Business Finance:

Business finance refers to money and credit employed in business. It involves procurement and utilization of funds so that
business firms may be able to carry out their operations effectively and efficiently. The following characteristics of business finance will make its
meaning more clear: (i)
Business finance includes all types of funds used in business.
(ii)
Business finance is needed in all types of organizations large or small, manufacturing or trading.
(iii)
The amount of business finance differs from one business firm to another depending upon its nature and size. It also varies from
time to time.
(iv)
Business finance involves estimation of funds. It is concerned with raising funds from different sources as well as investment of
funds for different purposes.

Significance:

Financing, simply put, is the act of bringing money into an organization. Businesses can be financed in a number of ways, each

of which features its own advantages, disadvantages and unique features. Common methods of financing a business include taking on debt and
taking advantage of credit arrangements, financing through equity investment or earning income through investment products that bear interest
or increase in value.

The important role of financial manager in modern business is as follows:

A financial manager is a person who takes care of all the important financial functions of an organization. The person in charge should maintain a
far sightedness in order to ensure that the funds are utilized in the most efficient manner. His actions directly affect the Profitability, growth and
goodwill of the firm. The important roles are,
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.

Provision Capital: How to create and implement programs for Provision of capital required by the Company.
Investor relations: the creation and maintenance of a sufficient market for company with the Securities and maintaining a sufficient
connection with the investment Bankers, analysts and shareholders.
Short long-term financing: To the appropriate sources for the company current loans from commercial banks and other lending
institutions.
Banking and storage: agreement with the bank, consider a given depots.
Credit and collections: the direct lending and collection accounts for the company, including oversight of the necessary sales financing
arrangements, such as the payment of time and Leasing plans.
Investment: To raise money from the company as needed and get create and coordinate measures for investments in pension and
other similar trust funds.
Insurance: Providing insurance protection as needed.
Planning Control: Develop, coordinate and manage an appropriate plan for monitoring the measures.
Reporting and Interpretation: To compare the information with business plans and standards and to report and interpret the results
of operations for all Levels of management and owners of the company.
Evaluation and Consulting: For all segments management is responsible for policy or action on any stage Operation of the company
in achieving the objectives and effectiveness of policies, organizational structure and procedures.
Tax Administration: the administration of tax policy and procedures.
Government Reporting: monitor or coordinate the preparation of the reports from government agencies.
Asset Protection: Protect company assets through internal controls, internal audit and the appropriate insurance Cover.

Scope of business finance

Difference Between Profit Maximization and Wealth Maximization

Profit Maximization: The process of obtaining the highest possible level of profit through the production and sale of goods and services.
The profit-maximization assumption is the guiding principle underlying production by a firm. In particular, it is assumed that firms undertake
actions and make the decisions that increase profit. The profit-maximization assumption is the production counterpart to the utility-maximization
assumption for consumer behavior.
The objective of financial management is profit maximisation. It cannot be the sole objective of a company as there is a directs /
relationship between risk and profit. If profit maximisation is the only goal, then risk factories ignored. Sometimes, higher the risk, higher is the
possibility of profits. Hence, risk has to be balanced with the objective of profit maximisation. In addition, a firm has to take into account the
social considerations, and normal obligations to the interests of workers, consumers, society, government, as well as ethical trade practices.
However, as profit maximisation ignores risk and uncertainty and timing of returns, a firm cant solely depend on the objective.

Wealth Maximisation: A process that increases the current net value of business or shareholder capital gains, with the objective of bringing in
the highest possible return. The wealth maximization strategy generally involves making sound financial investment decisions which take
into consideration any risk factors that would compromise or outweigh the anticipated benefits.
Hence, the objective of a firm is to maximise its wealth and the value of its shares. According to van Home value is represented by the
market price of the companys common stock. The market price of a firms stock takes into account present and prospective future earnings per
share (EPS), the timing and risk of these earnings, the dividend policy of the firm and many other factors that bear upon the market price of the
stock. The concept of wealth in the context of wealth maximisation objective refers to the shareholders wealth as reflected by the market price of
their shares in the share market. Hence, maximisation of wealth means maximisation of the market price of the equity shares of the company.

