula:
Kd = I / Po
Kd(after-tax) = I / Po (1 - t)
Where:

o I = Interest
o Po = Net proceeds
o t = Tax rate

 Redeemable Debt:
Debt repaid after a set period, with cost calculated from interest, par value, net
proceeds, and redemption time.
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Formula for Before-tax Cost:

Kd = (I + (P - NP) / n) / (P + NP) / 2
After-tax: Kd(after-tax) = Kd × (1 - t)
Where:

o I = Interest
o P = Par value
o NP = Net proceeds
o n = Years to redemption
o t = Tax rate

Cost of Preference Capital (kP):

 Perpetual Preference Capital:

o If issued at par: Kp = D / P
o If issued at premium/discount: Kp = D / NP
Where D = Annual dividend, P = Par value, NP = Net proceeds.
 Redeemable Preference Shares:
Formula: Kp = (D + (MV - MP) / n) / ((MV + MP) / 2)
Where D = Annual dividend, MV = Maturity value, MP = Market price, n = Maturity
period.

Cost of Equity Capital

The cost of equity is the return that shareholders expect from their investment. While
dividends aren't mandatory, shareholders generally expect them, making this expected return
the cost of equity.

It is the minimum return a firm must earn on its equity to keep the market price of its shares
stable.

Cost of equity can be calculated in two ways:

1. External Equity: For new shares issued.

2. Retained Earnings: For existing shares.

The Dividend Yield Approach is a common method for calculating cost of equity:

 Ke = D / NP for new shares

 Ke = D / MP for existing shares

Where:

 Ke = Cost of equity
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 D = Expected dividend per share

 NP = Net proceeds per share
 MP = Market price per share

This method works well for companies with stable earnings and dividend policies, but it
doesn't consider the effect of retained earnings.

Example:

A company issues 10,000 equity shares of Rs. 100 each at a 10% premium. It has been
paying a 20% dividend for the last five years and expects to continue.

Solution:

 If Net Proceeds (NP) = Rs. 110:

o Ke = D / NP = Rs. 20 / Rs. 110 = 18.18%
 If Market Price (MP) = Rs. 150:
o Ke = D / MP = Rs. 20 / Rs. 150 = 13.33%

So, the cost of equity changes depending on the market price of the share.

What Are Preference Shares?

Preference shares are stocks that give shareholders priority in receiving dividends before
equity shareholders. They may also be converted into equity shares and are paid first in case
of liquidation.

Types of Preference Shares:

1. Convertible: Can be converted into equity shares.

2. Non-Convertible: Cannot be converted into equity shares.
3. Redeemable: Can be repurchased by the company at a fixed rate and date.
4. Non-Redeemable: Cannot be repurchased by the company.
5. Participating: Shareholders receive part of surplus profits after dividends.
6. Non-Participating: Only receive fixed dividends, no share in surplus profits.
7. Cumulative: Dividends are paid even if no profit is made, with arrears carried
forward.
8. Non-Cumulative: No arrears; dividends are paid only from current year's profits.
9. Adjustable: Dividend rate changes based on market conditions.

Features of Preference Shares:

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 Convertibility: Can be converted into common stock.

 Dividend Payouts: Priority in receiving dividends over equity shareholders.
 Dividend Preference: Receive dividends first.
 Voting Rights: Limited voting rights in special cases.
 Priority in Assets: Paid before equity shareholders in case of liquidation.

What Are Retained Earnings?

Retained earnings are the profits a company keeps after paying dividends to shareholders.
These earnings are used for reinvestment in the business, like expanding operations or
launching new products. When a company makes profits but doesn't distribute them as
dividends, those profits are retained for future use

Key Points:
 Formula: Retained Earnings = Beginning Period Earnings + Net Income - Dividends
 Use: Retained earnings can be used to grow the company or pay off debt. If they go
negative, it’s called an accumulated deficit, which suggests the company has been
losing money.
 Difference from Profits: Retained earnings subtract dividends from profits, showing
the leftover funds for reinvestment.

