Financial Management

Faculty: Gautam Negi

Karm a Dharm a Moksh a

The Essence of Theory Lies in Practical Application

Objectives
Clarity on concepts Ask questions reason..keep me on my toes. Get attentive, interested and interactive Peer learning Stay disciplined and punctual Love the subject.it will love you back

 There are no shortcuts in learning We will create a glossary of 1000 financial words in the next 3 months Reference Books:

Prasanna Chandra Van Horne I M Pandey Damodaran

COURSE LAYOUT

INVESTME NT Capex decisions Complex decisions Cost of Capital Cash Flow Risk Analysis

FINANCING/WC Mgmt

DIVIDEND

VALUATI ON

Sources of Finance Dividend Relevance Dividend Irrelevance Value of firm Capital Structure Deci Leveraging Inventory Mgmt Cash Mgmt

ssential Tools: Time Value Of Money Analysis Of Financial Statements Risk Return Trade Off Valuation concepts and Models(CAPM/APT)

Contents
Introduction Agency Costs Time value of money Valuation of Assets Risk, Return, Portfolio Beta Estimation Financial Statements FS Analysis Capital Budgeting Decisions Cost of Capital Cash flow estimation Risk Analysis in Capex Operating and Financial Leverage Capital Structure Introduction to Dividends WC Management Receivables Management Inventory Management Cash Management WC finance

 Financial decisions can also be classified as

Long term Short term

Functions of a Finance Manager

Funds raising(Asset Mgmt-> Liability Mgmt-> Funds Mgmt). Funds Allocation Profit Planning(Pricing/Cost/Volume Of Output) Understanding the capital Markets

The firm and its Objective..

Defining the Firm Why a UNIQUE OBJECTIVE

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

Objective of the firm-> max value of the firm-> Max Stock Price

Managers are appointed by SHs. lenders can protect themselves contractually

 Why Stock Price as the Objective

Most observable and updated constantly Stock price reflects the long term effects of the firms decisions Stockholders can liquidate and receive value now

Agency Costs
Shareholde rs

Bondhold ers

MANAGERS

Socie ty
Conflict between Groups Stockholders and
Managers Stockholders and Bondholders Firm and the Financial Markets

Financial Markets
Firm positioned in an ideal world

Agency Costs between Groups

Shareholde rs
Overleveraging
Investing in bad projects Overleveraging Overpaying on a takeover Giving high dividends Resisting company Socie takeover

Bondhold ers

MANAGERS

ty

Financial Suppressing/delayiMarkets
ng Info (eg.Satyam)

 Should stock price be taken as a measure of Managerial performance

Ability of the managers to suppress/delay info Efficiency of the Capital Markets

Ways to reduce Agency Costs

SHs and Managers

Disciplining the managers through an effective Board/AGM Making Managers think like SHs Threat of takeovers(Greenmail/Poison Pills/Golden Parachute)

SHs and Bondholders

Bond Covenants(Affirmative/Negative) Restricting investment policy/dividend policy/additional levarage.

Ways to reduce Agency Costs

Firms and Financial Markets

Role of regulatory bodies(SEBI) Making markets more efficient

Firms and Society

Corporate Citizen Behavior

Other possible Objectives

Max of Profits

Window dressing/focus on the current only/ignores time value of money

Max Market Share(Japan/China) Max Growth/Size/Revenues Social Welfare Objectives..

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

 Defense strategies against possible takeover

Golden parachute Greenmail Poison Pills Sell valuable portfolio(crown jewels) Increase leverage Use up excess cash Third party partnership with a break up fee.

Introduction to FS Financial
Fund s Deposit s/share s Suppliers of funds: Individuals Companies Govt Funds funds Financial Markets securiti es Institutions Banks Insurance companies Mutual funds Provident funds loa ns Loan contract Demanders of funds: Individuals Companies Govt

securiti es

Time Value Of Money

Time Value Of Money

Money has time valuewhy

Productivity

Why do you need to earn interest..

Presence of inflation Preference to current consumption

How much return must you expect

Real rate Inflation

The Fischers Effect

Cont
Concept of compounding/discounting Concept of SI/CI FV of an amount being compounded Continuous compounding Understanding the doubling rule

Rule of 72 .35+69/r 2=(1+r)n

Time Value Formulae

PV of CF FV of a CF PV of an Annuity FV of an Annuity Finding Annuity given PV Finding Annuity given FV PV of a growing annuity PV of a growing annuity to perpetuity PV of a Perpetuity
Mathematically derive all the formulae

Uses of Time Value

In personal finance decisions
Amount to save annually Annual deposit in sinking fund Calculating annual growth How long to wait Determining periodic withdrawals

In Capex Decisions
NPV/IRR

Teasers
A company currently has 1000 employees and the number is expected to grow at 20% per annum.How many employees will the company have 10 years from now. ABC ltd had revenues of 100 lacs in 2000 which increased to 1000 lacs in 2010..What was the compound growth rate in revenues. Suppose you deposit Rs.50000/= per year in a fund which gives you an interest of 10%.What is the value 20 years from now.

Teasers
You want to buy a house after 5 years when it is expected to cost 20 lacs. How much should you save annually if your savings earn a compound return of 12%. ABC ltd has an obligation to redeem Rs.500 lacs bonds 6 years hence..how much should the company deposit annually in a sinking fund account wherein it earns 14% interest.