Profit Maximisation Vs Wealth Maximisation:

Total profits are not as important as earnings per share. Even maximisation of earnings per share is not enough because it does not
specify the timing or duration of expected returns. Further, it does not consider the risk of uncertainty of the future earnings. Hence, wealth
maximisation is appropriate and it is possible by maximising the market price per share.
According to Prof. Ezra Soloman, wealth maximisation also maximises the achievement of other objectives. Maximisation of wealth of
the firm implies maximisation of value of owners share capital reflected in the market price of shares. Therefore, the operative objective of
financial management implies maximisation of market price of sharesy.

Weaknesses of Profit Maximisation

Profit maximization is an obvious goal of management, but it does not necessarily imply that short-term profit increases will produce longterm sustainable gains. For example, a reduction in product quality that lowers production costs will produce a quick increase in profit, but lowered
quality standards can also tarnish a company's reputation and provide the competition with an advantage.
Lowering or eliminating a company's employee training or research and development budget will lessen operating expenses and also
maximize short-term profits. However, the competition may not follow suit and instead produce a much better product or service. The long-term
result could be a significant loss of market share for the company that decided to lower its budget to pursue a short-term profit gain.

Objective of Profit Maximisation in Managing Finance

Profit maximization is considered as the goal of financial management. In this approach, actions that Increase profits should be undertaken
and the actions that decrease the profits are avoided. Thus, the Investment, financing and dividend also be noted that the term objective provides
a normative framework decisions should be oriented to the maximization of profits. The term profit is used in two senses. In one sense it is used
as an owner-oriented.
In this concept it refers to the amount and share of national Income that is paid to the owners of business. The second way is an operational
concept i.e. profitability. This concept signifies economic efficiency. It means profitability refers to a situation where output exceeds Input. It means,
the value created by the use of resources is greater that the Input resources. Thus in all the decisions, one test is used I.e. select asset, projects and
decisions that are profitable and reject those which are not profitable.

Capitalization
Capitalization comprises of share capital, debentures, loans, free reserves, etc. Capitalization represents permanent investment in
companies excluding long-term loans. Capitalization can be distinguished from capital structure. Capital structure is a broad term and it deals with
qualitative aspect of finance. While capitalization is a narrow term and it deals with the quantitative aspect.
Capitalization is generally found to be of following types1. Normal
2. Over
3. Under

Overcapitalization
Overcapitalization is a situation in which actual profits of a company are not sufficient enough to pay interest on debentures, on loans and pay
dividends on shares over a period of time. This situation arises when the company raises more capital than required. A part of capital always
remains idle. With a result, the rate of return shows a declining trend. The causes can be-

1.

High promotion cost- When a company goes for high promotional expenditure, i.e., making contracts, canvassing, underwriting
commission, drafting of documents, etc. and the actual returns are not adequate in proportion to high expenses, the company is overcapitalized in such cases.
Purchase of assets at higher prices- When a company purchases assets at an inflated rate, the result is that the book value of assets is
more than the actual returns. This situation gives rise to over-capitalization of company.
A companys floatation n boom period- At times company has to secure its solvency and thereby float in boom periods. That is the time
when rate of returns are less as compared to capital employed. This results in actual earnings lowering down and earnings per share
declining.
Inadequate provision for depreciation- If the finance manager is unable to provide an adequate rate of depreciation, the result is that
inadequate funds are available when the assets have to be replaced or when they become obsolete. New assets have to be purchased at
high prices which prove to be expensive.
Liberal dividend policy- When the directors of a company liberally divide the dividends into the shareholders, the result is inadequate
retained profits which are very essential for high earnings of the company. The result is deficiency in company. To fill up the deficiency,
fresh capital is raised which proves to be a costlier affair and leaves the company to be over- capitalized.

2.
3.

4.

5.

6.

Over-estimation of earnings- When the promoters of the company overestimate the earnings due to inadequate financial planning, the
result is that company goes for borrowings which cannot be easily met and capital is not profitably invested. This results in consequent
decrease in earnings per share.

Effects of Overcapitalization
1.

2.

3.

On Shareholders- The over capitalized companies have following disadvantages to shareholders:

a. Since the profitability decreases, the rate of earning of shareholders also decreases.
b. The market price of shares goes down because of low profitability.
c. The profitability going down has an effect on the shareholders. Their earnings become uncertain.
d. With the decline in goodwill of the company, share prices decline. As a result shares cannot be marketed in capital market.
On Companya. Because of low profitability, reputation of company is lowered.
b. The companys shares cannot be easily marketed.
c. With the decline of earnings of company, goodwill of the company declines and the result is fresh borrowings are difficult to be
made because of loss of credibility.
d. In order to retain the companys image, the company indulges in malpractices like manipulation of accounts to show high
earnings.
e. The company cuts down its expenditure on maintainance, replacement of assets, adequate depreciation, etc.
On Public- An overcapitalized company has got many adverse effects on the public:
a. In order to cover up their earning capacity, the management indulges in tactics like increase in prices or decrease in quality.
b. Return on capital employed is low. This gives an impression to the public that their financial resources are not utilized properly.
c. Low earnings of the company affects the credibility of the company as the company is not able to pay its creditors on time.
d. It also has an effect on working conditions and payment of wages and salaries also lessen.

