Page CHAPTER 1: 1 The Finance Function. The Duties and Responsibilities of the Finance Manager .Organization.

Nature and scope of Financial Management. Maximisation of Shareholder Wealth . CHAPTER 2: 4 Types of Risk. Quantification of Risk. Risks and Returns. CHAPTER 3: 12 Time Value of Money, Discounted and Non-discounted Cash Flows,Evaluation methods of projects,Capital budgeting,Nature of Investment Decisions. CHAPTER 4: 21 Cost of different components of capital.Weighted average cost of capital. CHAPTER 5: 27 Optimal Capital Structure. Capital structure decisions. Operating Leverage, Financial leverage and Total Leverage. Measurements and Significance. CHAPTER 6: 37 Dividend Policy and decisions. Theories of Dividend Distribution . Dividend Policies in Practice CHAPTER 7: 41 Working Capital: Components of working capital. Cost of working capital items.Optimisation of working capital requirement. CHAPTER 8: 52 debt Instruments Long term

CHAPTER (i) The Finance Function

The finance function in the modern corporation has evolved out of the old accounting function in the nineteenth and early twentieth centuries,mainly in response to the following changes in the environment: (a) More sophistication in economic analysis, and its effect ,not only on business decisions, but also on the decision making process. (b) The dramatic increase in computerization, and in the speed,capability and mobility of computing,affecting the storage,processing analysis and transfer/retrieval of vast amounts of data. (c) The effect of (b) above on the speed and accuracy of managerial decision making. (d) The increase in merger/acquisition/consolidation activity in the latter half of the twentieth century,leading to a stress on the valuation of enterprises and on techniques to maximize, and accurately estimate valuations. (e) The deregulation and globalization , not only of financial institutions but also of industries, leading to 24x7 trading and investment activity,spread across all time zones, and the consequent demand for sophisticated real time investment /analytical advice from investors and lenders to support activities across national borders. (f) The effects of (d) and (e) above on the sophistication of the finance function, and the consequent development of analytical frameworks to appraise risks and returns for decision making. AND (g) The multiplication of stakeholders in a business, leading to multiple and often conflicting requirements,resulting in compromises in the incurring of costs, in the delivery of value, and in short term vs.long term value maximization (particularly

involving environmental /social responsibility issues, as exemplified in thepeople ,planet and profits buzzwords). (ii) The Finance Manager : Duties and Responsibilities To respond to the requirements of the job, the finance manager has to (a) Evaluate,quantify and mitigate risk in an environment where business and financial risks are getting more and more complex. (b) Take all actions required to manage the risk vs. return trade-off in a controlled way. (c) Take all actions required to maximize shareholders wealth without sacrificing the requirements of the other stakeholders in the business. This constantly involves compromises. 2 To achieve the above objectives,the finance manager has to acquire and use the funds to maximize value (i.e., the value of the firm). Similar to managerial responsibilities in other functional areas of the firm, specific activities involved in maximizing value are as below: (1) Planning: This includes interaction with the external environment, and with other functional areas within the firm to prepare long term plans,annual budgets and short term forecasts (which periodically update budgets and long term plans based on current data). (2) Financing and Investment: (Sourcing and using funds respectively). Capital budgeting to decide on projects which provide a return on invested capital which is higher than the cost of such capital. Sourcing funds at minimum cost within the constraints of acceptable risk and capital structure. (3) Monitoring and control: Ongoing interactions within and outside the firm to ensure that the firm operates at maximum financial efficiency. (4) Liaison with financial markets: Every firm is affected by conditions in the money and capital markets.The finance manager has to constantly keep on top of the situation to ensure that opportunities are utilized and threats are effectively countered. (iii) Organization of the function. The finance function in a firm is typically organized as follows (though there could be many variations in response to the specific needs of any particular business):

Board of Directors (including Finance Director)

President(Chief Executive Officer)

Vice President (Finance) functional Vice Presidents

Other

Treasurer

Chief Accountant (Controller)

3 The Finance function is all about raising and utilizing funds in the most efficient (i.e., cost effective , risk-acceptable and profitable) way so as to maximize shareholder wealth. This has two implications: (a) Manage the risk-return trade-off so that the risk taken is reasonable, and the returns are commensurate with the risk; and (b) Ensure that the returns to the shareholder are commensurate with the risk which the shareholder perceives that he has taken in buying the shares issued by the company. The returns to the shareholder, which provide him with wealth can come in two forms; (a) a cash component, which is called a dividend , and is usually paid annually by the stock-issuing company, and (b) a capital growth component which is realized (i.e., realized as cash) by the holder only when he sells the share(s) he has bought and makes a profit. Example A buys one share of XYZ company for Rs.100 on 1-1-2010. On 31-122010 ( or on any other date during the year 2010), A receives a dividend of Rs.5. On 1-1-2011, A sells his share in the market for Rs.120. We see that on his original investment of Rs.100,he has made a profit of Rs.5 (dividend) and Rs.20 (capital growth,also known as capital appreciation) in one year. The total annual return on his investment has been 25%. This is referred to as the return on investment, or return on capital employed.

The same logic and calculation will be employed if the money were to be invested in a house instead of a share. If an investor invests Rs.10 lakh on a house which he rents out for a year at an annual rental of Rs 50,000, and sells the house for Rs.11 lakhs a year later. His total return is Rs.1,50,000 on an investment of Rs.10 lakhs, i.e.,15% per annum. If,during the year when he owned the house, he spent Rs.1000 in paying property taxes, and Rs.5000 in repairs and maintenance (on the house), his returns would be reduced from a total of Rs.1,50,000 to Rs.1,44,000,when he sold the house a year later for Rs.11 lakhs,leading to a net return of Rs.1,44,000 on his investment of Rs.10,lakhs,or 14.4% per annum. As we shall see in the following chapters,assets will continue to be bought by investors so long as returns are adequate in relation to the risk taken in acquiring them.Shares will be bought so long as the company issuing the shares is seen to have taken reasonable ,well thought-out and calculated risks in producing the returns to the investor, and as long as the returns are acceptable in relation to the risks taken. In the next chapter, we will examine what kind of risks affect a firm, which of those are within, and which are outside, the control of the firm and its management, and how to assess,quantify and minimize those risks.

4 CHAPTER Types of Risk and Quantification of Risk. Risk,in a financial sense, is produced by volatility or variability in three factors, quantum ,probability and time. Variability in quantum of returns on an investment, the probability of specified quantums being achieved, and variability in the time frames in which these quantums are likely to be achieved,all contribute to uncertainty, and greater uncertainty produces greater risk. Variability and probability are estimated and plotted on a standard two dimensional graph, and statistical formulae are used to arrive at a single number i.e., the Standard Deviation or Co-efficient of variance which measures the combined risk due the probability of variable quantums in outcomes. The risk introduced by the time frames is taken care of by the time value of money, where the discount rates used in discounting future returns to present value will take into account the risk introduced by prolonging returns into the future. Let us assume that a company ABC is likely to achieve a net income of either Rs.50, or Rs.100 or Rs.150 next year. In our estimate, there is a 30% probability of the 2

company achieving net income of Rs.50, a 40% probability of its achieving net income of Rs.100, and a 30% probability of its achieving net income of Rs.150. These three amounts (of Rs.50, Rs.100 and Rs.150) are complete, in the sense that these are the only possible outcomes of the figure of net income, and consequently, the sum of the probabilities of these three outcomes is 100%. The table below summarises the position: Outcome (k) Product (k x p) Rs.50 15.0 Rs.100 40.0 -Rs.66.67 -20.0 ke = 35.0 Let us take another company XYZ for which the outcomes and probabilities are as below: Outcome (k) Product (k x p) Rs.26 13.0 Rs.40 12.0 Rs.50 10.0 Ks = 35.0 20% 30% 50% Probability (p) 30% 40% 30% Probability (p)

5 It is seen that for the two companies ABC and XYZ the expected outcome (profit) is the same at 35.0. The calculation of the expected rate of return can be expressed as an equation:

ke = p1k1 + p2k2 + p3k3 +.. + pnkn takes values from 1 to n;

piki,where I

and ki is the ith possible outcome, pi is the probability of that outcome, and n is the number of possible outcomes. Even though the expected outcome is the same for companies ABC and XYZ, at 35.0,the range of possible outcomes is much wider for ABC (ranging between -66.67 and +100) than for XYZ (ranging only between +26 and +50). In real life,outcomes form a continuous series rather than discrete,specific numbers. If outcomes are on the X-axis and probabilities are on the Y-axis, points on a continuous curve would be the probable outcomes.. If it is a continuous curve it would make more sense to plot probability density rather than probability on the Y-axis indicating that the highest probability density would represent the clustering together of outcomes around a high probability band. For example,for ABC company,the probability of obtaining an income of exactly Rs.50 was 30%,whereas in a continuous curve (which is closer to real life situations), there is a cluster of possible outcomes around a close cluster of probabilities. The graphs of probability densities vs.outcomes for ABC and XYZ companies would look as below, with a continuous range of outcomes:

Fig.2.1 The tighter (or sharper or more peaked) the probability distribution, the less risky the distribution,because the more likely it is that the actual outcome will be close to the expected value, and

6 consequently the less likely it is that the actual return will end up being very different (i.e., lower than) the expected return. Therefore, even though the expected return is the same at 35 for both ABC company and XYZ company, the latter has a much higher probability of producing an actual return closer to 35 than ABC.There is a finite probability of a negative return for ABC, but none for XYZ. Therefore, as a general rule,the tighter the probability distribution of future returns,the lower is the risk of an investment. Risk is therefore seen to have different dimensions. One is the quantum of the outcome,another is the probability of the outcome,the third is the variability of the outcome (which is sometimes viewed as a sub dimension of probability),and the fourth is the timing (spacing) of the returns (outcome). The first two dimensions are the subject of the preceding paragraphs;the other two are the subject of discounted cash flow and net present value analysis,which are covered in Chapter 3. Continuing with the quantums and probabilities of outcomes,it would be useful to have a number to quantify the measure of risk. However precise and definite the number we arrive at as a measure of risk by using a mathematical or statistical formula,it is useful to remember that it is only an estimate,the basis for which remains the subjective view(s) of the probabilities of various outcome, of an individual or a group of individuals (ie., consensus view),based on individual perceptions of the risk involved. Such a measure of risk is called standard deviation,the symbol for which is the Greek letter .The calculation of the standard deviations for ABC and XYZ companies are as below: ABC Company Company ki ke 2 ke) pi 50 35 = 15 25 0.3 100 35 =65 81 0.5 -60 -35=-95 225 0.2 Variance =
2

I pi 0.3 0.4 0.3

2

XYZ k i ke ( ki -

(ki ke)2 pi(ki ke)2 225 7.50 4125 40.50 9025 45.00

pi(ki ke)2 67.50 1650.00 2707.50 = 4425

I I I I I

40 35=5 26 35= -9 50 35= 15

Variance = =93.00

Standard deviation = deviation = 93.00 = 9.65

4425 = 66.50

Standard

The standard deviation is seen to be a probability weighted average deviation from the expected value, and therefore,the lower the standard deviation, the lower the likely deviation from the expected value, and consequently,lower the risk. There is greater variability in ABC company, and consequently,greater risk. Another related and useful measure of risk is the coefficient of variance CV defined as /ke. 7 It is 66.5/35 = 1.9 for ABC company and 9.65/35 = 0.275 for XYZ company. It shows the standard deviation per unit of expected outcome,and it provides a more useful measure of comparison when the expected outcomes of the two alternatives are not the same (unlike ABC and XYZ,where the expected outcomes are the same). Any investor who chooses a less risky (as represented by lower standard deviation) investment as compared to a more risky one,is considered to be risk averse, Most investors are risk averse,and this assumption is a cornerstone of theories in financial management. This leads us to the question of returns vs.risk. In a market dominated by risk averse investors, riskier (as perceived by the average investor) securities must have higher expected returns (again as estimated by the average investor),than lower risk securities; if this situation does not occur,then the prices of the securities will change to force it to happen. The effects of diversification: Risks are of two kinds : company specific risk and market risk. As the terminology indicates, the former is specific to the company (due to its financial structure/parameters, the industry in which it operates,the type of products it deals in,the nature of technology,competition,etc.,), and can be diversified away with a collection (portfolio) of different securities with different company specific risks. The latter (i.e.,market risk,) is common to the whole market (environmental factors,inflation,recession,interest and exchange rates,political uncertainties,upheavals like strikes,riots,civil commotion etc., which cannot be diversified away through portfolio methods ( but can be reduced /mitigated,to some extent, by insurance or by the purchase of financial hedging instruments). The former,(company specific risk) is called unsystematic risk, while the latter is called non-diversifiable or systematic risk. The reduction in unsystematic risk which can be achieved by diversification can be illustrated by flipping a coin.If the coin drops heads up, the investor wins Rs. I lakh. If the coin drops tails up, he loses Rs.50,000. The investor is offered the chance of flipping the coin only once. It is a good bet because the expected value is (0.5 x I

lakh) + (0.5 x - 50,000) = 0.5 0.25 = +0.25 lakh.However it is a highly risky proposition,because there is a high ( 50%) probability of the investor losing Rs.50,000. A risk averse investor might well refuse the bet. Assume now that instead of flipping the coin once,the investor is offered the chance to flip the coin 100 times,with the condition that he would gain Rs.1000 each time the coin dropped head up, and lose Rs.500 each time the coin dropped tail up. It is still possible, but highly improbable that the investor would end up with 100 heads (and gain Rs.1 lakh) or 100 tails ( and lose Rs.50,000) after flipping the coin 100 times. It is however very probable that he would end up with around 50 heads and around 50 tails,winning a net sum of Rs.25,000.Although each toss of the coin is a risky bet,collectively the risk has been diversified away, and the investor ends up with a proposition of lower risk. This is what happens when an investor holds a diversified portfolio of stocks rather than one stock.After unsystematic or company-specific risk has been diversified away,what remains is systematic or market risk.It is measured by the extent to which a given stock tends to move up or down with the market. 8 In the following paragraphs we quantify this degree of correlation with the market, of the price of a given stock . The Beta coefficient; The tendency of a stock to move with the market is reflected in its beta coefficient b which is a measure of the stocks volatility relative to that of the average stock in the market. (The mathematical steps involved in the calculation of b for any particular stock are outside the scope of this book). An average- risk stock is defined as one which tends to move up or down exactly in step with the market, the market movement being the movement of the market index (such as the Sensex or the Nifty) .Such a stock by definition has a beta b of 1. If the market (index) moves up or down by 10%, the value of the particular stock with a b of 1 will also move up or down by 10%. If a stock has a b of 0.5, the stock is only half as volatile or risky as the market, and will go up or down by only half as much as the market. If a stock has a b of 2, it is twice as risky as the market, and will go up or down by twice as much as the market. Beta (b) therefore measures a stocks volatility relative to the market. Beta for thousands of stocks are calculated and published by many organizations. Since a stocks beta measures its contribution to the riskiness of a portfolio, it is the theoretically correct measure of a stocks riskiness. Investors must be compensated for the risk they bear the higher the risk,the higher the required return. However compensation is required only for risk which cannot be eliminated by diversification., i.e., only for market risk. Risks vs.Returns . Let us begin this section with a few definitions. Let Rf be the riskfree rate of return i.e., the return expected on a risk-free security. This is usually

