Financial Management: Introduction, Scope, Functions

Financial Management

1. 22HSM04 ECONOMICS, ACCOUNTING AND FINANCE SRI KRISHNA COLLEGE OF TECHNOLOGY [ An Autonomous Institution | Affiliated to Anna University and Approved by AICTE | Accredited by NAAC with ‘A’ Grade ] KOVAIPUDUR, COIMBATORE – 641 042

2. Introduction of Financial Management Finance Decisions Goals of Financial Management Risk and Return Matrix Time Value of Money: Compounding and Discounting Capital Budgeting Sources of Finance Capital Structure Module 3-Topics Covered Cost of Capital

3. Economists believed that assets’ (Machineries, Buildings) values are based on future cash flows they generate. Accountants provided the information about the likely size of cash flows. Finance as stream lies between Economics and Accounting Finance Vs Economics and Accounting

4. Introduction- What is Financial Management Primary objective or goal of any business is to make profits. Each and every business always deals in large amounts of money. Finance and financial management play a crucial role in the successful and smooth functioning of any business. Good financial management practices in an organization can prove to be the difference between success and failure for any business. Concerned with the acquisition, financing, and management of assets with some overall goal in mind. Art and science of managing money. Process of procuring and judicious use of resources with a view to maximize the value of the firm. Means planning, organizing, directing and controlling the financial activities such as procurement and utilization of funds of the enterprise.

5. The Goals of Financial Management The goal of financial management is to enrich the shareholders by maximizing their wealth. Shareholders’ wealth means returns to shareholders i.e. the owners of the business. Returns to shareholders can be in recurring form i.e. dividends; and in the form of capital appreciation of their investments. The goals of a firm can be (a) Maximization of profit (b) Minimization of Cost ( c ) Maximization market share (d) Maximization of current value of the company’s stock (e) recurring form i.e. dividends; (f)in the form of capital appreciation of their investments.

6. The Objectives of Financial Management The goal of financial management is to enrich the shareholders by maximizing their wealth. Shareholders’ wealth means returns to shareholders i.e. the owners of the business. Returns to shareholders can be in recurring form i.e. dividends; and in the form of capital appreciation of their investments. To ensure an adequate supply of funds steadily To ensure efficient utilisation of funds To guarantee adequate returns to the investors and thus provide security to their investments To establish solid financial leverage

7. Functions of Financial Management Estimation of capital requirements Determination of capital composition Choice of sources of funds Investment of funds Disposal of surplus Management of cash Financial controls

8. Financial Decisions INVESTMENT DECISIONS FINANCING DECISIONS LIQUIDITY/ WORKING CAPITAL DECISIONS DIVIDEND DECISIONS RISK AND RETURN DECISION Short-term financial decisions are concerned with the firm's day-to-day capital requirements or working capital management decisions which impact the firm's liquidity and profitability. Long-term financial decisions , on the other hand, are concerned with financing the enterprise, investing funds, and managing earnings.

9. Includes investment in fixed or long-term assets ( capital budgeting decisions) and investment in current assets or short-term assets ( working capital decisions). Thus two major elements of investment decisions are liquidity and capital budgeting . Capital budgeting is dedication and allocation of funds to long-term investments that will generate earnings in the future. Future cash flows, profits, investment criteria are the influencing factors for investment decisions. Financial Decisions -Investment Decisions

10. Concerned about acquiring the funds from different sources. The finance mix-borrowing funds (Debt) and Equity funds (Equity) to be decided. Optimal combination of financing structure to be designed. The balance of debt and equity must be maintained in order to generate a sufficient return on equity with the least amount of risk. Cash flow position, cost of acquiring the funds, risk element, Market conditions influence financing decisions of firms. Financial Decisions -Financing Decisions