Undercapitalization
An undercapitalized company is one which incurs exceptionally high profits as compared to industry. An undercapitalized company situation arises
when the estimated earnings are very low as compared to actual profits. This gives rise to additional funds, additional profits, high goodwill, high
earnings and thus the return on capital shows an increasing trend. The causes can be1. Low promotion costs
2. Purchase of assets at deflated rates
3. Conservative dividend policy
4. Floatation of company in depression stage
5. High efficiency of directors
6. Adequate provision of depreciation
7. Large secret reserves are maintained.

Efffects of Under Capitalization

1.

2.

3.

On Shareholders
a. Companys profitability increases. As a result, rate of earnings go up.
b. Market value of share rises.
c. Financial reputation also increases.
d. Shareholders can expect a high dividend.
On company
a. With greater earnings, reputation becomes strong.
b. Higher rate of earnings attract competition in market.
c. Demand of workers may rise because of high profits.
d. The high profitability situation affects consumer interest as they think that the company is overcharging on products.
On Society
a. With high earnings, high profitability, high market price of shares, there can be unhealthy speculation in stock market.

b.
c.
d.

Restlessness in general public is developed as they link high profits with high prices of product.
Secret reserves are maintained by the company which can result in paying lower taxes to government.
The general public inculcates high expectations of these companies as these companies can import innovations, high technology
and thereby best quality of product.

Cost Theory and Earnings Theory of Capitalization

The problems of determining the amount of capitalization is necessary both for a newly started company as well as for an established
concern. In case of the new enterprise, the problem is more severe in so far as it requires the reasonable provision for future as well as for current
needs and there arises the danger of either raising excessive or insufficient capital. But the case is different with established concerns.
They have to revise or modify their financial plan either by issuing of fresh securities or by reducing the capital and making it in conformity with the
needs of the enterprises. However, to estimate the amount of capitalization two theories have been pronounced.
1. The cost theory of capitalization: Under this theory, the capitalization of a company is determined by adding the initial actual expenses
to be incurred in setting up a business enterprise as a going concern. It is aggregate of the cost of fixed assets (plant, machinery, building,
furniture, goodwill, and the like), the amount of working capital (investments, cash, inventories, receivables) required to run the business,
and the cost of promoting, organizing and establishing the business.
In other works, the original total outlay incurred on various items becomes the basis for determining the capitalization of a company. If the
funds raised are sufficient to meet the initial costs and day to day expenses, the company is said to be adequately capitalized. This theory is
very helpful for the new companies as it facilitates the calculation of the amount of funds to be raised initially.
Cost theory, no doubt, gives a concrete idea to determine the magnitude of capitalization, but it fails to provide the basis for assessing the
net worth of the business in real terms. The capitalization determined under this theory does not change with earnings.
Moreover, it does not take into account the future needs of the business. This theory is not applicable to the existing concerns because it
does not suggest whether the capital invested justifies the earnings or not. Moreover, the cost estimates are made at a particular period of
time.
They do not take into account the price level changes. For example, if some of the assets may be purchased at inflated prices, and some
assets may remain idle or may not be fully utilized, earnings will be low and the company will not be able to pay a fair return on the capital
invested. The result will be over-capitalization.
In order to do away with these difficulties and arrive at a correct figure of capitalization, earnings approach is used.
2. The earnings theory of capitalization: This theory assumes that an enterprise is expected to make profit. According to it, its true value
depends upon the companys earnings and/or earning capacity. Thus, the capitalization of the company or its value is equal to the capitalized
value of its estimated earnings. To find out this value, a company, while estimating its initial capital needs, has to prepare a projected profit
and loss account to complete the picture of earnings or to make a sales forecast.
Having arrived at the estimated earnings figures, the financial manager will compare with the actual earnings of other companies of similar
size and business with necessary adjustments.
After this the rate at which other companies in the same industry, similarly situated are making earnings on their capital will be studied. This
rate is then applied to the companys estimated earnings for determining its capitalization.
Under the earnings theory of capitalization, two factors are generally taken into account to determine capitalization
(i)
how much the business is capable of earning and
(ii)
What is the fair rate of return for capital invested in the enterprise. This rate of return is also known as multiplier which is
100 per cent divided by the appropriate rate of return.
These factors include nature of industry/ financial risks, competition prevailing in the industry and so on. New companies cannot depend
upon this theory as it is difficult to estimate the expected returns in their case.
As regards capitalisation, it is often said that a concern should neither be overcapitalized, nor under-capitalised, the aim should be to
achieve fair capitalisation. To understand the significance of this statement, let us first look into the technicalities of over and under
capitalisation.

