Lecture no. 13
Topic: Sources of raising capital
Cost of Capital
Meaning: It is the minimum rate of return expected by an investor of a firm. The capital used by a firm may be in the form of equity share, preference share, debt, retained earning etc. Cost of capital is the weighted average cost of these sources of finance used by the firm.
Definition: “The cost of capital is the minimum rate of return which a firm requires as a
condition for undertaking an investment.”
Significance of cost of capital
Helpful in designing the capital structure
Helpful in taking the budgeting decision.
Helpful in evaluation the efficiency of top management.
Helpful in comparative analysis of various sources of finance.
Helpful in taking other financial decision.
Computation of Cost of specific source of finance
Cost of debt:
a) Cost of redeemable debt after tax and before tax
b) Cost of irredeemable debt after tax and before tax
Cost of preference share capital
a) Cost of redeemable pref. share after tax and before tax
b) Cost of irredeemable pref. share after tax and before tax
Cost of equity share capital
a) Dividend yield method
b) Dividend yield plus growth in dividend method
c) Earning yield method
d) Earning yield plus growth in earning method
e) Realised yield method
f) Capital asset pricing model (CAPM)
Cost of retained earnings
Kr = Ke – (1-percentage brokerage or flotation cost)
Lecture no: 14
Topic: Weighted Average Cost of Capital
Weighted Average Cost of Capital:
Cost of different source of capital is calculated by different methods. So in order to calculate the cost of overall capital structure of the firm , financial manager develops the concept of weighted average cost of capital.
The computation of WACC involves the following steps.
(i) Compute the cost of each source of funds i.e., cost of debt, cost of pref. share, cost of
equity capital, cost of retained earnings.
(ii) Assign weight to specific cost.
(iii) Multiply the cost of each source by assigned weight.
(iv) Divide the total weighted cost by total weights.
Kw = submission of XW
Submission of W
where,
X= cost of specific source of finance
W= weight
Lecture no.: 18
Topic: Capital structure Decision
Capital structure:
It refers to proportion between the various long term finance in the total capital of the firm. While choosing the source of finance a financial manager makes an attempt to ensure that risk as well as cost of capital is minimum.
Importance of Capital structure:
Capital structure determines the risk assumed by the firm
Also determines the cost of capital of the firm.
It affects the flexibility and liquidity of the firm.
It affects the control of owner on the firm.
Concept of Optimum capital structure:
Optimum capital structure is one which maximizes the value of the firm and minimizes the cost of capital.
Features of Optimum Capital Structure:
Simplicity
flexibility
Minimum risk
Minimum cost of capital
Maximize Profitability
Legal requirements.
Retaining control.
Avoidance of Unnecessary Restriction.
Sufficient Liquidity.
Lecture no.: 19
Topic: Financial and operating leverage
Leverage:
Employment of an asset or source of funds for which the firm has to pay a fixed cost or fixed return. If the earnings before interest and taxes exceed the fixed cost, the leverage is called favorable otherwise not.
Types of Leverage:
(i) Operating Leverage.
(ii) Financial Leverage.
1. Operating Leverage:
It refers to the use of fixed operating cost to magnify the effect of changes of sales on the operating profits of the firm. OL results from the existence of fixed operating expenses in the firm’s income.
Operating cost is of two types: Fixed cost and Variable cost
Operating Leverage is good when sales volume increases and bad when sales volume decreases.
2. Financial Leverage:
It refers to “ability of a firm to use fixed financial charges to magnify to magnify the effects of changes in EBIT on the firm’s earning per share”.
FL involves the use of funds obtained at a fixed cost in the hope of increasing the return to the shareholders. It is favorable when earnings on fixed asset purchased with the funds are more than the fixed cost of their use.
Higher the proportion of fixed cost source in capital structure higher will be the financial leverage.
Lecture no. : 20 -23
Topic: Capital structure theories-NI
Capital structure theories seek to explain the relational ship between capital structure decision and the market value of the firm.