11. Well-thought-out dividend policy is essential to maximise firm’s wealth. Firm’s management team needs to select between the two alternatives (a) Distribute all profits to shareholders or not. (b) Keep a portion of profits and disseminate the remainder as dividends. Profitability and Growth, Taxation Policy of country on dividend earnings, Preference of share holders are the factors influencing the dividend decisions. Financial Decisions -Dividend Decisions

12. Decisions about Current Assets and Current Liabilities have to be made carefully to mange the working capital requirements well. Current Assets Cash Bills Receivable Inventory Short-term securities , and so on. Current liabilities Creditors Bills payable Outstanding expenses, Bank overdrafts, and so on. Factors like Scale of Operation, Operating Effectiveness, Seasonality of products and services influence the working capital decisions. Financial Decisions -Working Capital Decisions

13. Risk-Return Matrix   Risk Annual Return

14. Risk-Return Matrix   Risk is the probability that the actual returns on investments are different compared to expectations and measured by standard deviation in statistics. Simply, risk means that there is a probability of losing some, or even all, of your initial investment. The risk-adjusted return  measures the profit the investment has made relative to the amount of risk . If two or more investments delivered the same return over a given time period, the one that has the lowest risk will have a better risk-adjusted return.

15. Problem 1 Suppose 100 shares of the company are bought at the beginning of the year and at a market price of Rs 225. The par value of each share is Rs 10. During the year, company paid a dividend at 25 per cent on the par value of the share. The dividend per share would be: Rs 10 × 25% = Rs 2.50. Calculate the rate of return if the price of the share at the end of the year turns out to be Rs.267.50 . Risk and Return -Problems

16. 1.Total investment Rs 225 × 100 = Rs 22,500 2. Dividend Dividend per share × Number of shares Dividend = Rs.2.50 × 100 = Rs.250 3.Capital gain Capital gain/loss = (Selling price – Buying price) × Number of shares Capital gain/loss = (267.50 – 225) × 100 = Rs.4,250 4. Total return = Dividend + Capital gain = 250 + 4,250 = Rs. 4,500 5. Percentage returns Return in percentage = 4,500 /22,500 = 0.20 or 20% Thus, Returns from each share have two components: (a) The dividend income (b) the capital gain. Risk and Return - Problems

17. Standard deviation ( σ ) is the square root of the variance. Variance is the square of Standard deviation ( σ 2 )  Risk and Return - Problems Formula for Standard deviation

18. Problem Rates of Returns Under Various Economic Conditions Suppose one share of India Cements is bought at current market price of Rs.261.25 today and if the company pays a dividend of Rs.2.50 per share.. What is expected rate of return, if the share is held for one year? The outcomes may depend on the economic conditions, the performance of the company and other factors. The outcomes of dividend and the share price under possible economic scenarios are given to arrive at a judgment about the expected return Risk and Return - Problems

19. Risk and Return - Problems

20. Formula for finding Expected Rate of Return Expected rate of return = rate of return under scenario 1 × probability of scenario 1 + rate of return under scenario 2 × probability of scenario 2 +… + rate of return under scenario n × probability of scenario Risk and Return - Problems

21. The expected rate of return is the average return. It is 6 per cent in our example. We know that the possible outcomes range between –6 per cent to +18.5 per cent. How much is the average dispersion? Risk and Return - Problems

22. The following formula can be used to calculate the variance of returns: Risk and Return - Problems

23. Identify these persons

24. Identify these persons Nirmala Sitharaman Minister of Corporate Affairs of India K. V. Kamath Chairman of the board of directors of Jio Financial Services Deepak Parekh Indian businessman Arundhati Bhattacharya, Indian author Chairperson and Chief Executive Officer for Salesforce Warren Buffett Chairperson of Berkshire Hathaway

25. Most financial decisions, such as the purchase of assets or procurement of funds, affect the firm’s cash flows in different time periods. The recognition of the time value of money and risk is extremely vital in financial decision-making. If the timing and risk of cash flows is not considered, the firm may fail to maximize the owners’ welfare. The welfare of owners would be maximized when wealth or net present value (will be discussed later) is created from making a financial decision. Time Value of Money Comparison of cash flows from different time periods is possible if we convert them to common point in time