Teasers
6. A finance company advertises that it will pay a lump sum of Rs.8000 at the end of 6 years to investors who deposit annually Rs.1000/= for 6 years..What interest rate is implicit in the offer? 7. You want to take up a trip to the moon which costs Rs.10 lacs..You can save annually Rs.50,000 to fulfill your desire..How long will you have to wait if your savings earn an interest of 12%.

Teasers
9. Your father deposits Rs.3 lacs on retirement in a bank which pays 10% annual interest..how much can he withdraw annually for a period of 10 years. 10. At the time of his retirement Mr.X is given a choice a) An annual pension of Rs.10000 for 15 years b) a lump sum amount of Rs.50000 todayAssuming an interest rate of 15% which offer looks more attractive.

Teasers
As a winner of the competition you can choose one of the prizes:
Rs.5 lacs now Rs.10 lacs at the end of 6 years Rs.60000 a year forever Rs.1 lac per year for 10 years Rs.35,000 next year and rising thereafter by 5% per year forever

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

Teasers
You are 35 years old today and are considering your retirement needs. You expect to retire at age 65 and your actuarial table suggests that you will live to be 100you want to move to Bahamas when you retire you estimate that it will cost you Rs.3, 00,000/= to make the move on you 65th birthday and that your living expenses will be Rs.30000/= per year starting the end of 66th year and continuing through the end of year 100 after that
How much will you need to have saved by your retirement date to be able to afford this course of action You already have Rs.50,000 in savings if you can invest money, tax free, at 8% a year, how much would you need to save each year for the next 30 years to be able to afford this retirement plan If you did not have any current savings and do not expect to be able to start saving money for the next 5 yrs, how much would you have to set aside each yr after that to be able to afford this retirement plan

Teasers
You are an investment advisor who has been approached by a client for help on his financial strategy.he has Rs.2, 50,000/= in savings in the bank..he is 55 years old and expects to work for 10 more years making Rs.1,00,000 per yearhe expects to make a return of 5% on his investment for the foreseeable future.
Once he retires 10 years from now, he would like to be able to withdraw Rs.80,000 a year for the following 25 yearshis actuary tells him he will live to be 90 years old..how much would he need in the bank 10 years from now to be able to do this. How much of his income would he need to save each year for the next 10 years to be able to afford these planned withdrawals( Rs.80,000 a year after the tenth year) Assume that the interest rate declines to 4% ,10 years from nowhow much, if any, would your client have to lower his annual withdrawal, assuming that he still plans to withdraw cash each year for the next 25 years.

Teasers
A father is planning a savings program to put his daughter through college. His daughter is now 13 years old. She plans to enroll at the University in 5 years and it should take her 4 years to complete her education. Currently the cost (for everythingfood, clothing, tuition, books) is Rs.12500 but a 5% annual inflation rate in these costs is forecasted. The daughter recently received Rs7500 from her grandfather; this money which is invested in a bank account paying 8% interest compounded annually will be used to help meet the costs of the daughters education. The remaining costs will be met by money the father will deposit in the savings account. He will make 6 equal deposits to the account one deposit in each year from now until his daughter starts college. These deposits will begin today and will also earn 8 % interest compounded annually.
What will be the PV of the cost of 4 years of education at the time the daughter becomes 18? What will be the value of Rs.7500 that the daughter received from her grandfather when she starts college at age 18? If the father is planning to make the first of 6 deposits today, how large must each deposit be for him to be able to put his daughter through college?

Valuation.Bonds and shares

Concept of Valuation of assets

Real Assets

Asse ts

Financial Assets(Bonds/Shares)

Concept of shares---> converting physical assets into financial instrum Principle of Valuation: Discounting all future CFs. Will depend on Certainty of CF Magnitude of CF Discounting Rate

Cont
Concept of Value..

Book Value Replacement value Market Value Going Concern Value Liquidation Value Present Value

Understanding Bonds
What is a Bond(Par Value/Coupon/Maturity/Term) Types of Bonds

Fixed Rate Bonds Floating Rate Bonds Call /Put Option Bonds Zero Coupon Bonds Secured/Unsecured Bonds Perpetual Bonds Convertible Bonds

Cont
Interest rate on Bonds..

Coupon Rate Current Yield YTM: Bonds with Maturity/Perpetual ( PV= PV of Interest+ PV of Maturity Value).

Relationship between Coupon Rate/YTM

Coupon Rate> Required Yield--> Bond Sells at Premium Coupon Rate= Required Yield-- > Bond Sells at Par Coupon Rate< Required Yield-- > Bond Sells at Discount

Cont..
Valuation of Bonds

Bonds with Maturity Perpetual Bonds Deep Discount Bonds

Impact of changes in r on Bond Value Valuation of Preference shares Types of Preference Shares

Redeemable/non redeemable Participative/non participative Cumulative/ non Cumulative Convertibles/non convertibles

Cont
Bond Duration/Average Maturity Volatility Of Bond

Impacted by Duration/Yield

Valuation of bonds in the B/S

HTM AFS AFT

Bond Rating Agencies..

Cont
Valuation of Shares..

The Gordons Model Assumptions:

The firm declares dividends r>g g is constant

Difficulty in valuation of shares..

Dividend declared is discretionary Difficult to assess g

Cont
Specific cases..

When the g is constant When g is zero When the firm pays no dividends

Assume div is paid after n years P/E Model

Relationship between Stock Price/Dividends and Earnings g is a function of retained earnings and ROE.