measured by the return on long term U.S.Treasury bonds. However,(since the U.S.Treasury bond is no longer considered risk free, and for ease of collection of theoretical data in order to illustrate a principle, let us assume that, as a reasonably close approximation, the interest rate on a bank deposit of comparable tenor (i.e., comparable remaining period up to maturity) is the risk-free rate. The rate is expected to compensate the investor for the expected (estimated) inflation during the period the security is going to be held, but does not compensate him for any risk,since,by holding the risk-free security he does not assume any market risk. Let us assume that Re is the expected return on the stock.,while Rr is the required rate of return on the stock. Rm is the required rate of return on the b=1 stock ( i.e., on the portfolio which consists of all stocks. Rp is the market risk premium = Rm Rf = the additional return over the risk-free rate required to compensate an average risk-averse investor for the market risk he is assuming on a b=1 stock. The risk premium on a specific stock Rp1 = (Rm Rf)b1 where b1 is the beta coefficient of that stock. Rp1 i.e., the specific stocks risk premium is less than equal to or greater than the premium on an average stock,depending on whether its beta is less than,equal to,or greater than 1. In general terms, the Required return Rr = Risk-free Return Rf + Risk Premium Rp. 9 For example, if the risk-free rate of return on a security is 5%p.a.,the required rate of return on the average (b=1) stock is 9%p.a.,then the required rate of return on a b=2 stock will be 5% + ( 9% - 5%) x 2 = 13% p.a. Similarly on a b=0.5 stock,the rate of return required would be 5% + (9% - 5%) x 0.5 = 7%. Since we have assumed that the risk-free rate compensates investors for inflation but not for market risk,it follows that the risk free rate goes up or down with inflation. IMPORTANT NOTE: An example is given below to highlight how risks vary with perception, and how expected returns change to keep pace with the differerent perceptions. Consider the following balance sheet of company LMN: Current Assets = 50 = 40 Long Term Assets = 100 = 60 Long Term Liabilities Current Liabilities

Total Assets = 50.

= 150

Net Worth

Let us assume that the above simple financial structure has a certain inherent financial risk attached to it, and the banker provides long term debt to the company at 8% p.a. Let us now assume that the current asset portion remains the same ,but the composition of liabilities changes as below Current Liabilities = 25 Long Term Liabilities = 75 Net Worth = 50 The company which has changed the financial risk as above by changing the composition of the liabilities (increasing the long term debt and reducing the short term debt) has, in its own perception, reduced the financial risk by ensuring that less debt is due to be repaid in the short term (less than one year), so that the possibility of bankruptcy (due to a default on the payment of interest,or repayment of principal) is reduced. The lending banker , on the other hand, feels that by lending a higher amount for longer period, he has lost some control over the company, and consequently, over his own position,thereby leading to his assuming a higher risk. These opposite perceptions will need to be matched by differing returns to each of them,so that risk and returns are matched. To compensate himself for his perception of higher risk, the banker charges the company a higher interest rate,say 9%p.a (against the previous rate of 8% p.a.)., and ensures that the higher return matches his perception of higher risk. The borrowing company , on the other hand, finds that its profits have reduced because it has paid higher 10 interest (9%) on its debt (instead of the previous 8%p.a.).The reduced profits (returns) match the companys perception of its reduced risk. It is seen above that the same balance sheet and the financial risk in its structure,are viewed very differently by different stakeholders looking at it, and this difference in perception translates into very real differences in returns. Each shareholder will take a different view of the financial risk, and the business risk on which the financial structure is superimposed. The concepts of business risk and financial risk are explained in the following paragraphs.

Business Risk and Financial Risk; In earlier paragraphs we distinguished between market risk,which is measured by the firms beta coefficient, and total risk, which includes both market risk, and a type of risk which can be reduced by diversification. We now discuss two dimensions of company-specific risk: (a) Business Risk,which is the riskiness of the firms operations,if it uses no debt in its financial (capital) structure. (b) Financial Risk,which is the additional risk placed on the firms stockholders (investors) as a result of the firms use of debt in its financing mix (source of funds). (a) Business Risk Business risk is defined as the uncertainty inherent in the projections of future Returns on Assets (ROAs)* or Returns on Equity (ROEs)*, if the firm uses no debt, and this is the single most important determinant of how much financial risk (risk inherent in the capital structure by the infusion of debt in the company) the company can afford. This is reasonable because investors can tolerate a certain maximum level of risk; if there is already a high level of business risk, the company can afford less financial risk (risk resulting from the use of debt in the capital structure). Conversely, if the firms business risk is low,it can afford a higher level of financial risk without causing investors to feel nervous. *NOTE: Return on Assets = Net Income/ Average Total Assets and Return on Equity = Net Income/Average Shareholders Equity. Average= (Beginning of Year Value + End of Year Value) /2 Fluctuation in ROA and ROE can be due to booms and recessions in the national economy,new products introduced by the firm or its competitors,labour problems,natural disasters,riots,civil commotion,political upheavals, changes in technology affecting products/processes,etc. This element of uncertainty is the companys basic business risk,which varies from one industry to another,(and also between firms in the same industry) depends upon a number of factors.the more important of which are the following: 11. (a) Variability of consumer demand for the companys products leading to variability in sales. The more stable the sales volume,the lower is the business risk. (b) Variability of selling prices caused by volatile markets. Higher variability of selling prices translates into higher risk. (c) Input cost variability. High volatility in costs of raw materials,labour,power etc. results in higher business risk .

(d) Ability to adjust output prices to reflect changes in input costs. i.e.,ability to preserve gross margins. The lower this ability, the higher the business risk. (e) The extent to which costs are fixed; i.e., the level of operating leverage =Fixed costs/Total costs. The higher this level,the higher the business risk, because if costs remain fixed even when demand and sales are falling, it increases business risk. This factor (operating leverage) will be covered in more detail in Chapter 5. Each of the above factors is determined partly by the characteristics of the industry in which the firm operates,but each is also controllable to some extent by the management ( eg., by negotiating long term contracts to reduce input cost variability, expenditures on advertising/promotion, buy vs.lease decisions on assets, etc.,). (b) Financial Risk Financial risk is measured by financial leverage (See Chapter 5),which is the extent to which debt is used in the capital structure. It is the additional risk placed on the common stockholder as a result of using financial leverage. Conceptually,the firm has a certain amount of risk inherent in its operations,which is its business risk,defined as the uncertainty inherent in projections of its future ROA.By using debt,i.e., financial leverage,the firm concentrates its business risk on its stockholders,because debtholders get priority in repayment of their debt in the event of liquidation of the company, leaving the stockholders to collect whatever crumbs are left over. (Chapter 5 deals with optimal capital structure, how leverage affects a firms earnings per share, the riskiness of those earnings, and, consequently, the price of the firms stock,i.e., shareholder wealth). Determinants of market interest rates on debt securities: In general, the quoted (or nominal interest rate on a debt security k is composed of a risk free rate of interest Rf plus a risk premium Rp that has several components i.e, a default risk premium DRP, a Liquidity Risk Premium LP, and a maturity risk premium MRP. Therefore,k=Rf + Rp; and Rp = DRP + LP + MRP. The components are defined below: (a)Rf = the risk free rate, usually the quoted interest rate on a U.S.Treasury bill + a percentage to compensate the holder for the average inflation rate over the life of the security. (b) DRP = default risk premium, reflecting the risk of the issuer not making interest payments or principal repayments on time. (c)LP = liquidity or marketability premium, reflecting the risk that some securities cannot be converted to cash on short notice at a reasonable price.and (d) MRP = Maturity Risk Premium,reflecting the risk of price declines on the security. k = Rf + DRP + LP + MRP. 12 CHAPTER 3

Time value of Money,Dicounted/Non-Discounted Cash Flow, Methods of Project Evaluation, Capital Budgeting.

(a) Time Value of Money, Present ant Future Values,Net Present Value If the interest rate offered by a bank to a depositor (i.e., investor) theoretically compensates him for inflation,but not for risk, it is the risk-free rate. Rs.100 deposited in a bank for a period of,say,5 years at an annual compounded interest rate of 10%p.a. (compounded means that the interest accrued every year on the deposit is not paid in cash to the depositor, but re-invested along with the deposit for the remaining period at the same interest rate which is 10% p.a.in this example). The value of the deposit at the end of year 5 is 100(1+10%)(1+10%)(1+10%) (1+10%)(1+10%) = (100)(1.1)5=161.05. i.e., the Future Value (FV) at the end of year 5 of Rs.100 invested now at a compounded interest rate of 10% p.a is Rs.161.05. In general, the future value at the end of n years of Rs.P invested now at a compounded interest rate of x% p.a. is FV= P(1+x)n. Conversely, the Present Value (P) of a cash flow FV at the end of year n, at a discount rate of x%p.a is P = FV . In the example above, P = 161.05 = Rs.100, the original (current) investment. . (1+x)n 5 (1+0.1) The Net Present Value of an investment is defined as the present value of future cash flows from the investment,MINUS the present value of all cash outflows on the investment. In the above example,the present value of all future cash inflows is 161.05 =Rs.100, since the only . 5 (1.1) cash inflow is the Rs.161.05 at the end of year 5. The present value of cash outflows is Rs.100,since this is the only outflow,represented by the investment at the beginning (i.e.,now). Therefore, the Net Present Value (NPV)= Present value of inflows MINUS present value of outflows = 0. Let us now assume that we have borrowed money (Rs.100) at a simple interest rate of 8%p.a.payable annually (in arrears,not in advance). This amount has been invested,as before for 5 years at a compounded annual interest rate of 10% p.a. The inflows and outflows every year are as shown in the following table:

13 At the end of year2 Inflow(+) Nil Outflow (-) -8@ At the end At the end At the end . of year3 of year4 +100* + 161.05** -100* -108# Nil - 8@ -8 At the end At the end of year 0 of year1 of year5 Nil -8@ -8 Nil -8@ -8

Net (+) or (-) 0 -8 + 52.95

*= Borrowed money Rs.100 = Inflow. Invested in FD = Outflow. @ = Annual simple interest of 8%p.a on borrowed money of Rs.100 = outflow each year from end of year one to end of year 4. # = Annual interest rate at 8%p.a for the year from end of year 4 to the end of year 5 + the repayment of the borrowed money of Rs.100. ** Inflow of Rs.161.05 from the original Rs.100 invested for 5 years at 10%p.a. (compounded). Net Present Value (NPV) = Present Value (PV) of all cash inflows MINUS Present Value of all cash outflows =( 52.95 ) MINUS ( 8 + 8 + 8 8 ) = 36.037 26.497 = 9.54 . . 5 2 3 4 (1.08) (1.08) (1.08) (1.08) (1.08) +

Positive Net Present Value indicates that the project of borrowing Rs.100 @ 8%p.a. simple interest and investing it in a fixed deposit at 10%p.a.compounded interest is profitable on a NPV basis. If the amount had been borrowed at a compounded interest rate of 10% p.a, and invested in a fixed deposit at a compounded interest rate of 10% p.a. (identical terms as the borrowing), the NPV would have been zero. If the amount had been borrowed at 10% p.a COMPOUNDED, and invested in a deposit at a SIMPLE interest rate of 10% p.a, the NPV would have been positive, because the timing of the cash flows would have been favourable to the investor. (The reader should be able to work this out). When the NPV is zero, the interest rate at which the cash flows are discounted,i.e., the discount rate, is known as the Internal rate of return (IRR). Since NPV has to exceed zero for a project to be considered for acceptance, IRR must exceed the discount rate (i.e., the cost of capital). If the cash flows on the project are known, by equating the discounted cash flows to zero at a discount rate of x, we can find out that discount rate at which NPV is

zero. IRR must exceed this discount rate for the project to be considered. All projects which have a NPV at or below zero should be rejected, since they are not profitable and do not contribute to shareholder wealth. These concepts will be discussed at greater length in the later paragraphs in this chapter on capital budgeting. As we have seen above,the process of calculating future values from present values is called compounding, while the process of calculating present values from future values is called discounting. (b)Opportunity cost is defined as the rate of return on the best available alternative investment of equal risk. 14 Example Investor A has the chance to buy a low risk security (a bond) which pays the investor Rs.127.63 at the end of 5 years. At what price should he buy the bond now? To answer this question, alternative investment opportunities available to him of comparable risk and remaining life (tenor) have to be evaluated . In the investors opinion, another investment opportunity of equal risk which is available to him is a 5-year fixed deposit @ 5%p.a. (compounded)offered by the local bank. If Rs.100 is invested in the bank deposit at 5%p.a.compounded,the investor will get 100(1.05)5= Rs.127.63 at the end of 5 years. Therefore Rs.100 is the present value of Rs.127.63 got at the end of the 5th year,which is exactly what the bond is offering. If the bond is available today at any price below Rs.100,he should buy it,because it will cost him less than the deposit. By investing in the bond,the investor would have foregone the opportunity to invest in the banks fixed deposit at 5%p.a., and consequently 5% is the investors opportunity cost. If there are multiple investment opportunities of similar risk and tenor which the investor will forego by investing in the bond, his opportunity cost is the highest(best) rate of return among the foregone investment opportunities.This is the cost of his equity capital. (c) Security valuation,capital budgeting,project evaluation/selection techniques Investment decisions. Capital budgeting or investment decisions involving the use of funds over the medium or long term (i.e.,periods longer than one year) involve the following six steps. !. The cost of capital should be determined. The weighted average cost of the funds sourced through equity or debt (weighted according the proportion of debt/equity ) in the capital structure will be the cost of capital. 2. The capital cost of the project should be determined. This is similar to finding the