26. Time Value of Money- Future value of Single Cash Flow Future Value of a Single Cash Flow- Example Suppose your father gave you Rs.100 on your Twentieth birthday. You deposited this amount in a bank at 10 per cent rate of interest for one year. How much future sum or value would you receive after one year? You would receive Rs.110: Future value = Principal + Interest on Principal = 100 + (0.10 × 100) = 100 + (10) = Rs.110 What would be the future value if you deposited Rs.100 for two years? You would now receive interest on interest earned after one year: Future value = [100 + (0.10 × 100) + 0.10[100 + (0.10 × 100)] = 100 × 1.10 × 1.10 = Rs.121

27. Time Value of Money- Future Value of Lump sum Future Value of Lump sum- Example Suppose that Rs.1,000 are placed in the savings account of a bank at 5 per cent interest rate. How much shall it grow at the end of three years? The compound value can be computed for any lump sum amount at i rate of interest for n number of years, using the above equation .

28. Time Value of Money- Future Value of Lump sum

29. Future Value of an Annuity Annuity is a fixed amount (payment or receipt) each year for a specified number of years. If a flat is rented and it is promised to make a series of payments over an agreed period, an annuity is created. The equal-installment loans from the house financing companies or employers are common examples of annuities. The formula used to calculate the future value of annuity is given below. Time Value of Money- Future Value of Annuity Problem : Mr.X deposits Rs.2000 at the end of every 5 years in his savings account which pays him 5% interest compounded annually. He wants to determine how much sum of money he would receive at the end of 5 th year.

30. Time Value of Money- Present Value of Single Cash Flow Present Value (PV) is the current value of a future sum of money or stream of cash flows given a specified  rate of return . Future cash flows are discounted at the discount rate, and the higher the discount rate, the lower the present value of the future cash flows. Present value states that an amount of money today is worth more than the same amount in the future. Unspent money today could lose value in the future due to inflation or the rate of return if the money was invested. The following formula is used to calculate the PV of expected future sum, if it a single cash flow

31. Problem: Mr.X has been given an opportunity to receive Rs.1060 one year from now. He knows that he can earn 6% interest on his investments. What amount will he be prepared to invest for this opportunity. We need to determine how much rupees must be invested at 6% today. Substituting the values in the given formula P= 1060/1.06 PV = Rs.1000 Time Value of Money- Present Value of Single Cash Flow

32. Consider that an investor has an opportunity of receiving Rs.1,000, Rs.1,500, Rs.800, Rs.1,100 and Rs.400 respectively at the end of one through five years. Find out the present value of this stream of uneven cash flows, if the investor’s required interest rate is 8 per cent . Time Value of Money- Present Value of uneven cash Flow

33. Time Value of Money- Present Value of Annuity Problem Mr.X wishes to determine the present value of annuity consisting of cash inflows of Rs.1000 per year for 5 years. The rate of interest he can earn from his investment is 10%. Referring the table for PV of Annuity we get the PV for Interest Facto (10%) as 3.791. So, Rs.1000 X 3.791 PV value of Annuity= Rs.3791

34. Capital Budgeting or investment decisions

35. Capital Budgeting or Investment Decisions- Introduction Capital is the money available for a business to manage the day to day operations and also to fund its future growth. Generally, firms have working capital, equity capital and debt capital. Working capital is needed to pay for daily operations of the firms. Equity capital is sourced/collected from all the shareholders in exchange for a portion of ownership. Debt capital is borrowed by firms in the form of loans and bonds which has to be repaid later with interests . The firm’s investment decisions would generally include expansion, acquisition, modernization and replacement of the long-term assets and they have to be made so as to maximise the shareholder’s wealth.