Year 1 2 3 4

BV 100 106 112.36 119.1

EPS(10% DPS(40 ) %) 10 10.6 11.24 11.91 4 4.24 4.49 4.76

RE(60%) 6 6.36 6.74 7.15

Ending BV 106 112.36 119.10 126.25

Risk & Return

Introduction..
Concept of Return

On a single asset eg shares Arithmetic Mean/Geometric Mean(CAGR) Expected Return

Concept of Risk

Deviation from the average Standard Deviation/Variance

S.D and Normal Distribution

Understanding Portfolio..
What is a Portfolio Return on a Portfolio

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

Risk in a Portfolio( why portfolio is Return Return lessEconomy risky) Probabilit y A(%) B(%)
Good Bad .5 .5 40 0 0 40

 Measuring for a two Asset case

The relationship Influence of Covariance/Correlation The relationship between Cov/Correlation Finding the min variance portfolio(=0) Analysis:
=-1/0/1

Portfolio Risk for a n security case

1/n(Average Var) + (1-1/n)*(Av Covariance) Impact of increasing n in the portfolio.

 Risk
Systematic Unsystematic R= SR+USR

S R

No of Securities->

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

USR

SR-> cannot be diversified with n

Combining a risk free security and a Return Weights S.D risky security:
A 5% .5 .5 0 6 B 15%

Risk Return Models

CAPM
Establishes a relationship Simple to understand Used in estimating Kc and Valuation Models

Assumptions
Market Efficiency Homogeneous expectations of risk and return Risk free rate
E(Ri) = Rf + i{ E(Rm) - Rf}

Risk Return Models

Arbitrage Pricing Theory(APT)
What is Arbitrage(advantage of price differential)

The theory divides risk into two components(predictable/unpredictable)

Predictable is Rf while Unpredictable can be firm specific (URs)/market specific(URm) E(Ri) = Rf + (1F1+2F2+.nFn) + URs

Teasers.
Share A B C D Beta .8 1.25 1 .6 Investment 100000 100000 75000 125000

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

Beta Estimation..

 Revisiting the CAPM Understanding the Betafor various values Methods of Estimation

Direct Method.. The market modelregression on past data

Ri = + Rm ( Characteristic Line) and are obtained by Normal Equations The Normal Equations are Y = n + X XY = n X + X2

Beta Calculation by Excel

Year 1 2 3 4 5 6 7 8 9 10 11 12 Stock Return Market Return 12 10 -10 5 22 33 4 8 -6 12 18 22 1 23 -15 10 12 44 10 -10 12 3 22 30

Regression Statistics 0.7307 Multiple R 8 0.5340 R Square 4 Adjusted R 0.4874 Square 44 Standard 8.6389 Error 4 Observations 12

ANOVA Regression Residual Total df Significanc SS MS F eF 855.35 855.35 11.461 0.0069390 1 38 38 06 78 746.31 74.631 10 29 29 1601.6 11 67 Upper 95% Lower 95.0% Upper 95.0%

Intercept X Variable 1

Coeffic ients

SE

4.5059 3.1164 61 82 0.5347 0.1579 08 44

t Stat P-value Lower 95% 1.4458 0.1788 2.4379941 11.44991 2.437994 11.44991 48 22 55 616 155 616 3.3854 0.0069 0.1827857 0.886629 0.182785 0.886629 19 39 67 275 767 275

 Determinants of Beta Value(Covim / 2m)

Nature of business( cyclicality of the business leads to higher values of Beta). Operating leverage(use of FC) Financial leverage (use of Debt)

Relation between Asset Beta and Equity Beta..

Financial Statements

 What are financial statements

Indicates the financial position of a Firm Perspective of Risk and Return Answers the foll. Qs
How valuable are the Assets of the firm How have these Assets been acquired How profitable are these Assets What is the Risk embedded in the Assets

 Financial Statements comprise

Balance Sheet Income Statement Statement of Changes in Financial Position
Funds Flow Statement( WC )
Sources of WC( Liability(CL/SHE) Uses of WC ( CA and FA)

Cash Flow Statement

Cash flow from operating Activities Cash Flow from Financing Activities Cash Flow from Investing Activities

Understanding the I/S

Income
Sales Other income

Expenditure
Operating expenses Depreciation Interest Charges

Available for Distribution

Dividend Tax on Dividend Transfer to Reserves

EBT Provision for Tax PAT P/L carried forward

Understanding the B/S

Sources of Funds
Shareholders Equity Share Premium Reserves..

Investments
Minority(HTM/AFT/AFS) Minority Active.

CA
Cash MS Inventory
RM/WIP/FG

Long Term Debt Total Capital Employed Application of Funds Fixed Assets
Gross Block Accumulated Depn Net FA

CL
Provisions..

Net CA(CA-CL).. Net FA.