Effects of Over-capitalisation
1.
2.
3.

The shares of the company may not be easily marketable because of reduced earnings per share.
The company may not be able to raise fresh capital from the market.
Management may cut down expenditure on maintenance and replacement of assets. Proper amount of depreciation of assets may not be
provided for.
4. Over-capitalisation results in reduced earnings for the company. This means the shareholders will get lesser dividend.
5. Market value of shares will go down because of lower profitability.
6. There may be no certainty of income to the shareholders in the future.
7. The profits of an over-capitalised company would show a declining trend. Such a company may resort to tactics like increase in product
price or lowering of product quality.
8. Return on capital employed is very low. This means that financial resources of the public are not being utilised properly.
9. An over-capitalised company may not be able to pay interest to the creditors regularly.
Remedies for Over-capitalization: In order to correct the situation caused by over-capitalization, the following measures should be adopted:
1. The earning capacity of the company should be increased by raising the efficiency of human and non-human resources of the company.
2. Long-term borrowings carrying higher rate of interest may be redeemed out of existing resources.
3. The par value and/or number of equity shares may be reduced.
4. Management should follow a conservative policy in declaring dividend and should take all measures to cut down unnecessary expenses
on administration.

Effects of Under-capitalization:
1.
2.
3.
4.
5.
6.
7.

The profitability of the company may be very high. As a result, the rate of earnings per share will go up.
The value of its equity share in the market will go up.
The financial reputation of the company will increase in the market.
Because of higher profitability, the market value of companys shares would go up. This would also increase the reputation of the company.
The management may be tempted to build up secret reserves.
Higher rate of earnings will attract competition in the market.
Under-capitalization may lead to higher profits and higher prices of shares on the stock exchange. This may encourage unhealthy
speculation in its shares.
8. Because of higher profits, the consumers feel exploited. They link higher profits with higher prices of the products.
Remedies for Under-capitalization: The following remedial steps may be taken to correct under-capitalization of a company:
1. Under-capitalization may be remedied by increasing the par value and/or number of equity shares by revising upward the value of assets.
This will lead to decrease in the rate of earnings per share.
2. Management may capitalize the earnings by issuing bonus shares to the equity shareholders. This will also reduce the rate of earnings per
share without reducing the total earnings of the company.
3. Where under-capitalization is due to insufficiency of capital, more shares and debentures may be issued to the public.

Under-capitalization may be caused by the following factors:

1.
2.
3.
4.
5.

Acquisition of Assets during Recession: Assets might have been acquired at low costs during necessary conditions in the market. And now
higher incomes are being earned by their use.
Under-estimation of Requirements: There may be under-estimation of capital requirements of the company by the promoters. This may
lead to capitalization which is insufficient to conduct its operations.
Conservative Dividend Policy: The management may follow a conservative dividend policy leading to higher rate of ploughing back of
profits. This would increase the earning capacity of the company.
Efficient Management: The management of a company may be highly efficient. It may issue the minimum share capital and may meet
the additional financial requirements through borrowings at lower rates of interest.
Creation of Secret Reserves: A company may have large secret reserves due to which its profitability is higher.

Over-capitalization may be caused by the following factors:

1.
2.
3.

4.
5.
6.

