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Debt-to-Equity ratio indicates the relationship between the external equities or outsiders funds and the internal equities or shareholders funds.

It is also known as external internal equity ratio. It is determined to ascertain soundness of the long term financial policies of the company.

[Debt Equity Ratio = External Equities / Internal Equities]

Or

[Outsiders funds / Shareholders funds]

As a long term financial ratio it may be calculated as follows:

[Total Long Term Debts / Total Long Term Funds]

Or

[Total Long Term Debts / Shareholders Funds]

The two basic components of debt to equity ratio are outsiders funds i.e. external equities and share holders funds, i.e., internal equities. The outsiders funds include all debts / liabilities to outsiders, whether long term or short term or whether in the form of debentures, bonds, mortgages or bills. The shareholders funds consist of equity share capital, preference share capital, capital reserves, revenue reserves, and reserves representing accumulated profits and surpluses like reserves for contingencies, sinking funds, etc. The accumulated losses and deferred expenses, if any, should be deducted from the total to find out shareholder's funds

Some writers are of the view that current liabilities do not reflect long term commitments and they should be excluded from outsider's funds. There are some other writers who suggest that current liabilities should also be included in the outsider's funds to calculate debt equity ratio for the reason that like long term borrowings, current liabilities also represents firm's obligations to outsiders and they are an important determinant of risk. However, we advise that to calculate debt equity ratio current liabilities should be included in outsider's funds. The ratio calculated on the basis outsider's funds excluding liabilities may be termed as ratio of long-term debt to share holders funds.

From the following figures calculate debt to equity ratio:

Equity share capital |
1,100,000 |

Capital reserve |
500,000 |

Profit and loss account |
200,000 |

6% debentures |
500,000 |

Sundry creditors |
240,000 |

Bills payable |
120,000 |

Provision for taxation |
180,000 |

Outstanding creditors |
160,000 |

Required: Calculate debt to equity ratio.

Calculation:

External Equities / Internal Equities

= 1,200,000 / 18,000,000

= 0.66 or 4 : 6

It means that for every four dollars worth of the creditors investment the shareholders have invested six dollars. That is external debts are equal to 0.66% of shareholders funds.

Significance of Debt to Equity Ratio:

Debt to equity ratio indicates the proportionate claims of owners and the outsiders against the firms assets. The purpose is to get an idea of the cushion available to outsiders on the liquidation of the firm. However, the interpretation of the ratio depends upon the financial and business policy of the company. The owners want to do the business with maximum of outsider's funds in order to take lesser risk of their investment and to increase their earnings (per share) by paying a lower fixed rate of interest to outsiders. The outsiders creditors) on the other hand, want that shareholders (owners) should invest and risk their share of proportionate investments. A ratio of 1:1 is usually considered to be satisfactory ratio although there cannot be rule of thumb or standard norm for all types of businesses. Theoretically if the owners interests are greater than that of creditors, the financial position is highly solvent. In analysis of the long-term financial position it enjoys the same importance as the current ratio in the analysis of the short-term financial position.

Definition:

Price earnings ratio (P/E ratio) is the ratio between market price per equity share and earning per share.

The ratio is calculated to make an estimate of appreciation in the value of a share of a company and is widely used by investors to decide whether or not to buy shares in a particular company.

Price Earnings Ratio = Market price per equity share / Earnings per share

The market price of a share is $30 and earning per share is $5.

Calculate price earnings ratio.

Calculation:

Price earnings ratio = 30 / 5

= 6

The market value of every one dollar of earning is six times or $6. The ratio is useful in financial forecasting. It also helps in knowing whether the share of a company are under or over valued. For example, if the earning per share of AB limited is $20, its market price $140 and earning ratio of similar companies is 8, it means that the market value of a share of AB Limited should be $160 (i.e., 8 × 20). The share of AB Limited is, therefore, undervalued in the market by $20. In case the price earnings ratio of similar companies is only 6, the value of the share of AB Limited should have been $120 (i.e., 6 × 20), thus the share is overvalued by $20.

Significance of Price Earning Ratio:

Price earnings ratio helps the investor in deciding whether to buy or not to buy the shares of a particular company at a particular market price.

Generally, higher the price earning ratio the better it is. If the P/E ratio falls, the management should look into the causes that have resulted into the fall of this ratio.

Capital Structure Decisions

Introduction: The two principal sources of finance for a company are equity and debt. What should be the proportion of equity and debt in the capital structure of the firm? One of the key issues in the capital structure decision is the relationship between the capital structure and the value of the firm. There are several views on how this decision affects the value of the firm.

Capital structure theories:

Basic assumptions:

There are only two kinds of funds used by a firm i.e. debt and equity.

Taxes are not considered.

The payout ratio is 100%

The firm‟s total financing remains constant

Business risk is constant over time

The firm has perpetual life.