 Accounting profit Vs Economic Profit

AP = Profit window dressing

Method of inventory valuation Method of Depreciation Goodwill valuation

Economic Profit = Net Cash Flow to firm and focuses on wealth creation

The Funds Flow Statement

Current Assets
Cash/MS Inventories
WC = CA CL

Current Liabilities
Provisions Creditors Accounts Payable

Debtors The funds flow statement depicts sources and applications of WC. It is presented in 2 part: sources and uses of WC Schedule of WC

There will be a WC only when there is a transaction between a current account and a Non Current Account Sources of WC Uses Of WC cash flow from adjusted net loss from operations operations Sale of non CA purchase of Non CA long term financing repayment of Debt short term payment of Cash

Cash Flow statementOperating Activities

Cash from operating Activities EBT..
Add Depreciation Less Int Income received Less Div Income Less Gain on Asset Sale Add loss on Asset Sale
Adjustments for
CA( an in the value of a CA will imply outflow of Cash, will imply inflow) CL ( an in the value of a CL will imply inflow of cash, will imply outflow)

Operating Profit before WC Changes

Cash generated from Ops.. Taxes Paid CF from Operations..

CF from Investing & Financing

CF from Investing Activities: Sale of FA Less purchase of FA Sale of Investments Purchase of Investments Interest recd from Investments Dividend received

CF from financing Activities:

Dividends paid Tax on Dividends Interest paid on Debt Interest on short loans Repayment of debt Add New Debt Add New Issue

Net Cash used in Investing

Net Cash used in Financing Activities

Net Cash Flow to the firm

NCF = Cash Flow from Operating Activities + Cash Flow from Investing Activities + Cash Flow from Financing Activities
The Cash with the Firm Comprises: Cash on Hand Cash with Bank Cheques on hand

Financial Statement Analysis

 Analysis: Risk and Profitability Users of financial analysis and their perspective of analysis.

Trade creditors-> liquidity position Debt suppliers-> Solvency Investors-> profitability Management-> overall performance( risk/profitability) Trade analysts/Academicians/Students/Researchers Employees Public Government

 Financial Statement Analysis

Comparative Analysis Common Size Analysis Trend Analysis CVP Analysis Ratio Analysis

Liquidity Ratios Leverage Ratios Turnover Ratios Profitability Ratios Valuation Ratios

 Liquidity Ratios:

Current Ratio/Quick Ratio/Cash Ratio Interval Measure->(CA-Inv) / Av daily Op Expenses

Leverage Ratios:

Capital Structure

Total Debt/Capital Employed Debt to Equity Ratio Debt/ Capital Employed Interest coverage Debt service coverage ratio

Solvency

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

Inventory T/O DIH(Days of Inventory Holding) Debtors T/O ACP(Average Collection Period) Ageing Schedule of Debtors NA Turnover Ratio Total Assets Turnover Ratio CA Turnover Ratio

 Profitability Ratios(Sales/Investment)

Gross Profit Margin/ Net Profit Margin ROCE/ROA/ROE

Valuation Ratios

EPS DPS Dividend Yield Earning Yield P/E Ratio MV to BV of Share

 Evaluating a firms Earning Power:

Du Pont Analysis
ROE= ROA(1+ D/E) For No Debt Firm, ROE= ROA ROE= NPM * Assets Turnover * Equity Multiplier

Capital Budgeting Decisions

 What is Capex.Allocationwhy Features of Capex

Exchange of current funds for future benefits Funds invested in long term assets

Objectives of Capex.Value Types of Capex

Expansion/diversification/replacement/moderniz ation/contingent

 Importance of Capex
Long term investment/large investments/high risks/generally irreversible/strategic decisions/complex

Steps involved in evaluation of investment

Determination of Cash flows Estimation of required return/cost of capital Application of decision rule

 Characteristics of a good decision rule

Assist in wealth maximization Must work well for both revenue generating and cost reduction projects

Capex Evaluations
DCF Criteria Criteria NPV IRR Profitability Index Payback Period Discounted Payback Period ARR Non DCF

NPV
It is the PV of all discounted CFs( I and O). Steps(Determine CFs and r) Decision Rule.accept/reject Why is NPV important(. A firm has cash 1 lac) Features
It recognizes time value Measures true profitability since it considers CFs Value Additive.valuation of Corporate

IRR
Measures yieldrate which equates current CF to all future CFs Relationship between IRR/NPV Stepscalculating CFs Decision ruleaccept (IRR> Cost of Capital) Features

Popular since it uses % It recognizes time value Measures true profitability since it considers CFs No value additivity

Profitability Index
Ratio of PV of all CFs to Initial Outflow Steps(measuring CFs and r) Decision rule.PI > 1 Accept

Payback Period
Time required to recover initial investment Steps ( determine CFs each year) Decision rule..accept with shortest PB Features

Simplicity/risk shield/focus on liquidity

Limitations

Ignores CF after PB period/ inconsistent with our objective of SH wealth maximization/not a measure of true profitability

Discounted PB period..
No. of years required to recover the initial investment on a PV basis. Uses discounted CFs in calculating PBP.

ARR..
Ratio of Average EBIT(1-t) to average investment. Decision rule..Accept(ARR> required return) Features

Uses accounting Data Easy to understand and calculate Demerits

Does not use CFs Ignores time value of money

NPV/IRR
Project A B C0 -1680 -1680 C1 1400 140 C2 700 840 C3 400 1510 NPV(9 %) 301 321 IRR 23% 17%

NPV and IRR will give conflicting results in foll. Cases project has a non conventional CF Initial investments are different Projects have different lives Timing of CFs is different.