36. Example Consider a person who has Rs.100,000,00 has two options to invest in Project A or Project B. If he/she chooses Project A which is expected to provide cash flows (returns) at 10% of the investments at the end of year. At the same time, if Project B is expected to provide 12% of returns, the person is losing the opportunity of earning the 12% returns on his/her investment. Hence, the opportunity cost is the cost of forgone benefits while selecting between two different competing areas of investments. Capital Budgeting or Investment Decisions- Understanding Opportunity Cost

37. Opportunity cost is the potential benefits that are lost when an individual, business or investor chooses a substitute over another. Opportunity cost of capital is the rate of return that is earned by investing in the best alternative project/investment area available. Represents alternate uses of money. Helps business firms to take more informed decisions. Capital Budgeting or Investment Decisions- Understanding Opportunity Cost of Capital

38. The exchange of current funds for future benefits. The funds are invested in long-term assets. The future benefits will occur to the firm over a series of years. Appraisal techniques (based on discounted and non-discounted flow criteria) are used to measure the economic worth of an investment project. Profitability of an investment project is determined by evaluating its cash flows. Capital Budgeting or Investment Decisions- Features

39. Steps Estimation of cash flows Estimation of the required rate of return (the opportunity cost of capital) Application of a decision rule for making the choice Capital Budgeting or Investment Decisions-Steps in Investment Evaluation Criteria & Decision Rules Decision Rules Apart from maximizing the shareholders’ wealth, the following have to be considered. All cash flows- to determine the true profitability of the project and ranking of projects accordingly. Bigger and Earlier Cash flows are preferred than smaller ones and later cash flows respectively. The methods used should be able to separate good projects from bad projects.

40. Capital Budgeting or Investment Decisions-Investment Evaluation Criteria

41. What is Net Present Value (NPV)? Net Present Value (NPV) is the value of all future cash flows (positive and negative) over the entire life of an investment discounted to the present.  Why is Net Present Value (NPV) Analysis Used? NPV analysis is used to help determine how much an investment, project, or any series of cash flows is worth. Capital Budgeting or Investment Decisions-Investment Evaluation Criteria, Net Present Value (NPV)

42. Capital Budgeting or Investment Decisions-Investment Evaluation Criteria, Net Present Value (NPV), Formula NPV = sum of the present value of expected cash flows - initial investment C 1 , C 2 are net cash flows in year 1, 2 k = opportunity cost of capital C = Initial cost of Investment n = expected life of investment/project

43. Acceptance Rule Accept the project when NPV is positive, NPV > 0 Reject the project when NPV is negative, NPV < 0 May accept the project when NPV is zero, NPV = 0 Accept the investment project if its NPV > 0 and reject it if NPV < 0. Shareholders’ wealth and in turn the price of the firm’s share would be increased when there is positive NPV Positive NPV is possible only if the project generates cash inflows at a rate higher than the opportunity cost of capital Capital Budgeting or Investment Decisions-Investment Evaluation Criteria, Net Present Value (NPV)

44. Problem 1 Calculate the net present value for a small-sized project requiring an initial investment of Rs. 20000, which provides a net cash inflow of Rs. 6000 each year for six years. Assume the cost of funds to be 8% per annum. Capital Budgeting or Investment Decisions-Investment Evaluation Criteria, Net Present Value (NPV), Problems Given Data Rs. 6,000= Cash flows 8% or .08 = opportunity cost of capital Rs. 20,000 = Initial cost of Investment 6 = expected life of investment/project

45. Capital Budgeting or Investment Decisions-Investment Evaluation Criteria, Net Present Value (NPV), Problems Decision : Investment in the Project can be proceeded as the NPV is positive. Year Cash Flows (Rs.) Present Value @ 8% Present Value of Cash flows 1 6000 0.926 5556 2 6000 0.857 5142 3 6000 0.794 4764 4 6000 0.735 4410 5 6000 0.681 4086 6 6000 0.630 3780 PV of Cash inflow 27738 PV of Cash outflow 20000 Net Present Value (NPV) 7738