Net Income Approach (NI)

According to this approach, the cost of debt and the cost of equity do not change with a change in the leverage ratio. As a result the average cost of capital declines as the leverage ratio increases. This is because when the leverage ratio increases, the cost of debt, which is lower than the cost of equity, gets a higher weightage in the calculation of the cost of capital.

The formula to calculate the average cost of capital is as follows:

Ko = Kd (B/ (B+S)) + Ke (S/(B+S))

Where:

Ko is the average cost of capital

Kd is the cost of debt

B |
is the market value of debt |

S |
is the market value of equity |

Ke is the cost of equity

Net Operating income Approach (NOI)

According to this approach:

The overall capitalisation rate remains constant for all levels of financial leverage

The cost of debt also remains constant for all levels of financial leverage

The cost of equity increases linearly with financial leverage

The formula to calculate the cost of capital is Ko=Kd(B/(B+S))+Ke(S/(B+S))

Ko and Kd are constant for all levels of leverage. Given this, the cost of equity can be expressed as follows:

Ke =Ko+(Ko-Kd)(B/S)

Traditional or Intermediate Approach

This approach is midway between the NI and the NOI approach. The main propositions

of this approach are:

The cost of debt remains almost constant up to a certain degree of leverage but rises thereafter at an increasing rate.

The cost of equity remains more or less constant or rises gradually up to a certain degree of leverage and rises sharply thereafter.

The cost of capital due to the behaviour of the cost of debt and cost of equity

o |
Decreases up to a certain point |

o |
Remains more or less constant for moderate increases in leverage thereafter |

o |
Rises beyond that level at an increasing rate. |

MM Approach

According to this approach, the capital structure decision of a firm is irrelevant. This approach supports the NOI approach and provides a behavioural justification for it

Additional assumptions of this approach include:

Capital markets are perfect. All information is freely available and there are no transaction costs

All investors are rational

Firms can be grouped into „Equivalent risk classes‟ on the basis of their business risk

There are no taxes

This approach indicates that the capital structure is irrelevant because of the arbitrage process which will correct any imbalance i.e. expectations will change and a stage will be reached where further arbitrage is not possible.

Capital Budgeting for Multinationals

Nobody can really guarantee the future. The best we can do is to size up the chances, calculate the risks involved, estimate our ability to deal with them and make our plans with confidence. – HENRY FORD II

MNCs evaluate a direct foreign investment proposal using capital budgeting process but this Capital budgeting is different stand from domestic capital budgeting.

Once a firm has compiled a list of prospective investments, the next objective is to select that combination of projects that maximises the company‟s value to its shareholders.

Multinationals usually find their analysis complicated by a variety of problems that are rarely, if ever, encountered by domestic firms. Several such problems include:

Differences between project and parent company cash flow.

Foreign tax regulations

Expropriation

Blocked funds

Exchange rate changes and inflation

Project-specific financing

Differences between the basic business risks of foreign and domestic projects.

A framework has to be developed that allows measuring, and reducing to a common denominator, the consequences of these complex factors on the desirability of the foreign investment opportunities. This helps in comparing and evaluating projects on a uniform basis.

Proper capital budgeting for the MNC is necessary for all long-term projects that deserve consideration. The projects may range from a small expansion of a subsidiary to creation of a new subsidiary.

The basic question to be answered is “should capital budgeting be addressed by the parent company or by the subsidiary?”

Capital Budgeting involves a thorough analysis of decision criteria and application of rules that enable managers to arrive at a decision. The rule of thumb is “given an investment opportunity, should a project be accepted or not?”

The value of foreign investments to the parent company considers the difference between project and parent cash flow. Hence, capital budgeting also considers this.

Managers need to understand the options available; to adjust the scope of a project, failing which, the project cash flow might be negatively biased. The options include:

Expanding or contracting the project

Abandoning the project

Employing new technologies

Entering new lines of business

What Is Time Value? If you're like most people, you would choose to receive the $10,000 now. After all, three years is a long time to wait. Why would any rational person defer payment into the future when he or she could have the same amount of money now? For most of us, taking the money in the present is just plain instinctive. So at the most basic level, the time value of money demonstrates that, all things being equal, it is better to have money now rather than later.

But why is this? A $100 bill has the same value as a $100 bill one year from now, doesn't it? Actually, although the bill is the same, you can do much more with the money if you have it now because over time you can earn more interest on your money.

Back to our example: by receiving $10,000 today, you are poised to increase the future value of your money by investing and gaining interest over a period of time. For Option B, you don't have time on your side, and the payment received in three years would be your future value. To illustrate, we have provided a timeline:

If you are choosing Option A, your future value will be $10,000 plus any interest acquired over the three years. The future value for Option B, on the other hand, would only be $10,000. So how can you calculate exactly how much more Option A is worth, compared to Option B? Let's take a look.