The Cost Of Capital

 Required return = cost of Capital Concept of WACC (debt/equity/Preference) Significance of Kc

Used in investment evaluation(NPV/IRR) Designing debt policy Performance appraisal of management/CFO

Opportunity Cost of Capital Cost of Capital

Historical cost / Marginal Cost

 Determining the WACC of Firm

Cost of Debt Cost of Preference Cost Of Equity

The cost of capital of the firm will be the weighted average of the component costs

 Cost of Debt
Debt issued at Par ( Kd = Coupon Rate) Debt issued at Premium/Discount After tax cost of debt = Kd(1-t)

Cost of Preference
Irredeemable (Div/Issue price) Redeemable

Generally Kp > Kd since interest on Debt is Tax deductible

Cost of Equity
Equity( external/retained earnings) Is equity free of Cost Methods of calculating Ke

The dividend growth model E/P ratio CAPM

 Practical calculation of Ke
Dividend G Model
Ke = Div1/P + g g can be calculated by ( retention ratio * ROE) or by EPS growth of the last 10 years.

CAPM
E(Ri) = Rf + i [ E(Rm) Rf ] Beta can be found by regression.

Determining CF for Investment Analysis.

 CF vs Profit( FCF = EBIT(1-t) + Dep WC Capex) FCF for Capex decisions and is the cash available to lenders and shareholders.

Basic principles of CF estimation

Separation principle( investment CF and financing CF are to be treated separately) Incremental principle
CF from project = CF with implementation of project CF w/o implementation of project Incidental effects be considered( cannibalization) Ignore sunk costs Include opportunity cost

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

Risk Analysis in Investment Decisions

 Every investment decision is based on forecasted CFs. The forecasted CFs are influenced by

Economic factors Industry factors Company factors

Risk Measurement --> Variance Reducing risk through the concept of Expected NCF( CFi x Pi) where i= 1,2n

 Conventional techniques of risk analysis

Payback period Risk adjusted discount rate(k = kf + kp ) Certainty equivalent (0< < 1). Choice of is an indicator of the confidence level of the CFs being realized as forecasted.

 Other methods of risk analysis

Sensitivity analysis -> identifying variables that impact revenues/ sales and thus CFs DCF break even analysis
1 S.P V.C 15 6.5 2 15 6.5 3 15 6.5 4 15 6.5

Scenario analysis Simulation analysis Decision tree analysis

If Project Cost = Rs.1000, V(156.5) x PVIFA(r,4yrs) = 1000

Financial Leverage & Operating Leverage

 Relationship between investment decision and financing decision Defining capital structure( Capex -> need to raise funds -> capital structure decision(D/E).purpose is Kc and V Defining FL
ROI > cost of debt

 Measuring FL
Debt ratio( D/D+E) Debt to Equity Ratio Interest coverage = EBIT/ Interest Charges

Analyzing impact of FL
ROI>Kd -> Increase in SH returns-> EPS/ROE ROI< Kd -> Decrease in SH returns-> EPS/ROD

 How does FL impact EPS & ROE

Eg a project requires an investment of 5 lacs. The return on investment expected is 24% and the cost of debt is 15%. Which of these two alternatives should the firm take.
Raise 5 lacs through equity( 50,000 x Rs.10) Raise 2.5 lacs through equity (25,000 x Rs.10) and Rs. 2.5 lacs through debt.

All equity EBIT Interest EBT Tax(50%) PAT No. of shares EPS ROE

50% Debt

ROI > Cost of debt All equity EBIT Interest EBT Tax(50%) PAT No. of shares EPS ROE Return to investors 120000 0 120000 60000 60000 50000 1.2 12% 60000 50% Debt 120000 37500 82500 41250 41250 25000 1.65 16.5% 78750

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

If ROI is 12% < Cost of debt,15% All equity EBIT Interest EBT Tax(50%) PAT No. of shares EPS ROE Return to investors 60000 0 60000 30000 30000 50000 0.6 6% 30000 50% Debt 60000 37500 22500 11250 11250 25000 0.45 4.5% 48750

The impact on EPS and ROE is negative.

Impact of FL on varying EBIT

No Debt 15%, ROI = -5%, 10%, EBIT Interest EBT PAT # shares EPS ROE 50% Debt EBIT Interest EBT PAT # shares EPS -25 37.5 -62.5 -31.25 25 -1.25 50 37.5 12.5 6.25 25 .25 75 37.5 37.5 18.75 25 .75 120 37.5 82.5 41.25 25 1.65 160 37.5 122.5 61.25 25 2.45 300 37.5 262.5 131.25 25 5.25 -25 0 -25 -12.5 50 -.25 -2.5% 50 0 50 25 50 0.5 5% Investment = 5 lacs, cost of debt= 75 0 75 37.5 50 0.75 7.5% 120 0 120 60 50 1.2 12% 160 0 160 80 50 16 16% 300 0 300 150 50 30 30%

Impact of FL on varying EBIT

75% Debt EBIT Interest EBT PAT # shares EPS ROE -25 56.25 -81.25 -40.62 12.5 -3.25 -32.5% 50 56.25 -6.25 -3.13 12.5 -2.5 -2.5% 75 56.25 18.75 9.38 12.5 .75 7.5% 120 56.25 63.75 31.88 12.5 2.55 2.55% 160 56.25 103.75 51.88 12.5 4.15 41.5% 300 56.25 243.75 121.88 12.5 9.75 97.5%

Impact of FL on varying EBIT

Investment = 5 lacs, cost of debt= 15%, ROI = -5%, 10%, No Debt EBIT EPS ROE EPS ROE EPS ROE -25 -.25 -2.5% -1.25 12.5% -3.25 -32.5% 50 0.5 5% .25 2.5% -2.5 -2.5% 75 0.75 7.5% .75 7.5% .75 7.5% 120 1.2 12% 1.65 16.5% 2.55 2.55% 160 16 16% 2.45 24.5% 4.15 41.5% 300 30 30% 5.25 52.5% 9.75 97.5%

50% Debt

75% Debt

PS increases with increased EBIT for all financial plans L works both ways. It depresses EPS/ROE under unfavorable economic conditions d increases EPS/ROE under favorable conditions. gher the FL , wider is the range in which the EPS fluctuates with varying EBIT.