price that must be paid to buy a stock or bond. 3.The cash flows from the project through its life have to be estimated,including the scrap value of the assets at the end of their useful life. This is similar to estimating the future interest or dividend payments on a bond or stock along with the bonds maturity value or the stocks expected sales price. 4.The riskiness of the project should be determined and the weighted average cost of capital determined in Step 1 should be modified to take into account the riskiness,before deciding on the discount rate for future cash flows. As a general rule,discount rate needs to be increased to take higher risk into account, or lowered to account for reduced risk, but should never be lowered below the cost of capital. (See weighted average cost of capital in Chapter 4). 5. All expected cash flows are put on present value basis to estimate the assets current (present) value to the firm. This is equivalent to finding the present value of the stocks dividend stream and its disposal value (sale price). 6.Finally, the present value of the expected cash inflows should be compared with the required investment or cost.If the present value of the expected inflows exceeds the cost,the project is worth considering for acceptance along with other competing alternatives;otherwise it should be rejected. 15 Alternatively, the projects expected (estimated) rate of return on the investment should be calculated, and if this rate of return exceeds the projects cost of capital,it will be worth considering for acceptance. Project/Investment Evaluation Techniques,i.e., Capital Budgeting techniques Five primary methods are used to evaluate projects and to decide whether or not they should be accepted for consideration: (1) Payback (2) Discounted payback (3) Net Present Value (NPV) (4) Internal Rate of Return (IRR) and (5) Modified Internal Rate of Return (MIRR) (There are also two other methods,which are not used very much: (a) The Accounting Rate of Return (ARR) which measures a projects contribution to the net income. This really does not add any value to the other techniques. and (b) The Profitability Index (PI), which is nothing but the ratio of the present value of the projects cash inflows to the present value of its outflows. This is nothing but NPV in a different form) The various methods and their features are discussed in the following paragraphs: (1) Payback Period This method involves calculating the number of years required to recover the original investment. All cash flows are added until at least the original investment is recovered. The number of years required to achieve this is the payback period; the

lesser the number of years required, the better the project is. This method suffers from the following drawbacks: (a) Projects which offer heavy returns in later years will get sidelined in favour of projects giving faster returns. and (b) Time value of money is ignored. (2) Discounted Payback Period. This is similar to the regular payback period except that expected cash flows are discounted at the projects cost of capital before the payback period is calculated. Thus the discounted payback period is defined as the number of years required to recover the investment from the discounted net cash inflows. This method also suffers from the drawback (a) applicable to the earlier (Payback Period) method even though the time value of money issue is addressed. (3) Net Present Value (NPV). This method and its calculation have been discussed at the beginning of this chapter. The calculations in the earlier example illustrate the following steps: (a)Find the present value of the cash flows (both inflows and outflows),discounted at the projects weighted average cost of capital. (b) Sum these discounted cash flows (with a + sign in front of the inflows and a sign in front of the outflows. (c) If the NPV is positive,the project should be considered for acceptance (along with other competing 16 projects with positive NPVs). If the NPV is negative it should be rejected. If two projects are mutually exclusive, the one with the higher NPV should be accepted. The logic of the NPV method is simple. NPV=0 indicates that the projects cash flows are just sufficient to repay the invested capital, and to provide the required rate of return. If the project has a positive NPV, it is generating more cash than is required to service its debt and to provide the required rate of return to its shareholders, and this excess cash accrues solely to the shareholders. Therefore, if a firm takes on a project with a positive NPV, the position (wealth) of the stockholders is improved. (4) Internal Rate of Return (IRR). This has been illustrated in the example worked out at the beginning of this chapter. The IRR is defined as that discount rate at which the present value of the projects cash inflows is equal to the present value of its outflows,i.e., NPV=0. Mathematically,the NPV and IRR methods lead to the same accept/reject decisions for independent projects. If a projects NPV is positive,its IRR will exceed the cost of capital, while if NPV is negative,the cost of capital will exceed the IRR. The IRR is specially significant because it is the projects expected rate of return, and if the internal rate of return exceeds the cost of the funds used to finance the project,a

surplus remains after paying for the funds raised, and this surplus accrues to the firms shareholders. Therefore taking on a project whose IRR exceeds its cost of capital increases shareholders wealth,a prime objective of any business. On the other hand,if the internal rate of return is less than the cost of capital,then taking on the project imposes a cost on its stockholders. In between the two scenarios, the breakeven characteristic makes the IRR useful in evaluating capital projects. (5) Modified Internal Rate of Return (MIRR) This method corrects some of the problems with the regular IRR. MIRR involves finding the terminal value (TV) of the cash flows compounded at the firms cost of capital and then determining the rate (MIRR) which forces the present value of the terminal value to equal the present value of the cash outflows. (n = number of years after inception of the project, until termination,when TV is estimated). In other words, PV (costs) = PV (Terminal value) = TV/(1+MIRR)n. When the costs and terminal values are known/estimated, the only unknown quantity in the equation is MIRR which can be calculated. MIRR has a significant advantage over IRR. MIRR assumes that the cash flows are reinvested at the cost of capital,while regular IRR assumes that cash flows are re invested at the projects own IRR. The former is a more correct description.. The MIRR is superior to the regular IRR as an indicator of the projects true return or expected long term rate of return,but the NPV method is still better for choosing among competing projects that differ in size because it provides a better indicator of the extent to which each project will increase the value of the firm.Sophisticated managers consider all five of the project evaluation measures, particularly on large projects involving significant risk and uncertainty, and/or large capital outlays, because the different measures provide different types of information. 17 NPV,IRR and crossover rates: Comparison of the NPV and IRR methods: NPV and IRR are the most commonly used methods for project evaluation and capital budgeting.It is important to understand why at certain times and under certain conditions, a project with a lower IRR may be preferable to one with a higher IRR. Consider two projects A and B whose NPVs at different costs of capital (different discount rates)are as shown below:

Fig.3.1

Cost of Capital (%) NPV (Project B)

NPV (Project A) (Rs.)

(Rs.) 0% 400 5% 250 10% 100 15% 0 The point where the NPV line crosses the X axis indicates the projects internal rate of return (point at which NPV =0). It is 11.5% for project A and 15% for project B. 18 The NPVs of both projects A and B decrease as the discount rate increases. But at lower discount rates project A has the higher NPV, while project B has the higher NPV at higher discount rates.NPV of project B exceeds the NPV of project A if the discount rate exceeds 7.5% (in the above example), which is called the crossover rate. Project As net present value has the steeper slope,indicating that a given change in the cost of capital (discount rate) has a larger effect on the NPV of project A than on the NPV of project B. To see why project A has the greater sensitivity to discount rates,it is useful to note that cash flows are received faster from project B -200 70 325 600

than from project A; i.e., in a payback sense,B is a shorter term project than project A. The impact of an increase in the discount rate is much greater on distant than on near term cash flows, as the following example illustrates: PV of Rs.100 received after 1 year @ 5%p.a = 100/(1.05) = Rs.95.24 PV of Rs.100 received after 1 year @10%p.a = 100/(1.1) =Rs.90.91 % decline in PV = (95.24 90.91)/95.24 = 4.5% PV of Rs.100 received after 20 years @5%p.a. = 100/(1.05)20 =Rs.37.69 PV of Rs.100 received after 20 years @10% p.a. =100/(1.1)20 =Rs.14.86 % decline in PV = (37.69 14.86) = 60.6%. Thus a 5 percentage point increase in the discount rate causes only a 4.5% decline in the PV of a one year (short term) cash flow, but the same 5 percentage point increase in the discount rate causes the PV of a 20 year cash flow to fall by over 60%. Thus if a project has most of its cash flows coming in the early years,its NPV will not be lowered very much if the cost of capital increases,but a project whose cash flows come later will be severely penalized by high capital costs.Accordingly,project A which has its largest cash flows in later years is hurt badly when the cost of capital is high,while project B,which has relatively rapid cash flows is less affected by high capital costs. Independent Projects If two projects are independent, then the NPV and IRR criteria always lead to the same accept/reject decision, i.e., if NPV says accept, then IRR also says accept.If we look at Fig.3.1 and focus on project As profile, we see that (1) The IRR criterion for acceptance is that the cost of capital is less than (to the left of) the IRR. And (2) Whenever the cost of capital is less than the IRR, its NPV is positive. Thus at any cost of capital less than 11.5%, project A will be acceptable by both NPV and IRR criteria, while both methods reject the project if the cost of capital is greater than 11.5%.Similarly project B,or any other independent project under consideration could be analysed similarly, and it will always turn out that if the IRR method says accept,then so will the NPV method. Mutually exclusive projects Now let us assume that projects A and B are mutually exclusive rather than independent; i.e., we can 19 choose either project A or project B, or reject both, but we cannot accept both projects.The situation arises, when capital is scarce, and is sometimes referred to as capital rationing. In Fig.3.1, as long as the cost of capital is greater than the crossover rate of 7.5%p.a. the two methods (NPV and IRR) lead to the selection of the same project,viz., project B., since,above 7.5%, the NPV and IRR of project B

are greater than that of project A. However,if the cost of capital is less than the crossover rate of 7.5%,, the NPV method ranks project A higher,but the IRR method ranks project B higher. Which answer is correct? Logic suggests that the NPV method is better since it adds most to shareholder wealth. There are two conditions which cause NPV profiles to cross and thus lead to conflicts between NPV and IRR: (a) when project size (or scale) differences exist,meaning that the cost of one project is much larger than the other, or (b) when timing differences exist,meaning that the timing of the cash flows from the two projects differs such that most of the cash flows from one project come in the early years, while those from the other project come in the later years,as occurred with projects A and B above.When either size or timing differences occur, the firm will have different amounts of funds in various years,depending on which of the mutually exclusive projects it chooses. For example, if one project costs more than the other, the firm will have more money to invest (in time t=0) elsewhere, if it selects the smaller project. Similarly, for projects of equal size,the one with the larger early cash inflows provides more funds for reinvestment in the early years. Given this situation, the rate of return at which differential cash flows can be reinvested, is an important consideration. The critical issue in resolving conflicts between mutually exclusive projects is this: How useful is it to generate cash flows earlier rather than later? The value of earlier cash flows depends on the rate at which we can reinvest them. The NPV method implicitly assumes that the rate at which cash flows can be reinvested is the cost of capital,whereas the IRR method implies that the firm has the opportunity to reinvest at the IRR. These assumptions are inherent in the mathematics of the discounting process. Which is the better assumption that cash flows can be reinvested at the cost of capital, or that they can be reinvested at the projects IRR? It can be demonstrated that the best assumption is that cash flows can be reinvested at the projects cost of capital. Therefore the best assumption on the reinvestment rate is the cost of capital,which is implicit in the NPV method. Therefore the NPV method is preferable,at least for firms willing and able to obtain capital at a cost reasonably close to their current cost of capital. It should be reiterated that when projects are independent,both the NPV and IRR methods make exactly the same accept/reject decision. However when evaluationg mutually exclusive projects especially those that differ in scale/size and/or timing, the NPV method should be used. Conclusions on Capital Budgeting: (1) Capital Budgeting decisions are some of the most important decisions that financial managers must make. 20

(2)The five methods of evaluation all provide different bits of relevant information, and consequently, it is advisable to use all five while analyzing large/important projects. (3) Payback and discounted payback provide an indication of both the risk and the liquidity of a project; long payback means that the invested cash will be locked up for many years,and hence,the project is relatively illiquid. Also,it means that the projects cash flows must be forecast far out into the future,leading to increased uncertainty/risk. (4) NPV is important because it gives a direct measure of the cash benefit (on present value basis) to the firms shareholders. So NPV is regarded as the best single measure of profitability. IRR also measures profitability,but expressed as a percentage rate of return. Further, IRR contains information about a projects safety margin,which is not inherent in NPV. To illustrate this point, consider two projects X and Y which have the following features: X Y Current Cost Rs.100,000 Return at the end of one year Rs.115,500 Cost of capital 10%p.a. NPV Rs.5000 IRR 15.5% The NPVs, being the same, give no information about the safety margin in the cash flow forecasts or the amount of capital at risk. But the IRR does provide safety margin information. As a result of the very high 65% IRR of project X, the realized (achieved) return could fall substantially (upto 40%) below forecast for project X, and it would still make money, or at least recover its original investment of Rs.10,000. On the other hand,if project Bs inflows fell by only 14% below its forecasted Rs.115,500,the firm would not recover its original investment. Further, if no inflows were generated at all on both projects, the firm would lose only Rs.10,000 on project X, but would lose Rs.100,000 on project Y. In summary,the different methods provide different types of information,many of them complementary to each other, and all of them useful. 65% Rs.5000 Rs.16,500 10%p.a Rs.10,000

21 CHAPTER 4 COST OF CAPITAL The financial statements of a company consist of two sections (a) the Profit and Loss (P&L) Account, also called the Income Statement, which contains a summary of operational results (revenues,costs and net profit/loss) for the year preceding the date of the statement, and (b) the Balance Sheet,which is a snapshot of the assets and liabilities of the company on the date of record of the financial statements. The balance sheet consists of two sections, the assets of the company, and the liabilities of the firm to creditors (debt) and shareholders (equity or net worth). It is useful to think of the financial statements in the following framework: (a) The profit and loss statement is a summary and result of the operations of the firm made possible by deployment of the assets of the company. (b) The assets (plant and machinery,buildings,cash,goods,receivables etc.,) are the items deployed in the operations of the company, and result in the operating statement called the Profit & Loss Account. (c) The liabilities are the source of funds to acquire the assets (i.e., which finance the assets). (d) The cost of the liabilities, i.e., the cost of financing, is the interest on borrowings, or the implied financing cost as in accounts payable,or the dividends and capital growth which need to be delivered to shareholders in order to interest them in investing in the shares of the company. There are several different types of costs in the various items (sections) of the financial statements,as above: (i)Cost of goods sold is the manufacturing cost of the goods which have been sold. (ii) The cost of assets, i.e the financing required to acquire the assets, which is the external liabilities plus the shareholders equity. The liabilities + equity are the source of funds,while the assets are the use of those funds. (iii) The cost of the external liabilities is the interest due to be paid to lenders, and/or the implied financing cost in trade (accounts)payable. There are two broad categories of debt classified by tenor , i.e., short term bank debt and accounts payable , maturing within one year, and are called current liabilities, which finance (i.e., are the source of funds) for the current assets; and long term debt which matures over the long term term (beyond one year), which,along with shareholders equity finances the long term assets like plant and equipment,buildings