Acquisition of Assets at Higher Prices: Assets might have been acquired at inflated prices or at a time when the prices were at their peak.
In both the cases, the real value of the company would be below its book value and the earnings very low.
Higher Promotional Expenses: The company might incur heavy preliminary expenses such as purchase of goodwill, patents, etc.; printing
of prospectus, underwriting commission, brokerage, etc. These expenses are not productive but are shown as assets.
Underutilisation: The directors of the company may over-estimate the earnings of the company and raise capital accordingly. If the
company is not in a position to invest these funds profitably, the company will have more capital than is required. Consequently, the rate
of earnings per shares will be less.
Insufficient Provision for Depreciation: Depreciation may be charged at a lower rate than warranted by the life and use of the assets, and
the company may not make sufficient provisions for replacement of assets. This will reduce the earning capacity of the company.
Liberal Dividend Policy: The company may follow a liberal dividend policy and may not retain sufficient funds for self-financing. This may
lead to over-capitalisation in the long-run.
Inefficient Management: Inefficient management and extravagant organisation may also lead to over-capitalisation of the company. The
earnings of the company will be low.

Capital Budgeting
Capital budgeting is the planning process used to determine which of an organization's long term investments are worth pursuing.
The process in which a business determines whether projects such as building a new plant or investing in a long-term venture are worth pursuing.
Oftentimes, a prospective project's lifetime cash inflows and outflows are assessed in order to determine whether the returns generated meet a
sufficient target benchmark.
Ideally, businesses should pursue all projects and opportunities that enhance shareholder value. However, because the amount of capital
available at any given time for new projects is limited, management needs to use capital budgeting techniques to determine which projects will
yield the most return over an applicable period of time. Popular methods of capital budgeting include net present value (NPV), internal rate of
return (IRR), discounted cash flow (DCF) and payback period.

Capital Budgeting Process:

The specific capital budgeting procedures that the manager uses depend on the manger's level in the organization and the complexities
of the organization and the size of the projects. The typical steps in the capital budgeting process are as follows:
1. Brainstorming. Investment ideas can come from anywhere, from the top or the bottom of the organization, from any department or
functional area, or from outside the company. Generating good investment ideas to consider is the most important step in the process.
2. Project analysis. This step involves gathering the information to forecast cash flows for each project and then evaluating the project's
profitability.
3. Capital budget planning. The company must organize the profitable proposals into a coordinated whole that fits within the company's
overall strategies, and it also must consider the projects' timing. Some projects that look good when considered in isolation may be
undesirable strategically. Because of financial and real resource issues, the scheduling and prioritizing of projects is important.
4. Performance monitoring. In a post-audit, actual results are compared to planned or predicted results, and any differences must be
explained. For example, how do the revenues, expenses, and cash flows realized from an investment compare to the predictions? Post-

auditing capital projects is important for several reasons. First, it helps monitor the forecasts and analysis that underlie the capital
budgeting process. Systematic errors, such as overly optimistic forecasts, become apparent. Second, it helps improve business
operations. If sales or costs are out of line, it will focus attention on bringing performance closer to expectations if at all possible. Finally,
monitoring and post-auditing recent capital investments will produce concrete ideas for future investments. Managers can decide to
invest more heavily in profitable areas and scale down or cancel investments in areas that are disappointing.

Payback method of capital budgeting

The length of time required to recover the cost of an investment. The payback period of a given investment or project is an important
determinant of whether to undertake the position or project, as longer payback periods are typically not desirable for investment positions.
Under this method, an investment project is accepted or rejected on the basis of payback period. Payback period means the period of time that a
project requires to recover the money invested in it. The payback period of a project is expressed in years and is computed using the following
formula:
Formula of payback period:

According to this method, the project that promises a quick recovery of initial investment is considered desirable. If the payback period of a project
computed by the above formula is shorter than or equal to the managements maximum desired payback period, the project is accepted otherwise
it is rejected. For example, if a company wants to recoup the cost of a machine within 5 years of purchase, the maximum desired payback period of
the company would be 5 years. The purchase of machine would be desirable if it promises a payback period of 5 years or less.

Internal Rate of Return

The discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero.
Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake the project. As such, IRR can be used to rank
several prospective projects a firm is considering. Assuming all other factors are equal among the various projects, the project with the highest IRR
would probably be considered the best and undertaken first.
IRR is sometimes referred to as "economic rate of return (ERR)."
You can think of IRR as the rate of growth a project is expected to generate. While the actual rate of return that a given project ends up
generating will often differ from its estimated IRR rate, a project with a substantially higher IRR value than other available options would still
provide a much better chance of strong growth.
IRRs can also be compared against prevailing rates of return in the securities market. If a firm can't find any projects with IRRs greater
than the returns that can be generated in the financial markets, it may simply choose to invest its retained earnings into the market.