 Relationship between EBIT,EPS

EPS = PAT/N = [(EBIT-Interest)x (1-t)] / N = (1-t)/N [ EBIT Interest ] This can be rearranged as > -(1-t)/N x Interest + (1-t)/N x EBIT This shows EPS is a linear function of EBIT with EPS= a + b x EBIT From the above formula, EPS for varying levels of EBIT can be worked out.

 Calculating the level of EBIT for which EPS would be same under diff financial plans.
All equity firm, EPS1 = EBIT(1-t)/ N1 Debt firm , EPS2 = (EBIT- Interest) x (1-t) / N2 The indifference point can be calculated by equating EPS1 and EPS2.

 Combining OL and FL
OL affects EBIT while FL affects PAT/EPS DOL = % EBIT/ % Sales = Q(s-v)/ Q(s-v)-F DFL = % EPS/ % EBIT = Q(s-v)-F / Q(s-v)-F-Int DCL = % EPS/ % Sales = Q(s-v)/ Q(sv)-F-Int

Capital Structure

 Meaning of Capital Structure Advantages of Debt

Tax benefit( Tax rate x Interest) Disciplining effect

 Disadvantages of Debt
Expected bankruptcy

CF < Obligations High SD of CFs

When a firm approaches bankruptcy there are two associated costs

Direct Costs ( borne by lender) Indirect Costs( borne by firm) Customers stop buying Suppliers stop supplying Firm fails in raising fresh capital The cost is high for durable products, products requiring regular maintence, high value goods.

 Disadvantages of debt
Loss of flexibility(Covenants: Affirmative/Negative) Agency Costs

 Debt taken by a Company is influenced by

High tax will encourage debt Companies with low depreciation will prefer debt Generally as taxes go up, the D/E of Companies goes up Level of efficiency of Debt / Equity markets Level of variability of a Cos CFs.

 Is there a relationship between Capital Structure and Value of a firm..

Traditional View(Net Income and NOI Approach)

Capital structure impacts value

Miller & Modigliani View

Capital Structure is irrelevant

 Net Income approach

Ke and Kd are constant for a firm. The K0 of the firm declines as debt is taken Value of firm = V of Equity + V of Debt = NI/Ke + Interest/Kd K0 = Ke (Ke-Kd)xD/Vas D increases ,the value of K0 will decrease and will be minimum when D/V =1. Value of firm = EBIT/K0 K0 is minimum at Debt 100% and hence maximum value of firm is when Debt is 100% of the structure.

Cost K0 Kd

K e

D/

 Net Operating Income Approach

Kd and K0 for the firm is constant. As debt increases , Ke will increase Ke = K0 + (K0- Kd) x D/E.as D increases , Ke increases K0 for the firm remains constant because the substitution of cheap debt is compensated by the increase in cost of equity.
K e Cost K 0 KD/ dE

 MM Approach

The value of a firm is independent of Capital structure and only depends on earnings and risk. Assumptions of perfect capital markets , no transaction costs and no taxes.

 MM Proposition 1
EBIT K1 EBIT K2

> V1 = V2 = EBIT/K ( assuming K1= K2) In MM view the way in which the firms are structured only changes the way in which the earnings are distributed ( SH and Debt holders)

Why should Proposition1 work Levered Firm EBIT Debt Kd Ke Interest Equity Earnings MV of Equity MV of Debt Value of Firm 150000 500000 12% 16% 60000 90000 562500 500000 1062500

Unlevered Firm 150000 0 15% 150000 1000000 0 1000000

Assume you own 10% shares of the levered firm. Your investment of Rs.56250 Gives you a return of Rs.9000 in the levered firm. MM argue that if two firms have the same EBIT, their values must be same. If not then This will encourage arbitrage .

 A rational investor will do the foll.

Sell 10% equity in L Borrow 10% at rate 12% Total money 56250 50000 106250

Investor invests Rs.100000 in U (10%) His old income was Rs.9000 . His new income is as below
Income from 10% stake in U Less interest on Rs.50,000 @12% Rs.15000 Rs.6000

His net income Rs.9000 The customer make an income of Rs.6250 keeping his earnings constant.

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

 MM proposition 2
Higher the financial risk greater will be the required return of the investors and higher will be the cost of equity. K0 = Ke( E/D+E) + Kd (D/D+E) Ke = K0 + (K0 Kd) D/E

 The value of a firm increases with leverage and is theoretically max when D= 100%
Debt avoided on account of dangers of financial distress.

The pecking order theory

Internal equity Debt External equity

 Enhancing firm value through Debt

Book Value Equity Debt Total Capital Market Value Equity Debt Total Capital

1,50,000 0 1,50,000

Assets Total Assets

1,50,000 1,50,000

8,00,000 0 8,00,000

Assets

8,00,000 8,00,000

how will the Company value be impacted if it takes a debt of Rs.75,000 @ 10% and buys back its shares from the market ? Assume tax rate of 30%.