,goodwill,capitalized R&D expenditure etc. The short term portion.i.e., the difference between the current assets and the current liabilities is called net working capital, or,(more commonly) working capital. The long term debt + equity is called the capital employed or permanent capital, or investment. (iv) The cost of equity is the return in the form of dividends, and the growth rate in the dividends (if the stock is being continued to be held by the investor,) or dividends plus growth in stock price (if the sale price of the stock at the time of sale is what is taken into account), which have to be provided to potential investors in order to interest them in buying the stock, or to existing investors in order to interest them in continuing to hold the stock. 22 (v) There are other costs, which are cash expenses i.e., selling,general and administrative expenses like rent, taxes, insurance,office staff salaries etc., and non cash items like depreciation of plant and equipment, amortization of R&D expenses and goodwill etc, which appear in the Profit and Loss Account. To estimate returns on capital employed,we calculate the net income generated by the permanent capital ( i.e., investment = long term debt + shareholders equity) Return on capital Employed =Return on Investment= Net Income___ _______ . Average LTD+ Average Shareholders Equity (Average Equity or Average LTD =( Beginning of year equity (or LTD) + End of year equity (or LTD))/2 Working capital i.e., short term assets and liabilities, and their structure/costs are the subject of Chapter 7. In the following paragraphs of this chapter,we shall discuss the cost of permanent capital (i.e., the costs of long term debt and equity),and the calculations which go into working out the appropriate (optimal) capital structure,i.e., the mix of debt and equity which will minimize the cost of capital, and maximize the wealth of shareholders. The weighted average cost of capital. It is possible to finance a firm with (permanent) capital either in the form of equity,or in the form of debt, or a mixture of the two. If the firm is financed entirely with equity,the cost of capital used to analyse capital budgeting decisions should be the investors required return on equity.However most firms raise a substantial portion of their capital as long term debt, and many also use preference shares.For such firms their cost of capital must reflect the average cost of the various sources of long term funds used, and not just the cost of equity, weighted according to the proportion of such funds used.

Therefore,the cost of capital used in capital budgeting should be calculated as a weighted average of the various types of funds used by the firm, regardless of the specific financing used to fund a specific project. Example: Company X has long term debt of Rs.50,borrowed at an annual interest rate of 8%p.a,, preference shares of Rs.20 on which the rate of preferred dividend is 7%p.a, and shareholders equity of Rs.30, on which the cost (i.e., the investors required rate of return) is 10% p.a. The companys marginal tax rate is 40% p.a. Calculate the companys weighted average cost of capital The effective cost of debt = the after tax cost of debt = 8(1-tax rate) = 8(1-0.4)= 4.8%p.a. ( The effective cost of debt is the after tax cost of debt because interest expenses are tax-deductible i.e., deductible from the gross profit before arriving at the taxable profit on which tax must be paid This means that interest expense is one of the expenses which reduce tax liability to the extent of (interest 23 expense x tax rate) so that the company pays less tax to that extent,solely due to having incurred that interest expense; therefore the effective cost of the debt = after-tax cost of the debt = (1-tax rate) x interest rate). Cost of preferred equity = Rate of preference dividend = 7%p.a. Cost of ordinary (common) shareholders equity = Required rate of return on equity = 10%p.a. % of debt in capital structure = 50%. % of preferred equity in the capital structure = 20%. % of common equity in the capital structure = 30% Therefore weighted average cost of the companys capital = (0.5 x 4.8) + (0.2 x 7) + (0.3 x 10) = 6.8%p.a. Basic Terminology and Definitions kd = interest rate on the firms new debt before tax. kd(1-T) = after tax i.e., effective cost of debt ,where T is the firms marginal tax rate. This is cost of the debt component in the firms weighted average cost of capital. kp is the cost of the firms preferred stock. ks is the component cost of retained earnings (or internal equity). It is the required rate of return on common stock. ke is the component cost of external equity i.e., new equity (as opposed to retained earnings). (It is necessary to distinguish between ks and ke .The latter is always more than the former because the effective proceeds from the new equity are always less because of flotation costs leading to a lower P in the D/P + g equation for new equity.

WACC = weighted average cost of capital. Note 1 on debt: The cost of debt,for capital budgeting purposes, is the interest rate on new debt, and not that on debt which is already outstanding ; in other words, we are interested in the marginal cost of debt.This is because our primary concern with the cost of capital is to use it for capital budgeting decisions for future projects. The rate at which the firm has borrowed in the past is a sunk cost (applicable for past projects) and is irrelevant for cost of capital purposes in capital budgeting. Note 2 on debt:The tax rate is zero for a firm with losses instead of profits. Therefore for a company which does not pay taxes, after-tax cost of debt = before tax cost of debt = interest rate, because T =0. Note on Retained earnings (ks):The cost of retained earnings (ks) is the rate of return stockholders require on equity capital that the firm obtains by retaining earnings. (This is analogous to the cost of debt and the cost of preferred stock, which,respectively, are the returns required by lenders (i.e., interest) on debt, and by preferred stockholders (i.e., preferred dividends) on preferred stock. The term retained earnings can be interpreted to mean either the balance sheet item retained earnings or the P&L account item Additions to retained earnings. For the purpose of this chapter 24 the P&L Account item is used; retained earnings, in this case, refer to that part of earnings not paid out in dividends,and hence available for reinvestment in the business in the current year. The reason that we must assign a cost of capital to the retained earnings involves the principle of opportunity cost. Bondholders/debtholders are compensated by interest payments, and preferred stockholders by preferred dividends, but the earnings remaining after interest and preferred dividends have been paid, belong to common stockholders, and these earnings serve to compensate common stockholders for the use of their capital, since they have only been partly compensated by the dividends paid on common stock. Management has the option of how much of the earnings to pay out as common dividends, and how much to retain in the company as retained earnings. For whatever amount the management decides to reinvest in the business as retained earnings, there is an opportunity cost involved,i.e., stockholders could have received the amount as dividends and invested it themselves in other stocks,bonds,real estate or any other asset class. Thus the firm should earn on its retained earnings at least as much as its stockholders themselves could have earned on alternative investments of comparable risk. What rate of return can stockholders expect to earn on their investments? Stocks are normally in equilibrium,which,by definition,means that expected value of ks is equal to the required ks. Therefore in equilibrium it can be assumed that stockholders expect to earn a return of ks on their money. If the firm

cannot reinvest/retain the earnings and earn at least ks,it should pay these funds to its stockholders and let them invest directly in other assets that provide that return. (Note: Dividends and capital gains are taxed differently,with capital gains being taxed at a lower rate than dividends for most shareholders. This makes it beneficial for companies to retain earnings rather than to pay them out as dividends; this in turn results in a relatively lower cost of capital for retained earnings.( This point is discussed in Chapter 6 on Dividend Policy) Whereas debt and preferred stock are contractual obligations that have definite costs, it is not at all easy to measure ks.The best way to estimate it is as done above i.e., in equilibrium,required rate of return =expected rate of return =ks. Further the required rate of return is equal to a risk-free rate Rf plus a risk premium Rp,whereas the expected rate of return on a constant growth stock is equal to the stocks dividend yield D/P plus its expected growth g. Therefore , Required rate of return = Expected rate of return. Or ks = Rf + Rp = D/P +g. From the above equation,we can estimate ks as either Rf + Rp or as ks = D/P + g. Actually,three methods are commonly used for finding the cost of retained earnings: (i) the Capital Asset Pricing Model (CAPM) approach, (ii) the Bond Yield + Risk Premium Approach and (iii) the Discounted Cash Flow Approach These are discussed below: (i) The CAPM approach: Step 1: Estimate the Risk free rate Rf,generally taken as the U.S. Treasury bond rate or the short term 30 day Treasury bill rate in the U.S.A. In India, the bank deposit rate offered by a prime bank on short term 25 or medium term rupee deposits may be substituted . Step 2: Estimate the stocks beta coefficient b, and use this as an index of the stocks risk. Step 3 : Estimate the expected rate of return on the market on an average stock, i.e., kM. Step 4 : Substitute the preceding values into the CAPM equation to estimate the required rate of return on the stock in question; ks = Rf + Rp = Rf + (kM - Rf) x b As an example, if we assume that Rf = 8%, kM = 13%, and b=0.7 for a particular stock,then Ks = 8% + (13% - 8%)(0.7) = 11.5%., indicating that the stock has a lower-than-average risk. If b is,say,1.8 ( higher than average risk stock), then ks = 8% + (13% - 8%)(1.8) = 17%

For an average stock (b=1), ks =kM = 8% + (5%)(1.0) = 13%. It should be noted that although the CAPM approach appears to yield accurate,precise estimates of ks,there are actually several problems with it. First, if a firms shareholders are not well diversified, they may well be concerned with total risk rather than with market risk only; in that case,the firms true investment risk will not be measured by its beta, and the CAPM will underestimate the value of ks. Further, there are always controversies about what can correctly represent Rf. Also, it is hard to estimate what beta investors expect the company to have in the future and to estimate the market risk premium. Bond Yield Plus Risk Premium Approach : Although this is a short term, subjective procedure, analysts often estimate a firms cost of common equity by adding a risk premium of 3 to 5 percentage points to the interest rate on a firms own long term debt. It is logical to think that firms with risky and consequently,high interest rate debt, will also have risky high cost equity. For example, if a strong firm like IBM had bonds yielding 9%, its cost of equity might be 9% + 4% = 13%, where 4% is a subjective risk premium approach. This estimate,being subjective, gives us an approximation of the cost of equity, but not a precise estimate. Dividend-Yield+Growth-Rate, or Discounted Cash Flow (DCF Approach): We know that the investors required rate of return has to be fulfilled by the firm in order that the investors may continue to subscribe to the firms equity (i.e., continue to provide equity to the firm). This required return consists of two parts a current cash return and a future stream of returns through capital gain(growth). This required rate of return on common equity, which,for the marginal investor is also equal to the expected return becomes the cost to the company, i.e., ks = D/P + g. Thus investors expect to receive a dividend yield D/P, plus a capital gain g for a total return of ks,which,in equilibrium, is the required return. This method of estimating the cost of equity is called the Discounted Cash Flow (DCF) method. It is relatively easy to estimate the dividend yield, but care should be taken to 26 estimate growth correctly , appropriately correcting for exceptionally high or low growth due to unusual reasons. Many organizations provide growth rate estimates for a large number of companies. For example, if company As stock price is Rs.100; its next expected dividend is Rs.5, and its expected growth rate is 10%. Its expected and required rate of return, and its cost of equity capital is Ks = 5/100 + 10% = 15% p.a.

This 15% is the minimum rate that the management must expect to earn in order to justify retaining earnings rather than paying them out as dividends to stockholders. Weighted Average or composite cost of capital (WACC) As we shall see in the next chapter, every firm has an optimal capital structure,defined as that mix of debt,preferred stock and common equity that causes its stock price to be maximized. Therefore, a rational firm, which has as its prime objective the maximization of shareholders wealth,will establish a target (optimal) capital structure , and then raise new capital in a manner that will keep the actual capital structure as close to the target structure as possible over time. How that target is established will be seen in the next chapter. The target proportions of debt,preferred stock, and common equity,along with the costs of these components of capital are used to calculate the firms weighted average cost of capital. An example is shown below: Firm ABC has a target capital structure calling for 45% debt,5% preferred stock and 50% common equity. Before tax cost of debt =kd= 10%p.a. Marginal tax rate = 40%. Therefore after tax cost of debt = kd(1-0.4)=6%p.a. Cost of Preferred stock kp = 10.3%. Cost of common equity = 15%. All new equity will come from retained earnings (no flotation costs; all new equity internally generated ) WACC = 0.45 (10%)(0.6) + 0.05 (10.3%) + )+(0.50)( 15%) = 10.715%p.a

27 CHAPTER 5 CAPITAL STRUCTURE,LEVERAGE,FINANCIAL RISK AND SHAREHOLDER WEALTH

In the calculation of weighted average cost of capital,if the weights of debt,preferred stock and equity are changed, the weighted average cost of capital,and thus the set of acceptable projects, will also change.Further,changing the capital structure will affect the riskiness inherent in the common stock and thus will affect ks and P. Thus the choice of capital structure is an important decision. Target Capital Structure: This structure,established by the management of a firm as the optimal capital structure, may change over time as conditions vary, but at any given moment,individual financing decisions should be consistent with this target. If the actual debt ratio is below the target level, new capital will probably be raised in the form of debt,whereas if the debt ratio is currently at or above the target level,new capital will probably be raised by issuing equity. Capital structure determination involves a trade off between risk and return. Using more debt increases the riskiness of the firms earnings stream. However, a higher debt ratio generally leads to a higher expected rate of return. The higher risk associated with greater debt tends to lower the stock price,but the higher expected rate of return tends to raise it. Therefore,the optimal capital structure is one that strikes a balance between risk and return, so as to maximize the price of the stock. Four primary factors affect capital structure decisions: 1.The first is the firms business risk,or the riskiness that would be inherent in the firms operations if it used no debt. The greater the firms business risk, the lower is the financial risk it can afford, and consequently,lower is its optimal debt ratio. 2. The second key factor is the firms tax position.A major reason for using debt is that interest is tax deductible,which lowers the effective cost of debt. However, if much of the firms income is already sheltered from tax by accelerated depreciation or tax-loss carryforwards, its effective tax rate will be low,and in this case debt will not be as advantageous as it would be to a firm with higher effective tax rate. 3.The third important consideration is financial flexibility,or the ability to raise capital under adverse conditions. Corporate treasurers know that a steady supply of capital is necessary for stable operations,which in turn are vital for long term success. They also know that when money is tight in the economy,or when a firm is experiencing operating difficulties, suppliers of capital tend to stay away, and prefer to finance strong companies. Therefore the potential future need for funds as well as the unpleasant consequences of a funds shortage have a major influence on the target capital structure the greater the probable future need for capital and the worse the consequences of a capital shortage, the stronger the balance sheet should be to adequately survive such future turbulence. 4. The fourth determining factor is connected with managerial conservatism vs.aggressiveness. Some managers,who are more aggressive use more debt in an effort to boost profits. This does not change what the target should be, but does change actual, and might limit future flexibility.