Accounting rate of return method

Accounting rate of return (ARR) method uses expected net operating income to be generated by the investment proposal rather than
focusing on cash flows to evaluate an investment proposal.
Under this method, the assets expected accounting rate of return (ARR) is computed by dividing the expected incremental net operating
income by the initial investment and then compared to the managements desired rate of return to accept or reject a proposal. If the assets
expected accounting rate of return is greater than or equal to the managements desired rate of return, the proposal is accepted. Otherwise, it is
rejected. The accounting rate of return is computed using the following formula:
Formula of accounting rate of return (ARR):

In the above formula, the incremental net operating income is equal to incremental revenues to be generated by the asset
less incremental operating expenses. The incremental operating expenses also include depreciation of the asset.
The denominator in the formula is the amount of investment initially required to purchase the asset. If an old asset is replaced with a
new one, the amount of initial investment would be reduced by any proceeds realized from the sale of old equipment.

Financial leverage
Financial leverage (or only leverage) means acquiring assets with the funds provided by creditors and preferred stockholders for the benefit
of common stockholders. Financial leverage is a two-edged sword. It may be positive or negative.
The following paragraphs explain what is positive and negative financial leverage?
1. Positive financial leverage: A positive financial leverage means that the assets acquired with the funds provided by creditors and preferred
stockholders generate a rate of return that is higher than the rate of interest or dividend payable to the providers of funds. Positive financial
leverage is beneficial for common stockholders. For example, XYZ Company obtains a long term debt at a rate of 12%. The company can
use the funds to earn an after-tax rate of 14%. The interest on debt is tax deductible. If the tax rate is 40%, the after-tax interest rate would
be 7.2% [12% (1 0.4)]. The difference of 6.8% (14% 7.2%) is, therefore, the benefit of common stockholders.
In this situation, the financial leverage is positive because the after-tax rate of return is higher than the after-tax rate of interest on long-term
debts.
2. Negative financial leverage: A negative financial leverage occurs when the assets acquired with the debts and preferred stock generate
a rate of return that is less than the rate of interest or dividend payable to the providers of debts or preferred stock. Negative financial
leverage is a loss for common stockholders.

If you understand how leverage works and learn to handle it correctly, you can use its power to build wealth. Returning to the sword
analogy, the way to do this is to use the blade to cut out losses quickly, leaving the profits room to grow.
Similarly, some people liken trading with leverage to a journey in a car. You could walk to your destination, but driving is a much more
efficient solution, especially if the destination is far away. Driving a car is probably much riskier than walking, and statistically more people die in
road accidents. But how many people listen to those statistics and never drive in a car? Investors' fear of leverage is often similarly absurd.
Conclusion - There's no need to be afraid of leverage once you have learned how to manage it. The only time leverage should never be used is if
you take hands-off approach to your trades. Otherwise, leverage can be used successfully and profitably with proper management. Like any sharp
instrument, leverage must be handled carefully - once you learn to do this, you have no reason to worry.

Operating Leverage - Operating leverage compares sales to the costs of production. Fixed costs involve the property, plant and equipment
you use to create products. These costs are independent of the number of units you produce. Variable costs are the additional costs required to
produce a unit of marketable inventory, such as the costs of raw materials, electricity, packaging and transportation. You can measure operating
leverage as the ratio of fixed costs to variable costs or fixed costs to total costs. Higher values of this ratio indicate high operating leverage.
Effects of Operating Leverage - A high operating leverage means you are in a position to increase production without investing in additional
fixed costs. As production rises, you are in effect spreading fixed costs across a greater number of units, so the additional units have a lower ratio
of fixed costs to total costs. The degree of operating leverage -- the percent change in earnings before interest and taxes, or EBIT, divided by the
percentage change in sales -- gives you a means to gauge how earnings will respond to sales activity. When demand for your product increases,
you can easily ramp up production by increasing variable costs; your fixed assets allow you to magnify production. You can increase production as
long as your higher variable costs dont cause total costs to exceed your sales revenues. However, in a recession, high operating leverage is risky,
as it saddles you with high fixed costs even when you cut production.