The important capital structure theories:
Net Income Approach
Net operating Income Approach
Traditional Approach
Modigliani and Miller Approach
1. Net Income Approach:
A change in the financial leverage will lead to a corresponding change in the value the firm as well as the overall cost of capital.
Assumptions of this approach:
a) The cost of debt is lower than the cost of equity
b) The risk perception of investors is not changed not use of debt.
c) There are no corporate or personal income taxes.
The main contention of this theory is that an increase in the proportion of debt financing in capital structure results in an increase in the proportion of a cheaper source of fund. This in turns results in decrease in overall cost of capital leading to an increase in the value of the firm.
Overall cost of capital = EBIT/V
2. Net operating income approach:
The essence of this approach is that the capital structure decision of a firm is irrelevant. It means that the overall cost capital of a firm would remain same at whatever level of debt-equity mix.
Assumptions of this Approach:
a) The cost of debt is lower than the cost of equity.
b) Risk perception of the lenders does not change with the change in the financial leverage.
c) There are no corporate or personal income taxes.
d) The market capitalizes the value of the firm as a whole.
This approach advocates that the cost of equity increases with the increase in the financial leverage.
Traditional Approach:
This approach establishes a midway between NI and NOI. It resembles both the theories in one way and also contradicts them in another way.
The crux of the traditional approach is that through judicious use of debt, a firm can reduce its overall cost capital and can increase the value of the firm. The rationale behind this view is that debt is a relatively cheaper source of funds as compared to equity shares.
If the proportion of debt is increased beyond a certain point the overall cost of capital starts increasing and firm’s market value begins to decline. So, debt should be used in limit.
4. The Modigliani-Miller Approach:
The theory propounds that a change in the capital structure does not affect the overall cost of capital and the wotal value of the firm.
Assumptions of this approach:
a) Capital market are perfect
b) Homogeneous risk classes of firm
c) Expectations about the net operating income
d) 100% payout ratio
e) No corporate taxes
f) The cut-off rate of investment in a firm is the capitalization rate.
Lecture no.:24
Topic: Dividend policy
Dividend is that portion of profits of a company which is distributed among its shareholder according to the decision taken and resolution passed in the meeting of Board of Directors. This may be paid as a fixed percentage on the share capital contributed by them or at a fixed amount per share. It means only profits after meeting all the expenses and providing for taxation and for depreciation and transferring a reasonable amount to reserve funds should be distributed to shareholders as dividend
Factors affecting Dividend policy:
1. Stability of Earnings. The nature of business has an important bearing on the dividend policy. Industrial units having stability of earnings may formulate a more consistent dividend policy than those having an uneven flow of incomes because they can predict easily their savings and earnings. Usually, enterprises dealing in necessities suffer less from oscillating earnings than those dealing in luxuries or fancy goods.
2. Age of corporation. Age of the corporation counts much in deciding the dividend policy. A newly established company may require much of its earnings for expansion and plant improvement and may adopt a rigid dividend policy while, on the other hand, an older company can formulate a clear cut and more consistent policy regarding dividend.
3. Liquidity of Funds. Availability of cash and sound financial position is also an important factor in dividend decisions. A dividend represents a cash outflow, the greater the funds and the liquidity of the firm the better the ability to pay dividend. The liquidity of a firm depends very much on the investment and financial decisions of the firm which in turn determines the rate of expansion and the manner of financing. If cash position is weak, stock dividend will be distributed and if cash position is good, company can distribute the cash dividend.
4. Extent of share Distribution. Nature of ownership also affects the dividend decisions. A closely held company is likely to get the assent of the shareholders for the suspension of dividend or for following a conservative dividend policy. On the other hand, a company having a good number of shareholders widely distributed and forming low or medium income group, would face a great difficulty in securing such assent because they will emphasise to distribute higher dividend.