28 While the above four points largely determine capital structure, operating conditions can cause the actual to vary from the target at any given time, but the effort should be to get back to the target as quickly as possible when conditions permit. Business and Financial Risk. We have discussed these parameters in detail in Chapter 2. Those paragraphs should be re-read at this stage. We will now look at how financial leverage,i.e., the use of debt affects a firms expected earnings per share, the riskiness of those earnings, and consequently the price of the firms stock. It will be seen that the value of a firm (as represented by its stock price) will first rise as it substitutes debt for equity, then hits a peak, then finally declines as the use of debt becomes excessive.The objective of our analysis is to determine the capital structure at which the value of the firm is maximized. This structure is then the target (optimal) capital structure. Determining the Target (Optimal ) Capital Structure The effects of adding debt., increasing financial leverage are shown in the example below: Firm X has the following financial statements; 1. Profit and Loss Account for the year ended 31-3-2010:

Sales . . . ___0____ Taxable Income Taxes . Rs.24,000

Rs.1,00,000 Less Total Operating costs Earnings before interest and taxes Interest Rs.40,000 (Rs.16,000) Net Income

(Rs.60,000) Rs.40,000

2. Balance Sheet as on 31-3-2010: Debt 0 . Net Fixed Assets Rs.100,000 Common Equity (10,000 Shares) Rs.200,000 . Total Assets Rs.200,000 Total Liabilities and equity Rs.200,000 Current Assets Rs.100,000

1. Earnings per share (e.p.s.) = 24,000/10,000 shares = Rs.2.40 2. The firm pays out all its earnings as dividends. Therefore, Dividends per share = Rs.2.40 3. Book Value per share = Rs.200,000/10,000 = Rs.20 4 . The stock sells in the market at its book value So market price = P =Rs.20 5. Price/earnings ratio = p/e = 20/2.40 = 8.33. 29 The following table shows how the cost of the firms debt would vary if different percentages of debt were used in the capital structure: Amount Borrowed Interest Rate kd on debt Rs.20,000 8% p.a. Rs.40,000 . 9.0% p.a 40% Rs.100,000 . 15.0% p.a. 20% Rs.60,000 . 10.0% p.a. 50% Rs.120,000 30% Rs.80,000 . 12.0% p.a 60% Debt/Assets Ratio 10% . 8.3% p.a

The following table shows how the earnings per share varies with the changes in debt i.e, with changes in financial leverage. Let us assume, for example, that sales can have only three possible values , with probabilities as below: Sales . . 1. EBIT Sales / Probability Rs.200,000/0.2 (Rs.60,000) 0 Rs.50,000/0.2 Rs.100,000/0.6 .Total operating costs (Rs.50,000) (Rs.120,000) EBIT Rs.40,000 Rs.80,000 Rs.40,000 Less Interest 0_ Earnings before Rs.40,000 Rs.80,000 Rs.50,000 Rs.100,000 Rs.200,000 Probability 20% 60% 20%

2.SITUATION WHEN DEBT =0 EBIT from previous line 0 Rs.80,000 __0__ __0__ Taxes(EBT) 0

Taxes(40%) (Rs.32,000) Rs.24,000 Earnings per share Rs.4.80

0_ Net Income Rs.48,000 0 (on 10,000 shares)

( Rs.16,000) 0 Rs.2.40

Expected eps = (0 x 0.2) + (2.4 x 0.6) + (4.8 x 0.2) = Rs.2.40 Standard deviation of eps = 1.52 Co efficient of variation = 0.63

30 3. SITUATION WHEN DEBT/ASSETS =50% ( NOW ONLY 5000 SHARES ARE OUTSTANDING, AND EQUITY = RS. Rs.100,000, DEBT = Rs. 100,000 @ 12% p.a. INTEREST,FROM TABLE ON TOP OF THIS PAGE) EBIT from section 1 0 Rs.40,000 Rs.80,000 Less Interest(12% on Rs.100,000) Rs 12,000 Rs.12,000 Rs.12,000 Earnings before Taxes (Rs.12000) Rs.28,000 Rs.68,000 Taxes(40%; credit for losses) Rs.4800 (Rs.11,200) (Rs.27,200) Net Income/(loss) (Rs.7,200 Rs.16,800 Rs.40,800 Earnings/(loss) per share (Rs.1.44) Rs.3.36 Rs.8.16 (on 5000 shares) Expected e.p.s. = ( -1.44 x 0.2) + (3.36 x 0.6) + (8.16 x 0.2) = Rs. 3.36 Standard deviation of eps = Rs.3.04 Co-efficient of variation = 0.90 The eps distributions under the two financial structures (D/A = 0 and D/A =50%) are graphed in Figure 5.1 below, where we use continuous distributions rather than the discrete distributions in the table on Page 29.

Figure 5.1

Although expected eps would be much higher if debt were used, i.e., financial leverage were employed, it is clear that the risk of low or even negative eps would be higher if debt were employed.

31 Now let us calculate the expected eps,standard deviation of eps and coefficient of variation for different levels of D/A, in the same way as we did on Pages 29 and 30 for D/A =0 and D/A =50%. We get the table below: Debt/Assets Ratio Co-efficient of Variation 0% 0.63% . 10% 0.66 Rs. 1.90 Rs.2.97 . 40% 0.79 3.04 Rs.3.30 Expected eps Rs.2.40 Rs.2.56 20% 0.69 Rs. 2.17 Rs.3.20 50% 0.90 Rs. 3.79 Standard Deviation of eps Rs. 1.52 Rs. 1.69 Rs.2.75 . Rs. 2.53 Rs.3.36 . 60% 1.15. Rs.

30% 0.73

It is seen that the expected eps rises until the firm is financed with 50% debt. Interest charges rise,but this effect is more than offset by the declining number of shares outstanding,as debt is substituted by equity. However eps peaks at a debt ratio of 50 %. Beyond this amount, interest rates rise so rapidly that eps is depressed in spite of the falling number of shares outstanding. The risk, as measured by the co-efficient of variation of eps, rises continuously at an increasing rate as debt is substituted for equity.

We therefore see that using leverage has good and bad effects; higher leverage increases expected earnings per share ( in this example until D/A =50%),but it also increases the firms risk. Clearly, the D/A ratio should not exceed 50%, but where exactly should it be set? If the firms eps is maximized at a D/A ratio of 50%, does it mean that the target or optimal capital structure calls for D/A =50%. The answer is NO. The optimal capital structure is one that maximizes the price of the firms stock, and this always requires a debt ratio which is lower than the one which maximizes expected eps. The following table develops firm Xs estimated stock price and weighted average cost of capital at different D/A ratios . 1.The debt cost and eps data were taken from the calculations on Pages 29 and 30. 2.The beta coefficients were estimated. 3. It is assumed that the firm pays out all earnings as dividends; so eps = dps. 4.The risk free rate Rf is assumed to be 6% and the expected rate of return of the average stock in the market is kM =10%. Therefore at zero debt, ks = 6% + (10% 6%) x 1.5 = 12%. Other values of ks are calculated similarly. 5. Since all earnings are paid out as dividends,no retained earnings are ploughed back into the business, and so growth in eps and dps will be zero. Therefore at zero debt, the price of the stock P0 = dps/ks = 2.40/0.12 = Rs.20. Other prices were similarly calculated. 6.The last column WACC is found by the standard equation for WACC =( % of debt) (kd)(1-T) + (%of equity)(ks). For example at D/A = 40%, WACC = 0.4 (10%) 0.6 + 0.6 (14%) = 10.80% 32 D/A kd Expected eps Estimated ks=Rf+(kM Rf)b Resulting WACC . beta b Price P P/e ratio Estimated and dps

0% -Rs.2.40 1.50 12.0% Rs.20.00 8.33 12.00% . 10% 8.0% Rs.2.56 1.55 12.2% Rs.20.98 8.20 11.46% . 20% 8.3% Rs.2.75 1.65 12.6% Rs.21.83 7.94 11.08% . 30% 9.0% Rs.2.97 1.80 13.2% Rs.22.50 7.58 10.86% . 40% 10.0% Rs.3.20 2.00 14.0% Rs.22.86 7.14 10.80% . 50% 12.0% Rs.3.36 2.30 15.2% Rs.22.11 6.58 11.20% . 60% 15.0% Rs.3.30 2.70 16.8% Rs.19.64 5.95 12.12% The following are noticeable: (i) A stocks beta,which measures its relative volatility as compared with that of the

average stock,increases with financial leverage. The exact nature of this relationship is difficult to estimate but the values given in the beta column above show the approximate nature of this relationship. (ii) The required rate of return for the stock is 12% if no financial leverage is used, but goes up to 16.8% if the company finances with 60% debt. (iii) The expected stock price first rises with financial leverage,hits a peak of Rs.22.86 at a debt/assets ratio of 40%, and then begins to decline.Thus firm Xs optimal capital structure calls for 40% debt. (iv) P/e ratios should decline as the riskiness of a firm increases, and that pattern also exists in our example above, reinforcing our confidence in the estimated prices P shown above. (v) The weighted average cost of capital hits a minimum when D/A =40%, and then rises again when debt is increased.In the beginning,starting from D=0, when the firm begins to use lower cost debt, its weighted average cost of capital declines..However as the debt ratio increases, the costs of both debt and equity rise, leading to an increase in the WACC from its minimum of 40%. (vi) Thus the firms optimal capital structure calls for 40% debt and 60% equity, at which the weighted average cost of capital is minimized and the stock price is maximized, resulting in the maximization of shareholders wealth. The D/A ratio which maximizes eps does not maximize shareholder wealth (or minimize weighted average cost of capital).

Concepts of Operating and Financial Leverage: Measurement of the Degree of Operating Leverage (DOL) , Degree of Financial Leverage (DFL) and Degree of Total Leverage (DTL). In general, operating leverage, refers to the extent of fixed costs in the cost structure of the operating statement (i.e., Profit and Loss Account), while financial leverage is a balance sheet item, representing the proportion of borrowed funds (external liabilities) in the total capital employed. Increase in fixed costs as a percentage of total costs increases the level of sales/gross margins required to meet these fixed costs; the level of sales at which fixed costs are just covered, is the breakeven sales volume; higher the fixed costs, higher the breakeven levels. Similarly, in financial leverage, we have seen in the preceding paragraphs, the effects of increases in debt on cost of capital,eps and stock price. 33 Degree of Operating Leverage The above general definition of operating leverage caused problems in definitions and estimates/measurements, because many costs are not totally fixed or totally variable meaning that they do no not go up with increasing sales or down with falling sales at all sales volumes. Many costs therefore exhibit different characteristics at different sales volumes, or at different times for the same

volumes depending on environmental and business/economic conditions/variables. Therefore, many operating costs are described as semi-fixed or semi-variable. The purpose of the financial analyst or manager is to determine how capable the business is of meeting its fixed cost commitments, and what level of changes in sales values produce what level of changes in Earnings before Interest and Taxes (EBIT); EBIT will determine whether the next item of expense viz., interest, can be serviced. The formula that measures this variable,i.e., sensitivity of EBIT to changes in Sales, steers clear of controversies on the semi fixed and semi variable nature of costs, and is called Degree of Operating Leverage, given by the following formula: Degree of Operating Leverage (DOL) = Percentage change in EBIT = EBIT/EBIT --- (1) . Percentage change in Sales Q/Q In effect, DOL is an index number, which measures the effect of a change in sales on operating income. DOL can also be calculated by using the following equation: DOLQ = Degree of Operating Leverage at point Q = Q(P-V) ------- (2) . Q(P V) F Or, based on rupee sales rather than units, DOLS = Degree of Operating Leverage at point S of Sales = ___S - VC__ ----(2a) . S - VC - F Equation (2) is developed from Equation (1) as follows. The change in units of output is defined as Q. In equation form EBIT = Q(P V) where Q is the units sold,P is the price per unit,V is the variable cost per unit,and F is the total fixed cost. Since both price and fixed costs are constant, the change in EBIT is Q(P V). The initial EBIT is Q(P-V) F so the percentage change in EBIT is %EBIT =Q ( P - V)/ (Q(P-V)-F) --------------------------------------------(3) The percentage change in output is Q/Q -----------------------------------------------------(4) Therefore DOL = Percentage change inEBIT V) change in output Equation 4 = . Q(P-V) F Equation 3 = Q( P Percentage

Here Q is the initial units of output, P is the average sales price per unit of output, V is the variable cost per unit,F is the fixed operating cost,S is initial sales in rupees,and VC is total variable costs.