Example
Calculate degree of operating leverage in the following cases and predict the increase in operating income subject to 15% increase in sales.
Company A: operating income increases by 15% if sales increase by 10%.
Company B: sales are $2,000,000, contribution margin ratio is 40% and fixed costs are $400,000

Solution
Company A:
Degree of operating leverage = % change in operating income/% change in sales = 15%/10% = 1.5
In response to a 15% increase sales, operating income will increase by 22.5% [=1.5 15%]
Company B:
Operating margin = ($2,000,000 0.4 $400,000) $2,000,000 = 20%
Degree of operating leverage = contribution margin percentage/operating margin = $40% 20% = 2%
Increase in operating income in response to 15% increase in sales = 2 15% = 30%

Financial Leverage - Financial leverage is a measure of debt, usually defined as total debt divided by the owners equity, which is assets minus
liabilities. By increasing financial leverage instead of issuing stock, you can use the additional funds to increase production without diluting earnings
among a greater number of shareholders. In this sense, it magnifies your profits per share. You can measure this effect with the formula for degree
of financial leverage: EBIT divided by earnings before taxes. However, additional leverage increases your interest expense, which cuts into net
income, even though interest is tax deductible. If you are overleveraged and sales fall, you might find yourself short of cash and face default on
your debt.

Theories of Dividend: Walters model, Gordons model and Modigliani and

Millers Hypothesis
1. Walters model: Professor James E. Walter argues that the choice of dividend policies almost always affects the value of the enterprise.
His model shows clearly the importance of the relationship between the firms internal rate of return (r) and its cost of capital (k) in
determining the dividend policy that will maximise the wealth of shareholders.
Walters model is based on the following assumptions:
1. The firm finances all investment through retained earnings; that is debt or new equity is not issued;
2. The firms internal rate of return (r), and its cost of capital (k) are constant;
3. All earnings are either distributed as dividend or reinvested internally immediately.
4. Beginning earnings and dividends never change. The values of the earnings pershare (E), and the divided per share (D) may
be changed in the model to determine results, but any given values of E and D are assumed to remain constant forever in
determining a given value.
5. The firm has a very long or infinite life.
Walters formula to determine the market price per share (P) is as follows:
P = D/K +r(E-D)/K/K
The above equation clearly reveals that the market price per share is the sum of the present value of two sources of income:
1. The present value of an infinite stream of constant dividends, (D/K) and
2. The present value of the infinite stream of stream gains.
[r (E-D)/K/K]

Criticism: Walters model is quite useful to show the effects of dividend policy on an all equity firm under different assumptions about the
rate of return. However, the simplified nature of the model can lead to conclusions which are net true in general, though true for Walters
model. The criticisms on the model are as follows:
1. Walters model of share valuation mixes dividend policy with investment policy of the firm. The model assumes that the
investment opportunities of the firm are financed by retained earnings only and no external financing debt or equity is used
for the purpose when such a situation exists either the firms investment or its dividend policy or both will be sub-optimum.
The wealth of the owners will maximise only when this optimum investment in made.
2. Walters model is based on the assumption that r is constant. In fact decreases as more investment occurs. This reflects the
assumption that the most profitable investments are made first and then the poorer investments are made.
The firm should step at a point where r = k. This is clearly an erroneous policy and fall to optimize the wealth of the owners.
3. A firms cost of capital or discount rate, K, does not remain constant; it changes directly with the firms risk. Thus, the present
value of the firms income moves inversely with the cost of capital. By assuming that the discount rate, K is constant, Walters
model abstracts from the effect of risk on the value of the firm.

2. Gordons Model: One very popular model explicitly relating the market value of the firm to dividend policy is developed by Myron
Gordon. Gordons model is based on the following assumptions.
1. . The firm is an all Equity firm
2. No external financing is available
3. The internal rate of return (r) of the firm is constant.
4. The appropriate discount rate (K) of the firm remains constant.
5. The firm and its stream of earnings are perpetual
6. The corporate taxes do not exist.
7. The retention ratio (b), once decided upon, is constant. Thus, the growth rate (g) = br is constant forever.
8. K > br = g if this condition is not fulfilled, we cannot get a meaningful value for the share.
According to Gordons dividend capitalisation model, the market value of a share (Pq) is equal to the present value of an infinite
stream of dividends to be received by the share. Thus:

The above equation explicitly shows the relationship of current earnings (E,), dividend policy, (b), internal profitability (r) and the
all-equity firms cost of capital (k), in the determination of the value of the share (P0).

3.