5. Needs for Additional Capital. Companies retain a part of their profits for strengthening their financial position. The income may be conserved for meeting the increased requirements of working capital or of future expansion. Small companies usually find difficulties in raising finance for their needs of increased working capital for expansion programmes. They having no other alternative, use their ploughed back profits. Thus, such Companies distribute dividend at low rates and retain a big part of profits.
6. Trade Cycles. Business cycles also exercise influence upon dividend Policy. Dividend policy is adjusted according to the business oscillations. During the boom, prudent management creates food reserves for contingencies which follow the inflationary period. Higher rates of dividend can be used as a tool for marketing the securities in an otherwise depressed market. The financial solvency can be proved and maintained by the companies in dull years if the adequate reserves have been built up.
7. Government Policies. The earnings capacity of the enterprise is widely affected by the change in fiscal, industrial, labour, control and other government policies. Sometimes government restricts the distribution of dividend beyond a certain percentage in a particular industry or in all spheres of business activity as was done in emergency. The dividend policy has to be modified or formulated accordingly in those enterprises.
8. Taxation Policy. High taxation reduces the earnings of he companies and consequently the rate of dividend is lowered down. Sometimes government levies dividend-tax of distribution of dividend beyond a certain limit. It also affects the capital formation. N India, dividends beyond 10 % of paid-up capital are subject to dividend tax at 7.5 %.
9. Legal Requirements. In deciding on the dividend, the directors take the legal requirements too into consideration. In order to protect the interests of creditors an outsiders, the companies Act 1956 prescribes certain guidelines in respect of the distribution and payment of dividend. Moreover, a company is required to provide for depreciation on its fixed and tangible assets before declaring dividend on shares. It proposes that Dividend should not be distributed out of capita, in any case. Likewise, contractual obligation should also be fulfilled, for example, payment of dividend on preference shares in priority over ordinary dividend.
10. Past dividend Rates. While formulating the Dividend Policy, the directors must keep in mind the dividend paid in past years. The current rate should be around the average past rat. If it has been abnormally increased the shares will be subjected to speculation. In a new concern, the company should consider the dividend policy of the rival organisation.
11. Ability to Borrow. Well established and large firms have better access to the capital market than the new Companies and may borrow funds from the external sources if there arises any need. Such Companies may have a better dividend pay-out ratio. Whereas smaller firms have to depend on their internal sources and therefore they will have to built up good reserves by reducing the dividend pay out ratio for meeting any obligation requiring heavy funds. 12. Policy of Control. Policy of control is another determining factor is so far as dividends are concerned. If the directors want to have control on company, they would not like to add new shareholders and therefore, declare a dividend at low rate. Because by adding new shareholders they fear dilution of control and diversion of policies and programmes of the existing management. So they prefer to meet the needs through retained earing. If the directors do not bother about the control of affairs they will follow a liberal dividend policy. Thus control is an influencing factor in framing the dividend policy.
Lecture no.: 26
Topic: Dividends models
1. Gordon Model:
The Gordon growth model is a variant of the discounted cash flow model, a method for valuing a stock or business. Often used to provide difficult-to-resolve valuation issues for litigation, tax planning, and business transactions that are currently off market. It is named after Myron J. Gordon, who originally published it in 1959.[1] It assumes that the company issues a dividend that has a current value of D that grows at a constant rate g. It also assumes that the required rate of return for the stock remains constant at k which is equal to the cost of equity for that company. It involves summing the infinite series which gives the value of price current P.
.
Summing the infinite series we get,
，
In practice this P is then adjusted by various factors e.g. the size of the company.
，
k denotes expected return = yield + expected growth.
It is common to use the next value of D given by : D1 = D0(1 + g), thus the Gordon's model can be stated as
.
Note that the model assumes that the earnings growth is constant for perpetuity. In practice a very high growth rate cannot be sustained for a long time. Often it is assumed that the high growth rate can be sustained for only a limited number of years. After that only a sustainable growth rate will be experienced. This corresponds to the terminal case of the Discounted cash flow model. Gordon's model is thus applicable to the terminal case.