Why It Matters:

 Growth: Companies with high retained earnings can reinvest in expansion without
needing outside funding.
 Financial Health: Retained earnings show how much profit the company has saved
over time, which helps evaluate its long-term stability and growth potential.
What is WACC? WACC (Weighted Average Cost of Capital) is the average rate of return a
company needs to pay for all its capital sources, including equity, debt, and preferred stock.
It reflects the company's cost of financing.
WACC Formula: WACC=(EV×Re)+((DV×Rd)×(1−T))\text{WACC} = \left( \frac{E}{V} \times Re \
right) + \left( \left( \frac{D}{V} \times Rd \right) \times (1 - T) \right) Where:
 EE = Equity value
 DD = Debt value
 VV = Total capital (Equity + Debt)
 ReRe = Cost of equity
 RdRd = Cost of debt
 TT = Tax rate

What is WACC Used For? WACC serves as a discount rate for business valuation and
investment evaluations. It’s used to assess if an investment opportunity meets the
company’s required return rate (hurdle rate).
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Nominal vs Real WACC:

 Nominal WACC includes inflation, used for nominal cash flows.

 Real WACC excludes inflation, used for real cash flows.

Use in Valuation: WACC is used to discount unlevered free cash flows (UFCF) to determine
the company's enterprise value. The equity value is then derived by subtracting net debt.

Limitations of WACC:

 Difficult to measure: Inputs like cost of equity and beta are based on judgment and
may be hard to estimate.
 Difficult for specific projects: WACC may not apply to individual investments with
different risks.
 Use of historical data: WACC often relies on past data, which may not reflect future
performance.
 Private companies: Calculating WACC for private companies is harder, especially for
cost of equity.

Career Paths Using WACC:

 Investment Banking
 Equity Research
 Corporate Development
 Private Equity

Marginal Cost of Capital (MCC)

The Marginal Cost of Capital is the cost of raising one additional dollar of capital, considering
all sources like debt, equity, and preference shares. As more capital is raised, this cost
typically increases, especially when cheaper financing options are exhausted.

Key Points:

 Increases with Capital Raised: As more funds are acquired, the cost of obtaining
additional capital generally rises.
 Benchmark for Investment Decisions: MCC serves as a minimum acceptable return
rate for new investments.
 Helps in Evaluating Projects: If a project's return exceeds the MCC, it may be
considered worthwhile.

Example: If a company raises $100,000 through equity at a 10% cost, the MCC is 10%.
Understanding MCC is crucial for businesses to manage their capital structure and make
informed decisions about funding future projects.
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UNIT – 2
1.1 Introduction

Financial decisions are key for a business, involving how the company is financed (capital
structure) and how much it costs to borrow money (cost of capital). The mix of debt and
equity affects how much profit shareholders can make and the risk involved. Leverage is a
way to measure this balance.

What is Leverage?

Leverage is using borrowed money or fixed-cost assets to try to increase profits for
shareholders.

Types of Leverage
There are three types:
 Operating Leverage
 Financial Leverage
 Combined Leverage

2.1 Operating Leverage

Operating leverage is about how much a company uses fixed costs (like rent) in its
operations. It helps show how changes in sales affect profits.
Formula: Operating Leverage = Contribution / Operating Profit
Degree of Operating Leverage
This tells you how much profit changes with a change in sales.
Formula: Degree of Operating Leverage = % change in profit / % change in sales.
Example

Company A and Company B have different operating leverages. Company B has more risk
because small changes in sales affect profits more.
Uses of Operating Leverage

 Shows how sales changes affect profits.

 Helps find fixed and variable costs.
 Helps understand how much is spent on fixed costs in the business.

3.1 Financial Leverage

Financial leverage is about using debt or fixed financial costs to boost profits for
shareholders.
Formula: Financial Leverage = Operating Profit / Profit Before Tax
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Favorable vs. Unfavorable Financial Leverage

 Favorable: If the company makes more money than it spends on fixed costs (good for
profits).
 Unfavorable: If the company makes less money than it spends on fixed costs (bad for
profits).
Degree of Financial Leverage
This shows how much taxable income changes when EBIT (earnings before interest and tax)
changes.
Formula: Degree of Financial Leverage = % change in taxable income / % change in EBIT.
Uses of Financial Leverage
 Helps analyze how EBIT affects profits.
 Helps make decisions about how the company should be financed.
 Shows the impact of fixed costs like debt.

Financial Plan Example
Two different financial plans (A and B) are compared based on how they affect EBIT and
profits.
Operating vs. Financial Leverage
 Operating Leverage: Focuses on costs for running the business.
 Financial Leverage: Focuses on using borrowed money.
 Operating Leverage is not affected by taxes or interest rates, but Financial Leverage
is.
EBIT-EPS Break-even Chart
Shows the level of EBIT (earnings before interest and tax) where profits equal zero, helping
businesses understand their financial risk.
Combined Leverage

This looks at both operating and financial leverage together to see how sales changes affect
profits.