Modigliani and Millers hypothesis: According to Modigliani and Miller (M-M), dividend policy of a firm is irrelevant as it does not affect
the wealth of the shareholders. They argue that the value of the firm depends on the firms earnings which result from its investment
policy. Thus, when investment decision of the firm is given, dividend decision the split of earnings between dividends and retained earnings
is of no significance in determining the value of the firm. M Ms hypothesis of irrelevance is based on the following assumptions.
1. The firm operates in perfect capital market
2. Taxes do not exist
3. The firm has a fixed investment policy
4. Risk of uncertainty does not exist. That is, investors are able to forecast future prices and dividends with certainty and
one discount rate is appropriate for all securities and all time periods. Thus, r = K = Kt for all t.
Under M M assumptions, r will be equal to the discount rate and identical for all shares. As a result, the price of each share
must adjust so that the rate of return, which is composed of the rate of dividends and capital gains, on every share will be equal to the
discount rate and be identical for all shares. Thus, the rate of return for a share held for one year may be calculated as follows:

Where P^ is the market or purchase price per share at time 0, P, is the market price per share at time 1 and D is dividend per share
at time 1. As hypothesized by M M, r should be equal for all shares. If it is not so, the low-return yielding shares will be sold by investors
who will purchase the high-return yielding shares.
This process will tend to reduce the price of the low-return shares and to increase the prices of the high-return shares. This
switching will continue until the differentials in rates of return are eliminated. This discount rate will also be equal for all firms under the
M-M assumption since there are no risk differences.
From the above M-M fundamental principle we can derive their valuation model as follows:

Multiplying both sides of equation by the number of shares outstanding (n), we obtain the value of the firm if no new financing exists.

If the firm sells m number of new shares at time 1 at a price of P^, the value of the firm at time 0 will be

The above equation of M M valuation allows for the issuance of new shares, unlike Walters and Gordons models. Consequently,
a firm can pay dividends and raise funds to undertake the optimum investment policy. Thus, dividend and investment policies are not
confounded in M M model, like waiters and Gordons models.
Criticism: Because of the unrealistic nature of the assumption, M-Ms hypothesis lacks practical relevance in the real world situation.
Thus, it is being criticized on the following grounds.
1. The assumption that taxes do not exist is far from reality.
2. M-M argue that the internal and external financing are equivalent. This cannot be true if the costs of floating new issues exist.
3. According to M-Ms hypothesis the wealth of a shareholder will be same whether the firm pays dividends or not. But, because of the
transactions costs and inconvenience associated with the sale of shares to realize capital gains, shareholders prefer dividends to
capital gains.
4. Even under the condition of certainty it is not correct to assume that the discount rate (k) should be same whether firm uses the
external or internal financing. If investors have desire to diversify their port folios, the discount rate for external and internal financing
will be different.
5. M-M argues that, even if the assumption of perfect certainty is dropped and uncertainty is considered, dividend policy continues to
be irrelevant. But according to number of writers, dividends are relevant under conditions of uncertainty.

Factors Affecting Dividend Policy Of A Firm

A firm's dividend policy is influenced by the large numbers of factors. Some factors affect the amount of dividend and some factors affect types
of dividend. The following are the some major factors which influence the dividend policy of the firm:
1. Legal requirements - There is no legal compulsion on the part of a company to distribute dividend. However, there certain conditions
imposed by law regarding the way dividend is distributed. Basically there are three rules relating to dividend payments. They are the
net profit rule, the capital impairment rule and insolvency rule.
2. Firm's liquidity position - Dividend payout is also affected by firm's liquidity position. In spite of sufficient retained earnings,the
firm may not be able to pay cash dividend if the earnings are not held in cash.
3. Repayment need - A firm uses several forms of debt financing to meet its investment needs. These debt must be repaid at the
maturity. If the firm has to retain its profits for the purpose of repaying debt, the dividend payment capacity reduces.
4. Expected rate of return - If a firm has relatively higher expected rate of return on the new investment, the firm prefers to retain the
earnings for reinvestment rather than distributing cash dividend.
5. Stability of earning - If a firm has relatively stable earnings, it is more likely to pay relatively larger dividend than a firm with
relatively fluctuating earnings.
6. Desire of control - When the needs for additional financing arise, the management of the firm may not prefer to issue additional
common stock because of the fear of dilution in control on management. Therefore, a firm prefers to retain more earnings to satisfy
additional financing need which reduces dividend payment capacity.
7. Access to the capital market - If a firm has easy access to capital markets in raising additional financing, it does not require more
retained earnings. So a firm's dividend payment capacity becomes high.
8. Shareholder's individual tax situation - For a closely held company, stockholders prefer relatively lower cash dividend because of
higher tax to be paid on dividend income. The stockholders in higher personal tax bracket prefer capital gain rather than dividend
gains.