34 Equation (2) is normally used to analyse a single product, whereas Equation (2a) is used to evaluate an entire firm with many different types of products (for which quantity and sales price are not meaningful) Applying Equation (2a) to Firm X at a sales level of Rs.100,000, and assuming that fixed costs are Rs.20,000 and variable costs are Rs.40,000, . DOL100,000 = ___ 100,000 - 40,000___ 100,000 40,000 20,000 = 1.50

Thus an x% increase in sales will produce an 1.5x% increase in EBIT. A 100% increase in sales will produce a 150% increase in EBIT. However, it should be noted that a 50% decrease in sales will produce a 75% decrease in EBIT. It should also be noted that the DOL is specific to the sales level; thus for a sales level of Rs.200,000, when fixed costs remain fixed at Rs.20,000, and variable cost (proportional to sales) are Rs.80,000, DOL200,000 = . 200,000 - 80,000___ 200,000 80,000 20,000 = 1.20

In general, if a firm is operating close to breakeven level, the degree of operating leverage will be high, but DOL declines the higher the sales are above the breakeven point. At breakeven point, ,by definition, Sales minus variable cost = fixed costs, so the denominator is zero; consequently, at breakeven point the DOL is infinity. Degree of Financial Leverage: Operating leverage affects earnings before interest and taxes (EBIT) whereas financial leverage affects earnings after interest and taxes,or the earnings available to common stockholders. If a firm decided to use more operating leverage, its EBIT would be more sensitive to changes in sales.Financial leverage takes over where operating leverage leaves off, further magnifying the effects on earnings per share,of changes in the level of sales. For this reason,operating leverage is sometimes referred to as first stage leverage and financial leverage as second stage leverage. The Degree of Financial Leverage is defined as the percentage change in earnings per share that results from a given percentage change in earnings before interest and taxes (EBIT), and is calculated as follows; . DFL = % EPS = __ EBIT_______ % EBIT EBIT Interest

For Firm X at sales of Rs.100,000 , EBIT of Rs.40,000,and Interest of Rs.12,000, (at D/A =50%),

DFL = ____40,000____ =Rs.100,000 and D/A =50% . 40,000 - 12000

1.43, at Sales

35 This can be confirmed by looking at the example on Page 29/30, where a 100% increase in EBIT from Rs.40,000 to Rs.80,000 produces a 143% increase in eps from Rs.3.36 to Rs.8.16. Combining Operating and Financial Leverage: Degree of Total Leverage (DTL) It is seen that (a) the greater the degree of operating leverage, (or fixed operating costs),the more sensitive EBIT will be to changes in sales and (b) the greater the degree of financial leverage (financial fixed costs),the more sensitive eps will be to changes in EBIT. Therefore if both operating and financial leverage are high,then even small changes in sales will lead to wide fluctuations in eps. The equations on the preceding pages for operating and financial leverage can be combined to produce the equation for the degree of total leverage (DTL),which shows how a given change in sales will affect the eps.The equations are as below: . DTL = (DOL) (DFL) = _____Q(P V)____ Q(P V) - F I = _____S VC____ S VC F I 100,000 100,000 -

For firm X at sales of Rs.100,000, at D/A of 50%, DTL = __ 40,000__________ = 2.14 . 40,000 - 20,000 12000

From the preceding pages, we see that at sales = Rs.100,000 and D/A =50%, DOL =1.50, while DFL = 1.43. The DTL = (DOL)(DFL) = 1.50 x 1.43 = 2.14, (correct to the second decimal place), which is what we have calculated above. CHECKLIST FOR CAPITAL STRUCTURE DECISIONS 1.Sales stability : A company whose sales volumes are relatively stable and/or predictable, can take on more debt ( i.e., incur more financial fixed costs) than one with unstable sales. 2.Asset Structure: Firms whose assets are suitable for use as collateral (security) for loans tend to use debt more than companies (eg., technology companies) whose special purpose equipment is not readily marketable. For example real estate companies are fairly highly leveraged, while research oriented high-tech companies are not. 3. Operating Leverage : Other factors being the same, a firm with less operating leverage can use more financial leverage, because the product of the two determines the effect of changes in sales on operating incomes , net cash flows and

eps. 4. Growth Rate : Other factors being the same, faster growing firms have to rely more on external capital. 5. Profitability: Firms with high levels of returns on investment are able to generate enough capital through retained earnings, and tend to use relatively less debt. 6. Taxes : Interest is a tax-deductible expense. This deductibility is most useful to firms with high tax rates, which tend to use more debt. 7.Control : Too much debt can lead to too much risk and the likelihood of default. However too little

36 debt might increase the risk of a takeover. ( If management has voting control , i.e., control over more than 50% of the stock,but is not in a position to buy any more stock, it might choose debt for new financing). If management is insecure, it will take into account the effects of capital structure on control. 8.Management attitudes to risk: Since no one can conclusively prove that one capital structure will lead to better stock prices than another, managements exercise their own judgments, which are coloured by their attitudes towards risk (i.e., conservative managements use less debt, while aggressive managements use more debt in their quest for higher profits). 9. Lender and Rating Agency Attitudes: Irrespective of their own attitudes and judgments,managers have to listen to the opinions of lenders and rating agencies who can significantly affect the cost and availability of capital. 10.Market conditions: Conditions in the debt and equity markets, and the availability or otherwise, of capital at reasonable rates in these markets, ( when the firm needs to raise capital) will affect not only the capital structure, but also the timing and quantum of capital raised. 11. The firms internal condition: A firms own internal condition can also have a bearing on its target capital structure. For example, if the introduction of a new product has just been done, the company may wait until the new product fully realizes its profit potential (and effect on stock price), before it issues new equity; in the interim it may meet its financing requirements with debt, and repay the debt from the proceeds of the equity issue when the time is right. 12. Financial flexibility: No finance manager can be 100% sure about how financing decisions will affect stock price. But he has to always ensure that funds have to be made available at a reasonable price for a promising project ( for a capital budgeting decision). When times are good, both debt and equity will be available, but when times are bad suppliers of capital are much more willing to provide debt at reasonable cost, if the borrower makes collateral (security) available. This means that the goal of financial flexibility should always be high on the list of priorities of the finance manager ; this translates into maintaining

adequate borrowing capacity, which can be tapped when equity markets are not good.

37 CHAPTER 6 DIVIDEND POLICY :THEORIES AND PRACTICE Since the financing decision involves the use of equity or debt, and since the quantum of dividends paid out determines the extent of retained earnings,thereby influencing the financing decision,it follows that dividend policy influences the capital structure. A major aspect of the dividend policy of the firm is to determine the allocation of profits between dividend payments and additions to the firms retained earnings. But also important are the other issues pertaining to the firms overall dividend policy ; legal,liquidity,and control issues; stability of dividends; stock dividends and splits; stock repurchase, and last,but not the least, the clientele effect, meaning the kind of investor base the company has built up over the years is it a base looking for cash returns (dividends), or is it a base looking for capital gains? It therefore follows that a number of factors influence dividend policy, the most important of which are the investment opportunities available to the form,alternative sources of capital available to the firm,current capital structure vs.target (optimal) structure, and stockholders preference for current vs.future income.All decisions that the finance manager makes have to enable the firm to maximize shareholder wealth. Therefore, we have to answer the question of whether, and how, dividend policy helps to maximize the stock price. Three theories will be examined in the following paragraphs. 1. Miller & Modiglianis ( M&Ms)Dividend Irrelevance Theory: Merton Miller and Franco Modigliani provided the most comprehensive argument for

the hypothesis that dividend policy has no effect on the firms stock price or its cost of capital, I.e., that dividend policy is irrelevant. They argued that the value of the firm is determined only by its basic earning power and its business risk; in other words, that the value of the firm depends only on the income produced by its assets (and the risk undertaken in producing that income i.e., the risk return tradeoff), and not on how this income is split between dividends and retained earnings ( and hence growth).To develop their theory, they had to make certain assumptions,which are as below: (a) There are no personal or corporate taxes; (b)There are no stock flotation or transaction costs; (c) Financial leverage has no effect on the cost of capital; (d) Investors and the firms managers have the same information about the firms future prospects; (e) The distribution of income between dividends and retained earnings has no effect on the firms cost of equity; and (f) A firms capital budgeting policy is independent of its dividend policy. Obviously, these assumptions do not hold good in the real world. But to develop any theoretical model which attempts to define a relationship,(in this case between stock price and dividend policy), certain simplifying assumptions have to be made. Also the theories have to be judged on empirical evidence and not on the realism of the simplifying assumptions.

38 2. Gordon and Lintners Bird-in-the-Hand Theory: The assumption (e) in M&Ms theory above i.e., that dividend policy has no effect on the required rate of return on equity (ks) has been hotly debated in academic circles. For example, Gordon and Lintner argued that as dividends are increased (i.e., the dividend payout ratio is increased), ksdecreases,because investors are less certain of receiving capital gains than they are of receiving dividend payments. They said, in effect, that investors value a dollar of expected dividends more highly than a dollar of capital gains because the dividend yield component is less risky than the g component in the total expected return equation ks = D/P + g. M&M disagreed. They argued that ks is independent of dividend policy,which implies that investors are indifferent between D/P and g, and therefore between dividends and capital gains. They argued that Gordon & Lintners bird in the hand theory was a fallacy, because most investors plan to reinvest their dividends in the stock of the same or similar firms; and,in any event, the riskiness of the firms cash flows to investors in the long run is determined only by the riskiness of its operating cash flows, and not by its dividend payout policy. 3. Tax Preference Theory: There are three tax-related reasons for thinking that investors might prefer a low

payout to a high payout: (a) In most countries, capital gains are taxed at a lower rate than dividends. Therefore wealthy investors ( who own most of the stock and receive most of the dividends paid) might prefer to have companies retain and plough back earnings into the business. Then,earnings growth would presumably lead to stock price increases, and lower- taxed capital gains might be substituted for higher-taxed dividends. (b) Taxes are not paid on capital gains until the stock is sold. Due to time value effects, a rupee of taxes paid in the future has a lower effective cost than a rupee paid today. (c) If a stock is held until the holder dies, the beneficiaries pay no tax on the capital gains( accrued on the stock until the late holders death). The Tax preference theory therefore states that, because of these tax advantages, investors might prefer capital growth through retention of earnings than dividends. If so, investors should be prepared to pay more for the stock of lowdividend-payout companies than for the stock of high-dividend-payout companies. TESTS/EMPIRICAL EVIDENCE OF THE THREE THEORIES: The three theories offer contradictory advice to managers. The most logical way to proceed would be to test the theories empirically. Such tests have been conducted, but the results have been unclear. The tests suggest that any of the theories could be correct or that all of them could be incorrect. There are two reasons for this situation : (a) For a valid statistical test, things other than dividend policy and cost of equity should be held constant, and (b) we must be able to measure with a high degree of accuracy, the costs of equity for the sample firms being tested. Neither of these conditions actually holds. We cannot find a set of quoted companies, which differ only in their dividend policies,but

39 which are totally similar in all other variables. Neither can we achieve the required precision in estimating their costs of equity. Therefore we cannot empirically determine what effect dividend policy has on the cost of equity..Hence direct tests have been unable to determine the dividend policy controversy. There are two other theoretical issues that could affect our views of dividend policy,viz., (1) the information content, or signaling, hypothesis, and (b) the clientele effect. These are briefly discussed in the following paragraphs: (a) Information content, or Signalling ,Hypothesis: If investors expect a companys dividend to increase by 5% per year, and if the dividend is,in fact, increased by 5%, then the stock price will not change significantly on the date the dividend increase is announced. In stock market parlance, such a dividend increase would have already been discounted or anticipated by the market.However, if investors expected a 5% increase, but the company announced a 25% increase, this would generally result in an increase in the companys stock price. Conversely, a less than expected dividend increase, or a

reduction, would result in a stock price decline. The fact that large dividend increases generally cause stock price increases, suggests to some extent that a majority of investors prefer dividends to capital gains. However M&M argued differently. They noted the well established fact that corporations are always reluctant to cut dividends, consequently, they do not increase dividends unless they expect higher, or at least stable earnings in the future. Therefore, according to M&M, this means that a larger than expected dividend increase is taken by investors as a signal that the firms management forecasts improved earnings, whereas a dividend reduction signals a forecast of poor earnings. Thus M&M claimed that investors reactions to changes in dividend payments do not show that investors prefer dividends to retained earnings; rather, the stock price changes simply indicate that important information is contained in the dividend announcements. This theory is referred to as the Information content, or signaling hypothesis. (Note: There can be other interpretations of the signals sent out by a company through its dividend announcements,depending upon the companys financial health, its actual vs.target capital structure,its capital budgets etc. A lower than expected dividend may also indicate sizeable investment plans, and the need for equity. Conversely, a higher than expected dividend can also indicate lack of new projects/investment plans, and may be a confession telling the investor that the company has no particular plans for future growth. (b) The clientele effect: M&M also suggested that a clientele effect might exist, and,if so, this might help explain why stock prices change after announced changes in dividend policy. Their argument was as follows: A firm sets a particular dividend payout policy, which then attracts a clientele consisting of those investors who like this particular policy. For example, retired individuals prefer current income to future capital gains, so they want the firm to pay out a higher percentage of its earnings as dividends. Other stockholders have

40 no need for current income they would simply re invest any dividend income received, after first paying income tax on it, so they favour a low payout ratio. If the firm retained and reinvested earnings rather than paid dividends, those stockholders who need current income would be disadvantaged. They presumably could get some capital gains, but they would have to go to the trouble and expense of selling some of their shares to obtain cash. Since brokerage costs and securities transaction costs (wherever applicable) would form a significant outgo, particularly for small transactions, selling a few shares to obtain periodic income would be expensive and inefficient. On the other hand, if the firm paid out most of its income

as dividends, stockholders who did not need current income would be forced to receive them,either pay taxes on them,or have taxes deducted from the amounts before payment by the company (depending on the tax regulations), and then go to the trouble and expense of reinvesting what is left of their dividends after taxes. M&M concluded from all this that those investors who needed current income would purchase shares in high dividend payout companies,whereas those who did not need current cash income would invest in low payout firms. This suggests that each firm should establish the specific policy that its management deems most appropriate, and then let shareholders who do not like this policy sell their shares to other investors who do. However such switching is costly because of (a) brokerage costs (b) possible taxes on capital gains for the selling investors, and (c) a possible shortage of investors who like the firms newly stated dividend policy. This means that firms should not change their dividend policies too frequently,because such changes will result in net losses to the investors due to brokerage costs and capital gains taxes. As seen from the various paragraphs above all theories have been investigated, but there is no conclusive empirical evidence favouring any theory. In summary, the factors that firms take into account before deciding on any dividend policy are broadly classified as follows: (1) constraints on dividend payments; (2) investment opportunities; (3) availability and cost of alternative sources of capital; and (4) effect of dividend policy on investors required rate of return on equity ks.. The last is very important, and it is worth repeating that the effects of dividend policy on ks may be considered in terms of four factors: (a) stockholders desire for current vs.future income; (b) perceived riskiness of capital gains vs.dividends; (c)the tax advantage of capital gains over dividends and (d) the information content of dividends (signaling). Dividend policy decisions are not decisions that can be quantified precisely,but are exercises in informed judgment. To make rational dividend decisions,all the points discussed in the preceding paragraphs must be taken into account. 41 CHAPTER 7 WORKING CAPITAL POLICY AND MANAGEMENT Key definitions and concepts are as below: (a) Working capital means net current assets, i.e., current assets minus current liabilities. (b) The current ratio, defined as current assets divided by current liabilities,measures a firms liquidity. However, high

working capital, or a high current ratio, does not automatically ensure that the company will have all the cash it needs,( through the liquidation of its current assets), to meet its maturing short term liability commitments. If inventories cannot be sold in time or if accounts receivable cannot be collected in a timely manner, then a high current ratio on paper does not provide safety. (c) The quick ratio, or acid ratio or acid test also measures liquidity, and is found by subtracting inventories from current assets, and dividing the result by current liabilities. This has the effect of removing inventories (which are the least liquid of a firms current assets),before calculating the current ratio, so it is a stringent test or acid test of the firms ability to meet its current obligations. (d) Working capital policy refers to the firms basic policies regarding (i) target levels for each category of current assets, and (ii) how the current assets will be financed i.e, the composition and quantum of current liabilities. (e) Working capital management involves the administration, within policy guidelines, of current assets and current liabilities. (NOTR: The best and most comprehensive position of a firms liquidity position is obtained by examining its cash budget. This budget which forecasts cash inflows and outflows, along with the timing, focuses on what really counts, i.e., the firms ability to generate cash inflows to meet its outflows.) We must distinguish between those current liabilities which are specifically used to finance current assets, and those current liabilities which represent (a) current maturing instalments of long term debt, (b) financing associated with a construction programme, which will be liquidated by payments from the project owner after the project is completed in case of a project executed for an outside party, or, (in the case of the firms own project),by the proceeds of a long term debt or equity issue. Working capital needs fluctuate during business cycles; they increase during boom periods, and decline during recessions. Within business cycles, there are seasonal variations as seen for example,in agricultural product companies. Inventories get built up just prior to the busy season, leading to a need for short term financing through payables or short term debt. This need for financing continues until the inventories are sold for cash, and/or converted into accounts receivable, and the accounts receivables get paid, thereby liquidating the current liabilities. Operating cycle and Cash (conversion) cycle: The firms operating cycle is the length of time (usually in days) from the commitment of cash for purchases,until the collection of receivables resulting from the sale of finished products (goods) or services. 42 Operating cycle (in days) =Inventory turnover (in days) + Receivables collection period (in days).