Formula: Combined Leverage = Operating Leverage × Financial Leverage

Degree of Combined Leverage

Shows how a 1% change in sales affects EPS (earnings per share).

Formula: Degree of Combined Leverage = % change in EPS / % change in sales.
Example
Kumar company’s combined leverage is calculated using both operating and financial
leverage.
Exercise
Leverage calculations for two plans are made based on sales, variable costs, and fixed costs.
This helps determine which plan has more risk or reward.
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5.1 Meaning of Capital Structure

Capital structure refers to how a company raises funds (e.g., through debt, equity, and
retained earnings) to meet its capital needs. The goal is to find the right mix that reduces
costs and maximizes returns for shareholders.

5.2 Designing Capital Structure

A company can choose different ways to raise funds.

 Only debt
 Only equity
 Only preference shares
 A mix of debt and equity
 A mix of debt, equity, and preference shares
 A mix of debt and preference shares

Factors Governing Capital Structure

 Cost Principle: The ideal capital structure minimizes costs and maximizes earnings
per share (EPS). Debt is cheaper than equity since interest is tax-deductible.

 Risk Principle: Rely more on equity than debt. Too much debt means higher interest
payments, which increases financial risk.

o Business Risk: Risk due to market conditions, like sales fluctuations

o Financial Risk: Risk from using debt in the capital structure.

 Control Principle: Avoid issuing too much equity, as it can dilute control over the
company. More debt doesn’t affect control but increases financial risk.

 Flexibility Principle: Choose financing options that can be easily adjusted in the
future. Debt is easier to refinance, but equity is not.

 Other Considerations: Factors like industry type, competition, and timing of capital
issues should also be considered when designing capital structure.

A finance manager must balance these factors to create an effective capital structure.
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Key Concepts for Designing Optimal Capital Structure

1. Leverages
o Operating Leverage: Uses fixed costs to increase profit changes from sales
changes.
o Financial Leverage: Uses debt to boost returns, but only when debt returns
exceed its cost.
o Balance: Combine high operating leverage with low financial leverage to
reduce risks.
2. Coverage Ratio
o Measures if the firm can meet interest payments. A higher ratio means better
ability to pay.
3. Cash Flow Analysis
o Checks if the firm can handle debt payments based on cash flow, making high
debt manageable if cash flow is strong.
4. Optimal Capital Structure
o Debt helps a firm’s value up to a point. Too much debt hurts value and
reputation. The goal is a balanced mix of debt and equity.

8.1 EBIT-EPS Analysis

Objective
EBIT-EPS analysis helps design a capital structure that maximizes Earnings Per Share
(EPS), which is a key performance measure for investors.

Financial Break-even and Indifference Analysis

 Financial Break-even Point: The minimum EBIT to cover all fixed financial charges
(interest and dividends), where EPS is zero. If EBIT is below this, EPS is negative. If
EBIT exceeds it, more debt can be added.
 Indifference Point: The EBIT level where EPS is the same for two different
financing alternatives (e.g., all equity vs. debt-equity mix). At this point, EPS is
identical regardless of the financing choice.

Computation of Earnings per Share (EPS)

EPS=EBIT−Interest−TaxesNumber of Shares\text{EPS} = \frac{\text{EBIT} - \

text{Interest} - \text{Taxes}}{\text{Number of Shares}}

Indifference Point Calculation

(EBIT−I1)(1−T)=(EBIT−I2)(1−T)(EBIT - I_1)(1 - T) = (EBIT - I_2)(1 - T)

 26

Where:

 EBIT = Indifference point (EBIT level where EPS is the same for both plans)
 I₁ and I₂ = Interest charges for Alternative 1 and 2
 T = Tax rate
 E₁ and E₂ = Number of shares in Alternative 1 and 2

Graphical Representation
Plot EPS against different EBIT levels for various financing plans. The intersection of the
lines represents the Break-even Point or Indifference Point, identifying the best financing
choice.

Cost of Capital, Capital Structure, and Market Price of Share

 Financial leverage boosts the effect of EBIT on earnings per share (EPS).
 The aim is to maximize shareholder wealth by choosing the right mix of debt and
equity.
 This balance increases the firm's market value, reduces the cost of capital, and drives
growth.