2. Walter Model:
According to Walter, the investment policy of the firm and its dividend policy are interlinked. The main proposition of the Walter approach is the relationship between the following two factors.
a) the return on firm’s investment or its internal rate of return
b) its cost of capital or the required rate of return
Assumptions of Walter’s Model:
Constant return and cost of capital.
Internal financing.
100% payout or retention.
Constant earning per share and constant dividends per share.
Infinite time.
Limitations of Walter’s Model:
No external financing.
Constant rate of return.
Constant equity capitalization rate.
Lecture no. 27
Topic: Dividends models-M.M. model
Modigliani and Miller Approach:
The crux of this approach is that the dividend policy of the firm is a passive decision which does not affect the value of the firm. The dividend policy is a residual decision which depends upon the availability of investment opportunities to the firm.
Assumption of the approach:
1. Perfect capital markets.
2. No taxes.
3. Fixed investment policy.
4. Certainty of earnings.
Criticism of M.M. Approach:
Companies have to pay corporate tax on profits distributed by way of dividends.
Flotation cost.
Transaction cost and inconvenience costs.
Institutional Restrictions
Near Vs distant dividend.
Informational utility of dividends.
Sale of new share at lower prices.
Lecture no.: 28
Topic: Working Capital
There are two concepts of working capital
1 Gross Working Capital : It represents the total current assets and is also referred to as circulating capital because current capital as current assets, are circulating in nature.
2. Net Working Capital : It is a measure of liquidity and it can be defined in two ways.
a. The most usually implied definition of net working capital is that it represents the difference between current assets and current liabilities. Some people also define it as excess of current assets over the current liabilities.
b. It is that portion of the firm’s current assets, which is financed by long term funds.
Net working capital as a measure of liquidity is generally not very useful to compare the performance of different units due to difference in scales of operation, efficiency, and creditability in the market etc., between the different firms. However it is a very useful measure for internal control purposes. It can also be used to compare the liquidity position of the same unit over a period of time. This will help in maintaining the acceptable level of net working capital.
Objectives of working capital
1. To minimize the amount of capital employed in financing the current assets. This also leads to an improvement in the “Return of Capital Employed”.
2. To manage the current assets in such a way that the marginal return on investment in these assets is not less than the cost of capital acquired to finance them. This will ensure the maximization of the value of the business unit.
3. To maintain the proper balance between the amount of current assets and the current liabilities in such a way that the firm is always able to meet its financial obligations, whenever due. This will ensure the smooth working of the unit without any production held ups due to paucity of funds.
Lecture no.: 29
Topic: Need and Determinants of WC
Determinants of working capital:
Working capital management is an indispensable functional area of management. However the total working capital requirements of the firm are influenced by the large number of factors. It may however be added that these factors affect differently to the different units and these keep varying from time to time. In general, the determinants of working capital which are common to all organizations can be summarized as under:
a. Nature and Size of Business
b. Production Cycle
c. Business Cycle
d. Production Policy
e. Credit Policy
f. Growth & Expansion
g. Proper availability of raw materials
h. Profit level
i. Inflation
j. Operating Efficiency
Lecture no.: 30
Topic: Cash Management
Cash management is a broad term that refers to the collection, concentration, and disbursement of cash. It encompasses a company's level of liquidity, its management of cash balance, and its short-term investment strategies. In some ways, managing cash flow is the most important job of business managers. If at any time a company fails to pay an obligation when it is due because of the lack of cash, the company is insolvent. Insolvency is the primary reason firms go bankrupt.
Obviously, the prospect of such a dire consequence should compel companies to manage their cash with care. Moreover, efficient cash management means more than just preventing bankruptcy. It improves the profitability and reduces the risk to which the firm is exposed.