 Current tax structure:

Corporate tax rate (30% + 3% education cess) Personal taxes(10% - 30%) Tax is 10% on Capital gains (investment<1year) Investors do not pay tax on dividends Cos pay dividend tax of 15% on the dividends distributed. Thus dividend income is taxed twice.

Introduction to Dividend Theory..

 What are dividends Objective of the dividend policy.. ( balance between funds for growth and distribution to SHs. Concept of Payout ratio/ retention ratio/dividend yield The dividend decision is impacted by the investment decisions of a firm.

 Impact of dividend payouts

High payout firm (80%) Year 1 2 3 10 15 20 1 2 3 10 15 Equity 100 104 108.16 142.33 173.17 210.68 100 116 134.56 380.30 798.75 Earnings@2 0% 20 20.8 21.63 28.47 34.63 42.14 20 23.2 26.91 76.06 159.75 Dividend 16 16.64 17.31 22.77 27.71 33.71 4 4.64 5.38 15.21 31.95 RE 4 4.16 4.32 5.69 6.92 8.43 16 18.56 21.53 60.85 127.80

Low payout firm (20%)

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

 Dividend theories

Walters Model Gordon Model

Walters Model:

P = PV of an infinite stream of dividends + PV of an infinite stream of Capital gains P = Div/k + r(EPS-DPS)/k / k Assumptions:
Constant r, k, EPS and DPS 100% payout or 100% retention The firm has an infinite life

 Demonstration of Walters Model

Consider three firms(growth firm/normal firm and declining firm).Assume EPS = Rs.10
Growth firm (r=15%, k= 10%) Payout = 0 Payout = 40% Payout = 80% P=150 P = 130 P= 110 Normal firm ( r=10%, k=10%) P = 100 P = 100 P = 100 Declining firm( r= 10%, k = 15%) P = 80 P = 88 P = 96 P = 100

Distribute all earnings when r<k When r =k, the dividend decision has no impact on the value of the firm. Assumptions in the model Constant k and r.

Payout P =100 P = 100 Retain all earnings when r>k =100%

 Gordons Model
The price of a share is the PV of an infinite stream of dividends expected to grow @ g P=Div1 / k-g = EPS1( 1-b) / k r.b Mathematically derive the formula..

 Demonstration of Gordons Model

Consider three firms(growth firm/normal firm and declining firm).Assume EPS = Rs.10
Growth firm (r=15%, k= 10%) Payout = 40%,b= 0.6 Payout = 60%, b = 0.4 P=400 P = 150 Normal firm ( r=10%, k=10%) P = 100 P = 100 Declining firm( r= 10%, k = 15%) P = 77 P = 88 P = 98

When >= k, keep low payout P = 100 Payout = 90% r ,b P= 106 When r < k, payout should be maximum 0.1

When r =k, the dividend decision has no impact on the value of the firm. Assumptions in the model Constant k and r. Both models have the same conclusions THE DIVIDEND DECISION OF A FIRM HAS AN IMPACT ON ITS VALUE

 Factors that influence the dividend policy of a firm

Current available investment opportunities

Stage of firm(introduction/growth/maturity/decline) Thumb rule(r > k)

Expectation of the shareholders

Clientele effect( identifying the investors)

 Constraints on paying dividends

Legal restrictions-> dividend to paid out of profits only Liquidity constraints Borrowing capacity Access to capital markets Restriction in loan agreements Control

Forms of dividends

Cash Dividends Bonus Shares Shares Buyback

 Bonus shares.. Eg a 2:1 bonus issue

Equity( 1 lac 10,00, shares @ 000 Rs10) Reserves 20,00,0 00 Equity( 1.5 lac shares @ Rs10) Reserves Total NW 15,00,000

15,00,000 30,00,000

Total NW 30,00,0 Bonus issue is only a recapitalization..(E/R) 00

Advantages of bonus:
It is an indication of higher future profits Psychological value Company conserves cash Ideal for a company when in a financial crunch Share price brought in the trading range

 Share Splitreverse split

Equity( 1 lac 10,00, shares @ 000 Rs10) Reserves Total NW 10,00,0 00 20,00,0 00 Equity( 2 lac shares @ Rs 5) Reserves Total NW 10,00,000

10,00,000 20,00,000

Reasons for share split

Bring price of stock in trading range Indication of companys higher earning in future Increased expected dividend to the shareholders

 Shares buyback..
Rationalize capital structure Pop up the share price When company has idle cash
Manas Corp expects to earn Rs.66 lacs for the current year and it plans to distribute 50% of this amount to its shareholders. There are 11 lac outstanding shares and the market price per share is Rs.30. The Co. believes that it can pay a cash dividend of Rs. 3 per share or buyback 1 lac shares at an offer price of Rs.33. what is the impact if the shares are brought at less than Rs.33 or greater than Rs.33.

WC Management..

 Assets Management:

Fixed Assets Management CA Management

Concept of WC

Gross WC Net WC

Why is investment in CA required

The concept of Operating Cycle

Operating cycle of a firm

Order stock Placed arrives AP Inventory period Cash Cycle Operating Cycle Cash Paid FG sold Cash received AR

Operating Cycle is a function of Inventory period and AR.

 Factors influencing WC requirements..