Capital Structure Theories (In Pointers)

1. Net Income Approach

o More debt lowers the cost of capital.
o Increases firm value by using cheaper debt.
o Assumes constant cost of debt.
2. Net Operating Income Approach
o Capital structure doesn’t affect firm value.
o Cost of equity rises with more debt.
o Total cost of capital remains constant.
3. Modigliani-Miller Approach
o In perfect markets, capital structure doesn’t affect firm value.
o Debt can add value through tax shields.
o Assumes no taxes, bankruptcy costs, or market imperfections.
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Key Concepts for Designing Optimal Capital Structure

1. Leverages
o Operating Leverage: Uses fixed costs to increase profit changes from sales
changes.
o Financial Leverage: Uses debt to boost returns, but only when debt returns
exceed its cost.
o Balance: Combine high operating leverage with low financial leverage to
reduce risks.

2. Coverage Ratio
o Measures if the firm can meet interest payments. A higher ratio means better
ability to pay.

3. Cash Flow Analysis

o Checks if the firm can handle debt payments based on cash flow, making high
debt manageable if cash flow is strong.

4. Optimal Capital Structure

o Debt helps a firm’s value up to a point. Too much debt hurts value and
reputation. The goal is a balanced mix of debt and equity.

Key Concepts in Working Capital Management

1. Importance of Working Capital

o Shortage of working capital leads to business failure.
o Proper management of current assets and liabilities ensures business survival
and success.

2. Definition
o Working capital is the excess of current assets over current liabilities.

3. Concepts of Working Capital Management

o Quantitative Concept: Refers to total current assets (gross working capital).
o Qualitative Concept: Refers to the net working capital (current assets minus
current liabilities).
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4. Types of Working Capital

o Permanent Working Capital: Minimum required to keep the business
running.
o Variable Working Capital: Fluctuates with business activity (seasonal or
special needs).

5. Gross vs Net Working Capital

o Gross Working Capital: Total investment in current assets.
o Net Working Capital: Current assets minus current liabilities. It indicates
liquidity and creditworthiness.

6. Factors Determining Working Capital

o Business size, volume of sales, production cycle, cash requirements, and terms
of purchases affect working capital needs.
o Seasonal fluctuations and business cycles also impact working capital levels.

7. Operating Cycle
o The time taken from purchasing raw materials to collecting cash from sales.
o Varies by industry (manufacturing vs non-manufacturing).

8. Liquidity vs Profitability
o Conservative policy: Focuses on high liquidity, low risk, but lower returns.
o Aggressive policy: Focuses on higher returns, but higher risk and potential
liquidity issues.

9. Solvency and Profitability

o Firms must balance profitability (high returns) with solvency (ability to meet
obligations).
o A liquid firm faces less risk of insolvency but may have lower profitability
due to idle assets.

10. Cost Trade-off

 Cost of Liquidity: Too much liquidity reduces profitability.

 Cost of Illiquidity: Too little liquidity leads to cash shortages and higher borrowing
costs. Balancing both is crucial for financial health.
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Dividend and Dividend Policy

1. Dividend
o Portion of profits distributed to shareholders.
o Reflects shareholders' share in the company’s profits.

2. Dividend Policy
o Guidelines set by the board for distributing returns to equity shareholders.
o Aims to balance debt and equity in financing.

3. Theories of Dividend Policy

o Irrelevance Theories: Dividend policy does not affect firm value.
 Residual Theory: Dividends paid from leftover earnings after funding
investments.
 Modigliani & Miller (MM) Approach: Firm's value depends on
earnings and investment, not dividends.

o Relevance Theories: Dividend policy affects firm value.

 Walter’s Model: Dividend policy depends on investment
opportunities.
 Gordon’s Model: Dividend policy directly affects firm value as
investors prefer current income.

4. Walter’s Model
o Firm’s value depends on earnings, dividend payout, and the return on
investment.
o Assumes internal financing and constant rates of return and capital cost.

5. Gordon’s Model
o Emphasizes the direct relationship between dividend policy and firm value.
o Assumes constant cost of capital, internal financing, and perpetual earnings.

6. Modigliani and Miller Approach

o Dividend policy is irrelevant to firm value under perfect market conditions.
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o The market price of a share is based on the firm's earnings and investment, not
its dividend payout.

7. Formulae
o Walter’s Model:

P=Ek−bP = \frac{E}{k - b}

o Gordon’s Model:

P=E(1−b)k−brP = \frac{E (1 - b)}{k - br}

8. Illustration
o Gordon's Model: Price per share calculated based on different dividend
payout ratios.
o MM Approach: Market price changes with dividend policy and investment
strategy.

These models help in understanding the impact of dividend policies on firm value and
investor satisfaction.