Inventory turnover . (days) sold

= ______ Inventory______ = . Cost of goods sold per day

Inventory x 365 Cost of goods

Similarly, Receivables collection period = _ Receivables_____ 365 . (days) Sales per day Sales

Receivables x

The payables deferral period is the average length of time between the purchase of materials and labour, and the payment of cash for them. Similar to the definitions above, Payables deferral period ( also called payables turnover) is defined as below: . Payables deferral period =___Payables x 365___ Cost of goods sold Cash cycle = Operating cycle payables deferral period = Inventory turnover ( days) + Receivables collection period ( days) Payables deferral period (days) The cash conversion cycle is the period (gap) between payment of cash and receipt of cash, which will need to be bridged by external financing, i.e., this is the need for external financing for the number of days represented by the cash cycle. The firms goal will be to shorten the cash conversion cycle as much as possible without hurting operations, so that the need for external financing is reduces, thereby reducing the cost, and improving profits.. The cash conversion cycle can be shortened by (a) reducing the inventory turnover, by processing and selling goods more quickly, (b) by reducing the receivables collection period by speeding up collections and/or (c) by lengthening the payables deferral period by slowing down its own payments. The above actions should be carried out to the extent possible,without increasing costs,or depressing sales. Working capital policy involves two basic questions (a) What is appropriate level of current assets, both for individual asset categories, and for total current assets, and (b) how should they be financed . These decisions are influenced by the trade off that must be made between profitability and risk. Profitability: Lowering the level of investment in current assets, while still being able to support the desired level of sales, would lead to a reduction in financing costs, and an increase in the firms total return on assets. To the extent that costs of short term financing are less than the costs of long term financing, the profitability of the firm is higher if it uses a greater proportion of short term debt compared to long term debt. The other advantages of short term debt are; (i) Speed : It can be arranged at short notice and (ii) Flexibility : It can be

repaid early, without incurring pre-payment penalties(as in long term debt),when seasonal requirements or other reasons indicate that it is not required.

43 Risk (of Long term vs.Short term debt) : Even though short term debt is less expensive than long term debt, short term credit subjects the firm to more risk than does long term financing. This occurs for two reasons; (1) If a firm borrows on a long term basis,its interest costs will be relatively stable over time,but if it uses short term credit,its interest expense will fluctuate widely,at times going quite high; and (2) If a firm borrows heavily on short term basis it may find itself unable to repay this debt, and may find itself in a weak financial position. As seen above, deciding on the appropriate level of short term and long term financing involves ( as all other financial decisions do), a tradeoff between returns (profitability) and risk. In the following paragraphs, we discuss the methods for management and control of each of the current asset items, and the associated current liabilities i.e., short term financing and accounts payable. 1. CASH. Cash is often called a non-earning asset, because it earns no interest. The goal of the cash manager is to minimize the amount of cash the firm must hold for use in conducting its normal business activities, yet, at the same time, to have sufficient cash (a) to take trade discounts, (b) to maintain its credit rating, (c) to take advantage of favourable business opportunities like special offers from suppliers, or the chance to acquire another firm, and (d) to meet unexpected cash needs, such as during strikes,fire, to counter competitors marketing campaigns etc. In addition to the above three transactional (i.e., operational) reasons,very often companies compensate banks by keeping cash balances with them in return for other services received from banks ( at low cost or no cost). The above reasons can fall into four categories : transactional,speculative, precautionary, and compensatory. Cash Management Techniques encompass proper management of both the cash inflows and cash outflows of the firm. This entails ; (1) synchronizing cash flows (2) using float (3) accelerating collections of receivables (4) getting available funds to where they are needed, and(5) controlling disbursements. These are briefly discussed below: (1) Cash Flow synchronization: By improving their forecasts, and arranging things,as far as possible, so that cash receipts coincide with cash outflows, firms can reduce their transaction-related bank balances to a minimum,( i.e., reduce idle cash),decrease bank loans,reduce interest expenses, and boost profitability. (2) Float is of two kinds: (a) Disbursement float is defined as the amount of cheques

issued by a company, but not yet presented by the drawee to the companys bank for payment. Collections float is the amount of cheques received by the company, but not yet cleared and credited to the companys account. If X = disbursement float minus the collections float, then X is called the net float. A negative net float on the books of the company indicates that the companys own collection and clearing process is more efficient than that of the recipients of its cheques, and this indicates efficiency of cash management by the company (i.e., it gets to use the proceeds from its cheque receipts faster than it pays out on cheques drawn by it).

44 (3) Acceleration of receipts: (a) Lockboxes are one of the oldest tools for speeding up collections. A firm headquartered in Kolkata might have its South Indian customers send their cheque payments to a lockbox in Chennai, its West coast customers send their cheques to a lockbox in Mumbai, and so on. The company bank will arrange to have its branches open the lockboxes and deposit the cheques into the companys local account, and discount the cheques (if requested by the company), and provide the funds for use by the companys head office in Kolkata on the same day (again,if requested). There are variations of this scheme, the end result being to speed up collections. (b) Pre-Authorized debits: allow funds to be transferred on specified dates from the customers account to the firms account, based on instructions issued by the customer (as pre-arranged with the firm).While this chequeless ,paperless transaction speeds up the collection, the payer loses the benefit of the disbursement float. (4) Getting available funds to where they are needed: Concentration banking: Lockbox systems and pre-authorised debits result in the firms cash being spread around among many locations ( and possibly among many banks). Concentration banking achieves the transfer of these decentralized cash balances into one centralized cash pool,where it can be used for short term investing,(for boosting earnings) or for neutralizing debit balances (loans /overdrafts) and reducing interest expense. The concentration process is dependent on the timely transfer of funds between financial institutions. This is achieved through ACH-DTC (Automated Clearing House Depository Transfer Cheque), which moves funds through the use of a pre-printed depository cheque drawn on a local bank, and payable to a single company account at a single concentration bank; or through automated clearing house electronic transfer, or a wire transfer. (5) Controlling Disbursements: This is achieved by one or more of the following three methods: (a) Payables centralization: This is the most effective single method of controlling disbursement. It permits the financial manager to evaluate the payments due for

the entire firm, and schedule funds on a companywide basis. The disadvantage is that regional offices may not be able to make prompt payment for goods or services received, thereby creating ill-will among suppliers, which may offset the savings realized by centralizing payments. (b) Zero balance accounts: Zero balance accounts are special disbursement accounts having a zero balance,on which cheques are written. Typically, several such zero balance accounts are established, and when the cheques drawn on such accounts are presented for payment, they are funded from a master concentration account. This reduces the amount of idle cash. Costs and benefits of cash management.: Clearly, implementing the various cash management techniques above is not a costless operation. As a general rule, the firm can incur these expenses when the marginal returns exceed the marginal costs. Also, the value of careful cash management depends upon the costs of the funds invested in cash,which in turn depend on the levels of interest. Such techniques acquire a great deal of importance when interest rates are high. 45 2. MARKETABLE SECURITIES: Since cash is a non-earning asset, and in spite of all techniques used by companies to minimize holdings of cash, it is likely that companies will have short term investible surpluses, on which they might like to earn some returns. They achieve this through investments in marketable securities,which are tradeable debt securities issued by various organizations.. A wide variety of securities, differing in terms of default risk,price risk,liquidity risk, and expected rates of return are available. In Chapter 2, we developed the equation for determining the nominal interest rate : . k=Rf + DRP + LP + MRP. In our definition, the Risk free rate Rf includes no risk, but does include a premium for expected inflation over the term that the security is going to be held. In addition the required return for any bond includes premia for default risk,maturity risk,and liquidity risk. Marketability risk would be closely associated with liquidity risk. 3.RECEIVABLES MANAGEMENT: The total amount of receivables outstanding at any given time is determined by two factors (1) volume of credit sales and (2) the average credit period,i.e., the average length of time between sales and collections. The receivables on the assets side of the balance sheet have to be financed by some items on the liabilities side;however, the entire amount of the receivables does not have to be financed because the profit portion of the receivables is not a cash outgo . The best way of reducing the receivables financing cost is to either reduce the portion sold on credit

or shorten the credit period , if this can be done without affecting sales. Also, if by offering 90 days credit on an item whose cash sale price is Rs.100,if the company is able to realize Rs.103, it is effectively being paid Rs3 on Rs.100, i.e., 3% for 90 days credit, or 12 % p.a. If short term bank finance costs the company only 9% p.a., and that too not on the entire Rs.100 (since Rs.100, as mentioned earlier,includes a profit margin which does not need to be financed,since it is not a cash outgo ) it is clearly better for the company to sell as much as possible on credit in the interest of profit maximization; however as the company borrows more and more to finance the receivables, the leverage goes up and the companys risk will be perceived to be deteriorating, leading to an increase in interest rates. Clearly it is better for the company not to borrow the maximum possible, but to still keep some debt capacity available for future financial flexibility. If on the other hand , by selling the above item(cash price = Rs.100) for Rs.102, on 90 days credit, the company gets 8%p.a, while it pays 9%p.a for short term bank financing. In this case it is better for the company to maximize its cash sales, and minimize its credit sales. Credit sales are governed by the firms credit policy, which consists of the following variables: (1) The credit period, which is the length of time buyers are given for their credit purchases (2) The credit standards, which refer to the minimum financial strength of acceptable credit customers, 46 and the amount of credit available to different customers. (3) The firms collection policy, which is measured by its toughness or laxity in following up on slow-paying customers . and (4) Any discounts given for early payment. The receivables turnover period has been defined earlier. Monitoring of receivables is done by setting a target turnover period and monitoring it constantly. The monitoring is aided by an ageing schedule, which consists of classifying amounts due under various bands ( 0-30 days,31-60 days,61-90 days over 90 days etc.) as appropriate, and by a separate schedule showing overdue amounts in each band, and the periods by which they are overdue. Vigorous follow up action should be taken on overdue customers. Setting the credit standards, and the credit periods applicable to different customers,involve the use of the five Cs of credit, as follows: (1) Character refers to the probability that customers will try to honour their obligations.. Credit reports from external agencies plus the firms own experience, plus information from bankers, will help to evaluate this important issue in credit evaluation. (2)Capacity is a subjective judgment of the customers ability to pay.Independent credit analysts can obtain this information from a variety of sources. It can also be gauged in part

by the customers financial statements (if available), their past records and business methods and market information and opinions. (3)Capital is measured by the general financial condition of a firm as indicated by its financial statements, and its calculated financial ratios. (4) Collateral is represented by assets that customers may offer as security in order to obtain credit. (5) Conditions refer to both general economic trends and to special developments in certain geographic areas or sectors of the economy that might affect customers abilities to meet their obligation. Information on all the above counts goes into the managers final judgmental call on the overall credit quality of the customer, which will determine the amount and the period of credit offered. 4.INVENTORY MANAGEMENT. Inventories,which may be classified as (a) raw materials, (b) work-in-process, and (3) finished goods are an essential part of virtually all business operations. As is the case with accounts receivable, inventory levels also depend heavily on the volume of sales, in particular,on the cost of goods sold, since raw materials,work-in-process and finished goods are all valued at cost.. Inventories have to be built up ahead of sales. The necessity of forecasting sales before establishing target inventory levels,makes inventory management a difficult task. Also,errors in inventory management quickly lead either to lost sales (inadequate inventories) or excessive carrying costs (too much inventories). Inventory management focuses on four basic questions (1) How many units should be ordered (or produced) at a given time. (2)At what point should inventory be ordered or produced? (3) What inventory items warrant special attention? (eg., long lead times, ordering costs, high value items.) 47 (4) Can changes in the costs of inventory items be hedged? The following paragraphs will attempt to answer these questions. Inventory costs: The goal of inventory management is to provide the inventories required to sustain operations at the lowest possible cost. The typical costs associated with carrying inventory are as follows: 1. Carrying costs Cost of capital tied up (i.e., financing cost of the value of the inventory). Storage and handling costs. Insurance. Property taxes. Depreciation and obsolescence. 2. Ordering,Shipping and Receiving Costs. Costs of placing orders, including production and setup costs.Shipping and handling costs.