Nature of business ( OC/retailers) Seasonality of operations Production policy Market conditions Conditions of supply/ supplier credit Credit policy of Co Operating efficiency

 WC management is a trade off between liquidity and profitability

A Sales EBIT FA CA TA ROI 15,00.000 1,50,000 500000 500000 10,00,000 15% B 15,00,000 1,50,000 500000 400000 9,00,000 16.67% C 15,00,000 1,50,000 500000 300000 8,00,000 18.75%

Cost of liquidity

Low returns, inventory wear off, carrying cost

Cost of illiquidity

Unable to meet short term obligations Borrowing at high cost ,production shortage

 Estimation of WC needs
CA holding period cost

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

WC as a % of sales WC as a % to fixed investment

Receivables Management and Factoring..

 How are receivables created-> Credit Sales

Receivables involve an element of risk It implies futurity

Measuring receivables

Net Credit Sales per day x Average collection period NCS is a function of sales ACP is a function of the cos credit policy

 Why do companies grant credit

Competition Buyers requirements Companys bargaining power Relationship with dealers Marketing tool Industry practice

the purpose of all is to enhance sales.

 Receivables is a function of the Credit Policy

Credit Standards Credit Terms Collection Effort

Goals of the credit policy

Increased Sales Bad Debt losses Credit Administration and supervision Collection Costs

Increasing sales ( Benefits > Costs)

 Credit Standards and evaluation:

Individual: ( Character/Capacity/Cash/Collatoral/Condition ) -> intention and the ability Company -> Financials and ratios Evaluation and analysis of credit

Fact or Past p NPM CR D/E

wt .3 .2 .1 .4

5 4 3 2 1

Traditional approach Numerical credit scoring Discriminant analysis

Sco re CR

RO

 Credit Terms

Rate of cash discount Cash discount period Net credit period

Eg. 2/10, net 30.

 Monitoring receivables
ACP -> 360/ Debtors Turnover Ageing Schedule Collection Experience Matrix
O/S day s Amou nt % Sales 20% 30% 40% 10% Rec( %) J F M A M Mon th J 100 80% 60% 20% 78% 50% 10% 90% 40% 10% 60% 10% 70% F 250 M 375 A 400 M 570

0-25 20000 0 2635 3645 > 45 30000 0 40000 0 10000 0

Factoring
1 seller 3 buyer

4 2

6 factor

1: buyer places order, 2: factor fixes buyer limit, 3: seller supplies goods to the Buyer , 4: seller raises invoice to the factor, 5: factor pays a portion upfront 6: factor follows up with buyer for payment 7: buyer makes the payment to the factor.

Inventory Management

 Types of inventory( RM/WIP/FG) Why hold inventory

Transaction Motive Precautionary Motive( D/S fluctuation) Speculative Motive

Objectives of inventory management

Efficient and smooth production Maintain optimum level

Costs associated with inventory management

Ordering cost Carrying cost

 Inventory management seeks to answer

How much should be ordered ? At what level should the order be placed ?

How much to order->

TC = ordering cost + Carrying Cost = (Annual usage/Q ) x Per order cost + (Average inventory) x carrying cost per unit EOQ = Q = Sq root( 2UF/c)

When to order->
Reorder Point = Average Usage x Lead time if safety stock is being maintained, its value is added to the reorder point.

 Inventory control systems

ABC Analysis Just in Time FSN ( fast moving, slow moving, non moving ) Computerized inventory controls.

Cash Management

 Cash management concerns managing

Cash flow into and out of the firm Cash flow within the firm Cash balances with the firm

Motives for holding cash

Transaction motive Precautionary motive Speculative motive

 Cash Management covers

Cash planning Managing the cash flows Optimum level of cash Investing surplus cash

 Cash planning
Forecasting

Short term: Receipts and disbursements Long term: Cash flows generated through P/L

Managing the cash flows

Minimizing deviation between projected and actual CFs. it includes
Accelerating cash collections Controlling disbursements

 Speeding cash collections

Customer mails cheque co receives co deposits cheque cash available

Mailing time

Processing

Availability delay

Minimizing floats
Disbursement float: cheque issued and not debited Collection float: cheques received and not credited Net Float = Disbursement float + Collection float

 Maintaining Optimum Cash level

Under certainty: when the firm is able to forecast cash needs with certainty
Baumols Model

Under uncertainty
The Miller Orr Model

 Baumols Model
Total Cost = Holding Cost + Transaction Cost TC = (average cash balance) x k + (Number of transactions) x cost per transaction TC = C/2 x k + (T/C) x Ct = sq root( 2TCt/k)
Cash balance

C= starting cash balance, k = opportunity cost, T = total cash requirement in the year, T/C = total number of transactions, Ct = cost per transaction.

tim e

 Miller Orr Model

UL cas h tim e R PL L

3 limits are specified( upper limit, return point, lower limit) RP = 3 Sq root( 3b 2/4I) + LL UL = 3RP 2LL
b= fixed cost per order for converting MS-> cash 2 = variance of daily changes in expected cash balance I = interest rate (daily) earned on MS

 Investing surplus cash

Factors considered: risk/return/liquidity Types of short term investments
T Bills Commercial Paper Certificates of Deposit Bank Deposits Inter Corporate Deposits/ Call Money

 Working Capital Finance

Trade Credit: easy availability/flexibility( 3/15,net 45).implicit interest rate Deferred Income Bank Finance

OD, CC limit Bills discounting Letter of credit WC loan

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

All The Best