Future Value Basics If you choose Option A and invest the total amount at a simple annual rate of 4.5%, the future value of your investment at the end of the first year is $10,450, which of course is calculated by multiplying the principal amount of $10,000 by the interest rate of 4.5% and then adding the interest gained to the principal amount:

Future value of investment at end of first year:

= ($10,000 x 0.045) + $10,000

= $10,450

You can also calculate the total amount of a one-year investment with a simple manipulation of the above equation:

Original equation: ($10,000 x 0.045) + $10,000 = $10,450 Manipulation: $10,000 x [(1 x 0.045) + 1] = $10,450 Final equation: $10,000 x (0.045 + 1) = $10,450 The manipulated equation above is simply a removal of the like-variable $10,000 (the principal amount) by dividing the entire original equation by $10,000.

If the $10,450 left in your investment account at the end of the first year is left untouched and you invested it at 4.5% for another year, how much would you have? To calculate this, you would take the $10,450 and multiply it again by 1.045 (0.045 +1). At the end of two years, you would have $10,920:

Future value of investment at end of second year:

= $10,450 x (1+0.045)

= $10,920.25

The above calculation, then, is equivalent to the following equation:

Future Value = $10,000 x (1+0.045) x

(1+0.045)

Think back to math class and the rule of exponents, which states that the multiplication of like terms is equivalent to adding their exponents. In the above equation, the two like terms are (1+0.045), and the exponent on each is equal to 1. Therefore, the equation can be represented as the following:

We can see that the exponent is equal to the number of years for which the money is earning interest in an investment. So, the equation for calculating the three-year future value of the investment would look like this:

This calculation shows us that we don't need to calculate the future value after the first year, then the second year, then the third year, and so on. If you know how many years you would like to hold a present amount of money in an investment, the future value of that amount is calculated by the following equation:

Present Value Basics If you received $10,000 today, the present value would of course be $10,000 because present value is what your investment gives you now if you were to spend it today. If $10,000 were to be received in a year, the present value of the amount would not be $10,000 because you do not have it in your hand now, in the present. To find the present value of the $10,000 you will receive in the future, you need to pretend that the $10,000 is the total future value of an amount that you invested today. In other words, to find the present value of the future $10,000, we need to find out how much we would have to invest today in order to receive that $10,000 in the future.

To calculate present value, or the amount that we would have to invest today, you must subtract the (hypothetical) accumulated interest from the $10,000. To achieve this, we

can discount the future payment amount ($10,000) by the interest rate for the period. In essence, all you are doing is rearranging the future value equation above so that you may solve for P. The above future value equation can be rewritten by replacing the P variable with present value (PV) and manipulated as follows:

Let's walk backwards from the $10,000 offered in Option B. Remember, the $10,000 to be received in three years is really the same as the future value of an investment. If today we were at the two-year mark, we would discount the payment back one year. At the two- year mark, the present value of the $10,000 to be received in one year is represented as the following:

Present value of future payment of $10,000 at end of year two:

Note that if today we were at the one-year mark, the above $9,569.38 would be considered the future value of our investment one year from now.

Continuing on, at the end of the first year we would be expecting to receive the payment of $10,000 in two years. At an interest rate of 4.5%, the calculation for the present value of a $10,000 payment expected in two years would be the following:

Present value of $10,000 in one year:

Of course, because of the rule of exponents, we don't have to calculate the future value of the investment every year counting back from the $10,000 investment at the third year. We could put the equation more concisely and use the $10,000 as FV. So, here is how you can calculate today's present value of the $10,000 expected from a three-year investment earning 4.5%:

So the present value of a future payment of $10,000 is worth $8,762.97 today if interest rates are 4.5% per year. In other words, choosing Option B is like taking $8,762.97 now and then investing it for three years. The equations above illustrate that Option A is better not only because it offers you money right now but because it offers you $1,237.03

($10,000 - $8,762.97) more in cash! Furthermore, if you invest the $10,000 that you receive from Option A, your choice gives you a future value that is $1,411.66 ($11,411.66 - $10,000) greater than the future value of Option B.

Present Value of a Future Payment Let's add a little spice to our investment knowledge. What if the payment in three years is more than the amount you'd receive today? Say you could receive either $15,000 today or $18,000 in four years. Which would you choose? The decision is now more difficult. If you choose to receive $15,000 today and invest the entire amount, you may actually end up with an amount of cash in four years that is less than $18,000. You could find the future value of $15,000, but since we are always living in the present, let's find the present value of $18,000 if interest rates are currently 4%. Remember that the equation for present value is the following:

In the equation above, all we are doing is discounting the future value of an investment. Using the numbers above, the present value of an $18,000 payment in four years would be calculated as the following:

Present Value

From the above calculation we now know our choice is between receiving $15,000 or $15,386.48 today. Of course we should choose to postpone payment for four years! (For related reading, see Anything But Ordinary: Calculating The Present And Future Value Of Annuities.)

Conclusion These calculations demonstrate that time literally is money - the value of the money you have now is not the same as it will be in the future and vice versa. So, it is important to know how to calculate the time value of money so that you can distinguish between the worth of investments that offer you returns at different times.

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