3. Costs of shortfall in Inventory. Loss of Sales.Loss of customer goodwill.Disruption of production schedules. Carrying costs: Cost of capital tied up in inventory = (Average value of inventory)x (cost of capital used in financing). To this figure of capital cost are added the annual storage costs,handling costs,insurance premia, property taxes,depreciation and obsolescence. Ordering,Shipping and Receiving costs: These costs are the (fixed) costs of placing an order i.e., memoranda, telephone calls, etc, and the costs of shipping or receiving (including setting up a production run,, handling, taking delivery, clearing charges etc). Total inventory costs = Carrying costs + Ordering,shipping and receiving costs The third type of cost (i.e., costs of shortfall), are self explanatory, and will depend on the measures taken to handle specific situations. The Economic Ordering Quantity (EOQ) Model for Inventories: The basic premise on which the EOQ model is built is that some costs rise with larger inventories, while other costs decline, and that there is an optimal order size ( and an average inventory size associated with that order size) which minimizes the total costs of inventories. First, the average investment in inventory depends on how frequently orders are placed,and the size of each order if we order each day, the average inventory will be much smaller than if we order, say,once a year. The firms carrying cost will rise with larger (less frequent) orders: larger orders mean larger inventories, larger warehousing,inventory,insurance and obsolescence costs, and larger funds tied up in inventory. However ordering costs decline with larger orders, because fewer orders will mean lesser ordering 48 costs. The point where total inventory cost is minimized represents the economic ordering quantity, and this in turn determines the average inventory level. The formula for EOQ is determined as below: Total Inventory cost = Total carrying cost + Total ordering Cost (C)(P)(A) + _FS_ (since N =S/2A) . 2A where C is the annual percentage carrying cost, P is the cost per unit, A is the average inventory in units =Q/2,where Q is the quantity per order,F =Fixed cost per order, and S = Total quantity ordered per year through N orders. The Economic = (C)(P)(A) + FN =

Ordering Quantity is found by finding the Q at which the value of the above equation is minimized, i.e., by differentiating the above equation with respect to the ordering quantity Q, and setting the derivative equal to zero, as follows: . EOQ = _d_ ( CPA + FS/2A) where Q=2A. =__d__ (CPQ/2 + FS/Q) dQ dQ Or EOQ = (2FS/CP) 5.SHORT TERM FINANCING: Short term credit is defined as any liability originally scheduled for repayment within one year. There are many sources of short term funds, the major ones being (i) accruals, (ii) accounts payable (trade credit),(iii) bank loans and (iv) commercial paper . Statements made about the flexibility, cost and riskiness of short term vs.long term debt,depend on the type of short term credit used.. The four types of short term credit indicated above are discussed in the following paragraphs: (i) Accruals : Firms generally pay employees on a weekly or monthly basis,so the balance sheet will show some wages due but not paid i.e., accrued wages, as on a particular date. Similarly there may may be other items accrued, like taxes, which are accumulated and due to be paid at a later date. Such accruals represent short term financing, and increase automatically and spontaneously, as a firms operations expand. This type of debt has no explicit cost. However, the amounts and timing of these accruals are not within the firms control, since the dates for payment of wages and taxes are either set contractually or by law. (ii) Accounts Payable (Trade Credit): Firms generally make purchases from other firms on credit,recording the debt as an account payable. It is a spontaneous source of financing in the sense that it arises from ordinary business transactions. The determinants of the quantum of accounts payable are (a) the amount purchased on credit and (b) the credit period. Thus lengthening the credit period as well as expanding purchases on credit generates additional financing.The cost of trade credit is calculated as follows; Suppose company A buys an item, 49 the cash price of which is Rs.100. If the supplier offers 90 days of credit to A if the company is willing to pay Rs.102, then the cost of this particular trade credit is 2% for 90 days or approximately 8%p.a. Another way of calculating trade credit, more common in the market, is as follows. Suppose the price of the item is Rs.100, accompanied by 30 days credit. A discount = 0

of Re.1 is offered if the company pays cash. Therefore the financing cost is Re 1 on Rs.99, for 30 days or approximately 12.12% p.a.. The company has to decide whether to avail of the trade credit or pay cash to the supplier and avail of short term bank financing. The decision will depend on three factors (a) which is cheaper, (b) which gives the company more financial flexibility, and (c) which is more favourable for the companys overall risk profle. As always, it is a tradeoff between risk and return. (iii) Short term bank loans: These are usually second in importance to trade credit as a source of short term financing. Key features of bank loans are the following: (i) Maturity/repayment schedule: The final date of maturity,and whether the principal amount is to be repaid as a lump sum on that date, or in a series of instalments culminating in the final instalment payable on the date, is indicated. (ii) Interest rate (%p.a.) (iii) Promissory note containing the borrowers promise to pay interest, and repay the principal amount as per the terms agreed to. (iv) Description of any collateral that might have to be put up as security for the loan. (v) Any other conditions that might have been agreed to between the lender and the borrower. In addition to charging interest, banks may sometimes require borrowers to maintain an average deposit in their current(checking ) account equal to anywhere upto 20% of the face amount of the loan. Such balances obviously increase the effective interest rate on the loans.These balances are called compensating balances. A line of credit is an informal agreement between a bank and a borrower indicating the maximum amount that the borrower can owe to the bank at any given time. Interest will be charged on the actual amounts outstanding. Amounts once drawn cannot be repaid until the maturity date of the line of credit,usually one year , at which time the entire amount owed has to be repaid. A revolving credit agreement is a formal line of credit. It is a legal commitment to extend credit upto a maximum amount. For the privilege of having this commitment, the borrower pays a commitment fee on the unused portion of the revolving credit,in addition to the interest applicable on the used amount. Amounts repaid can again be redrawn by the borrower, upto the maximum permitted under the revolving credit,and until the date of maturity/expiry of the facility. Revolving credit agreements frequently extend beyond one year, and are consequently sometimes considered intermediate rather than short term borrowings. 50

The cost of bank loans varies for different types of borrowers at any given point in time, and for all borrowers over time. Interest rates are higher for riskier borrowers, and rates are also higher for small loans because of the fixed costs involved in making and servicing loans. Rates also vary widely depending on economic conditions, and on Central bank (Reserve Bank of India) policies. Interest rates on loans are calculated in three ways (a) simple interest, collected on the outstanding loan balance at the end of each period (eg.,quarterly) when interest is due. The simple interest rate eg., 12% p.a is calculated on the outstanding loan say Rs.10,000, for 90 days as follows. Interest due and payable at the end of every 90 day period is !2% x 10,000 x 90/365 =Rs.295.89, if the quarter has 90 calendar days; otherwise, the actual number of calendar days in the quarter will be used in the numerator. (b)Discount Interest which is calculated at the contractual rate say 12% p.a, and deducted in the beginning from the loan of Rs.10,000, so that the actual loan amount available to the borrower is only Rs.10000 (0 .12 x 10000) = Rs.8800, for a period of one year. If the discount loan is for a period of less than one year, its effective annual rate is as follows: Effective annual rate = ( 1.0 + ____Interest_______)m =12/Number of months. Face Value Interest _ 1.0 where m .

For example,if we borrow Rs.10,000 face value at a nominal rate of discount interest of 12% for three months, then m =12/3 =4, and the interest payment is (0.12/4) x 10,000 = Rs.300, so Effective annual rate is ( 1.0 + ______300______)4 _ 1.0 = 0.1296 =12.96% . 10,000 300 . (c) Add-on interest in Instalment loans: This means that the interest is calculated for the total period, say 12 months, and added on to the loan. For example, if it is an instalment loan of Rs.10,000 at 12% p.a for 12 months, the interest of Rs.1200,is added to Rs.10,000, and the borrower has to repay Rs.11,200 in 12 equal monthly instalments. The monthly payment is therefore Rs.933.33. The bank is effectively buying a 12 period annuity of Rs,933.33 for Rs.10,000.So Rs.10,000 is the present value of the annuity. Therefore ,using the formula for annuity,we get the effective rate as 1.788. However this is a monthly rate. The effective annual rate is (1 + kd)12 -1.0 = (1.01788)12 -1.0 = 23.7%p.a. (d) Simple interest with compensating balances: If a firm needs a loan of Rs.10,000, and if the bank stipulates that 20% of the loan amount has to be kept as a compensating balance with it in a current account (i.e., with no interest), then in order to get a loan of Rs.10,000, the firm has to borrow Rs.12500 at the contracted interest rate of 12% p.a., ,pay interest on Rs.12,500 and keep Rs.2500 as a compensating balance

in the current account. Therefore the firm effectively pays (0.12) (12500) = Rs.1500, but the amount received is only Rs.10,000. Therefore effective interest rate = Interest paid ___ = 15% p.a. . Amount received (iv) Commercial Paper: Commercial paper is a type of unsecured promissory note issued by large,

51 strong firms and sold primarily to other business firms, to insurance companies, to pension funds,to money market mutual funds and to banks. This is not in common use in India. The use of commercial paper abroad is restricted to a small number of firms that are exceptionally good credit risks. Maturities of commercial paper vary generally from one to nine months, with an average maturity of 5 months. Commercial paper interest rates are about 2 percentage points below the prime rate of banks. Using commercial paper enables companies to tap a wide range of potential credit sources (investors),and thereby reduce interest costs. A disadvantage here is that there are no personal contacts between borrower and investor, and no long term business relationships get built. A banker who knows a customer well over a long period of time helps the customer weather a temporary downturn,or overcome a short term problem, but no such relationship gets built in a commercial paper market.

52 CHAPTER 8 LONG TERM DEBT INSTRUMENTS Long term debt instruments are of many types: term loans (secured and unsecured), bonds,( secured and unsecured),notes and so on. The following paragraphs discuss the features of some of these instruments. (a) TERM LOANS: A term loan is a contract under which a borrower borrows a lump sum, and agrees to make a series of interest payments and principal repayments on specific dates to the lender. Term loans are usually negotiated directly between the borrowing firm and a financial institution.Although term loan maturities vary from 2 to 30 years,most are for periods in the 3 to 10 year range. Term loans have three major advantages over public offerings speed,flexibility and low issuance costs. Formal documentation is much less than what would be required for a public issue (required to be registered with Securities and Exchange Board). A further advantage is future flexibility; if a bond issue is held by a large number of individuals/institutions, it becomes very difficult,if not impossible to obtain consent to amend the original conditions if required. The interest rate on a term loan can either be fixed for the life of the loan or be variable. If a fixed rate is used, it will generally be set close to the rate of bonds of equivalent maturity and risk. If the rate is variable,it will usually be set at a certain number of percentage points over the banks prime lending rate (PLR), or for international loans in foreign currency at a few basis points ( 100 basis points = 1%) over the London Interbank Offered rate (LIBOR). With increased volatility in the rates at which banks can raise funds, they have become reluctant to lend money long term at fixed rates . (b) BONDS: A bond is a long term contract contract (promissory note) under which a borrower agrees to make payments of interest and principal on specific dates to the holder of the bond. Although bonds have been traditionally issued with maturities of over 15 years, in recent years,shorter maturities such as 7 to 10 years have been used to an increasing extent. Bonds are similar to term loans, but a bond issue is generally advertised,offered to the public and actually sold to many different

investors.With bonds the interest rate is generally fixed,although in recent years,there has been an increase in the various types of floating rate bonds. There are also a number of different types of bonds, the more important of which are discussed below: (i) Mortgage Bonds: Under a mortgage bond the issuing organization pledges certain assets as security for the bond. All mortgage bonds are written subject to an indenture, which is a legal document that spells out in detail the rights of both bondholders and the issuing firm. Indenture provisions include covenants on ratios ( for example levels below which coverage of interest must not fall, Debt/equity ratios, restrictions on issue of certain types of new debt, working capital levels to be maintained etc.). Violation of covenants involves penalties,or declaration of default. (ii) Debentures: A debenture is an unsecured bond, and as such, it provides no lien against specific

53 property as security for the obligation.Debenture holders are therefore general creditors, whose claims are protected only by properties not otherwise pledged specifically to others. Strong companies tend to use debentures, because they simply do not need to put up property as security for debt. (iii) Subordinated debentures: The term subordinate means below or inferior to, and in the event of bankruptcy,subordinated debt has claims on assets only after senior debt has been paid off. Subordinated debentures may be subordinated either to specific senior debt,or to all other debt. In the event of liquidation or reorganization,holders of subordinated debentures cannot be repaid until all senior debtholders ( listed in the debentures indenture), have been repaid. Due to the higher risk they are taking,subordinated debentures carry a significantly higher interest rate ( couponrate) than senior debt. (iv) Convertible bonds: are securities that are convertible into a certain number of shares of common stock at a fixed price, on or after a certain date, at the option of the bondholder. Convertibles have a lower coupon rate than non-convertibles, but they offer investors a chance for capital gains in exchange for the lower coupon rate. Bonds issued with warrants are similar to convertibles. Warrants are options which permit the holder to buy a certain number of shares at a certain price,thereby providing a capital gain if the price rises. Bonds that are issued with warrants, like convertibles carry a lower coupon rate than straight bonds. (v) Putable bonds: are bonds that can be redeemed for cash at the holders option; generally, the put option can be exercised only if the issuer takes some action, such as violating a covenant or condition ,or in the event of being acquired by a weaker company. (vi) Zero coupon bonds: Some bonds pay no interest, but are offered at a substantial discount below their par values, and hence provide capital appreciation, rather than interest income. These are called zero coupon bonds. Such bonds have been issued

by corporations, municipalities and by the U.S.Treasury. (vii) Floating Rate Debt:. Whenever interest rates go up they cause declines in the market prices of long term bonds which have fixed coupon( interest) rates which are below current interest rates .As a result of this loss in value for fixed rate bonds under conditions specified above, many lenders became reluctant to lend money at fixed rates on long term basis, and they would do so only at extraordinarily high interest rates. There is normally a maturity risk premium (See Chapter 2) embodied in long term interest rates; this premium is designed to offset the risk of declining bond prices if interest rates rise. This made long term debt very expensive compared to short term debt. However corporations were reluctant to borrow short term to finance long term assets; such mismatch in maturities is very dangerous. The problem was solved by the introduction of long term floating rate debt. A typical floating rate bond works as follows. The coupon (interest) rate is set for,say, the initial six month period, after which it is adjusted every six months based on some market benchmark rate (prime, LIBOR,etc.). Additional features are added to these issues (based on considerations like the issuers requirements, marketability, etc.) like convertibility to fixed rate, convertibility to common stock, incorporation of caps , collars ( restricting the limits upto which the floating rate can move upward 54 or downwards) etc. (viii) Junk Bonds: Based on their features, specific bond issues are rated for creditworthiness by rating agencies like Moodys Investor Service,and Standard and Poors (S&P) in the U.S.A. and Crisil in India. Above a certain level ( say, BBB of S&P or Baa of Moodys), the issues are called investment grade securities. Below that level they are called non-investment grade or junk bonds. As expected junk bonds carry a high coupon rate of interest. In normal situations a secondary market exists for these securities, but in any kind of financial panic, the secondary market for junk bonds dries up, and they become illiquid. In an unstable market, few investors will be found for these securities.