Cash management has very serious problems attached to it. We can examine these problems under the following four heads:-
1. Controlling of level of cash,
2. Controlling inflow of cash,
3. Controlling outflow of cash
4. Optimal investment of surplus cash
Lecture no.:31
Topic: Inventory Management
Inventory management is primarily about specifying the size and placement of stocked goods. Inventory management is required at different locations within a facility or within multiple locations of a supply network to protect the regular and planned course of production against the random disturbance of running out of materials or goods
The scope of inventory management also concerns the fine lines between replenishment lead time, carrying costs of inventory, asset management, inventory forecasting, inventory valuation, inventory visibility, future inventory price forecasting, physical inventory, available physical space for inventory, quality management, replenishment, returns and defective goods and demand forecasting.
The following techniques may be used to control the size of inventory in a manufacturing concern
1. Fixing the Maximum-Minimum Limits of Inventory2. Re-ordering Level or Ordering Level3. Economic Order Quantity (EOQ)4. Two-Bin System5. Order cycling system6. Statistical Inventory Control System7. A.B.C Analysis system8. Budgetary Control system
Such factors are those which influence the decision of investment in inventories:
1) Seasonal Nature of Raw Material. If certain raw material is available during a particular season, but its consumption continues throughout the year in the firm, the investment in such raw material shall naturally be heavier to store the stock in order to streamline the production throughout the year. Similarly, seasonal industries purchase raw material in the particular season.(2) length and Technical Nature of the Production Process. If production process is such that takes much time in its completion, the investment in inventories shall be larger such as ship-building industry. Moreover if production process is of technical nature, even then it requires heavy investment in inventories. (3) Style Factor in the End Product. The style factor of end product or nature of finished goods determines the size of investment in inventories. The durability and perishability of the finished product are such important factors. (4) Terms of Purchase. If supply of raw material is available on favorable terms i.e., long credit, conditions of supply, concession or rebate available etc., the management may have larger investment in inventories in order to avail of the opportunity of favorable terms. If on the other hand, raw material is available only on cash terms, the management will dare not to invest heavy amount in inventories.
(5) supply Conditions. Certainty and regularity in supply of raw material are also important factors in determining the size of investment from the view point of operating continuity. Suppose, if the source of material is outside the country and a ban on imports is feared or supply may be disturbed due to weather, a great stock of inventory will be needed. (6) Time Factor. Time is also an important factor in determining the size of inventory and affects the inventory management in a number of ways-(i) bad time i.e., time lag between indenting and availability of raw material, (ii) time lag between purchase of raw materials and the commencement of process, (iii) time required in production process, and (iv) average time required for sale of product. These all exercise their impact on investment in inventories. (7) Price Level Variation. If a price rise is expected in the near future, the investment in raw material will be grater in a bid to keep the cost of product minimum. On the other hand, if price level is expected to go down, there will be a tendency to purchase the goods in the open market a an when it is needed. (8) Loan Facilities. Generally raw materials are purchased on credit. Moreover banks advance credit to the firms against their stock of inventories. If the cost of carrying stock and cost of availability of funds is cheaper than the interest payable to the bank, the investment in inventories will be higher. (9) Other Factors. Others factors like industry wide strike threats, proposed control of raw material, or revision of excise duty rates, price control of finished stock etc., also affect the investment decisions in inventories
Lecture no.: 32
Topic: Management of receivables
Accounts receivable include reimbursements due from state and federal sponsors of externally funded research, patient billings, accrued income on investments, tuition, fees and various other receivables. In order to effect early
conversion of these receivables to cash and minimize credit losses, each campus must maintain a diligent program for managing receivables.
The management function consists of granting credit, billing accounts, effecting collection, analyzing outstanding accounts (aging), and providing for bad debts. This chapter outlines the policies and procedures pertaining to these management functions.
The major categories of cost associated with the extension of credit and accounts receivables are:
Collection cost
Capital Cost
Delinquency Cost
Default cost
The management of receivables involves crucial decision in three areas:
a) Credit Policy
b) Credit termsCollection Polici
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