46. Do It Yourself (DIY) Calculate NPV for the following project. An outflow of Rs7000 followed by inflows of Rs.3000, Rs.2,500 and Rs.3,500 at one-year interval at a cost of capital of 7%. Calculate NPV for the following project. A cash flow of initial outlay of Rs.35,400 followed by inflows of Rs.6,500 for three years and then a single cash inflow of Rs.18,000 at the fourth year and at a cost of capital 9%. Capital Budgeting or Investment Decisions-Investment Evaluation Criteria, Net Present Value (NPV), Problems

47. IRR (denoted as r) is another discounted cash flow technique, which takes account of the magnitude and timing of cash flows. ”k” is also called as required rate of return. The Internal Rate of Return (IRR) is  the discount rate that makes the net present value (NPV) of a project zero. Acceptance Rule Accept the project if its internal rate of return(r) is higher than the opportunity cost of capital or required rate of return(r > k) Reject the project when r < k May accept the project when r =k Capital Budgeting or Investment Decisions-Investment Evaluation Criteria, Internal Rate of Return (IRR)

48. It is the ratio of the present value of cash inflows, at the required rate of return, to the initial cash outflow of the investment. The formula for calculating benefit-cost ratio or profitability index (PI) is as follows Capital Budgeting or Investment Decisions-Investment Evaluation Criteria, Profitability Index

49. Acceptance Rule Accept the project when PI is greater than one PI > 1 Reject the project when PI is less than one PI < 1 May accept the project when PI is equal to one PI = 1 The project with positive NPV will have PI greater than one. PI less than one means that the project’s NPV is negative. Capital Budgeting or Investment Decisions-Investment Evaluation Criteria, Profitability Index(PI) In the already discussed problem the PI is 1.34 and as per the acceptance rule the PI is > 1 hence the project is accepted

50. Payback is the number of years required to recover the original cash outlay invested in a project. If the project generates constant annual cash inflows, the payback period(PB) can be computed by dividing cash outlay by the annual cash inflow. The formula is given below Capital Budgeting or Investment Decisions-Investment Evaluation Criteria, Pay back Period In the already discussed problem the PB is calculated and it is found to be 3.3 years, that is, the initial investment can be recovered during 3.3 years.

51. Problem The annual cash flows of a project is given below. If the initial investment is Rs.80,000, calculate the when the firm would be able to recover the initial investment. Capital Budgeting or Investment Decisions-Investment Evaluation Criteria, Pay back Period, Problem Decision :The project would be accepted if its payback period is less than the maximum or standard payback period set by management Year Cash flow (Rs.) 1 14000 2 16000 3 18000 4 20000 5 25000 Year Cash flow (Rs.) Cummulative Cash Flow (Rs.) 1 14000 14000 2 16000 30000 3 18000 48000 4 20000 68000 5 25000   Pay back Period = 4 year + ( 12000/25000) X 12 = 4 year + 0.48 X 12 = 4 year 6 months

52. It is also known as the return on investment (ROI), uses accounting information, as revealed by financial statements, to measure the profitability of an investment. It is the ratio of the average after tax profit divided by the average investment. ARR is calculated using the below-mentioned formula. Capital Budgeting or Investment Decisions-Investment Evaluation Criteria, Average Rate of Return (ARR)

53. Know our Indian Financial System Non Banking Financial Institutions (NBFCs) function like a company without a banking license and does not accept demand deposits Financial Institutions

54. Sources of Finance

55. Sources of Finance- Classification

56. Sources of Short Term Finance ( i ) Trade credit - Firm pays the supplier after a certain agreed period of time. (ii) Factoring - accounts receivables(invoices) are sold to a third party to meet short-term liquidity needs. (iii) Commercial papers - an unsecured, short period debt tool issued by a company, usually for financing inventories and temporary liabilities. (iv) Short term loans from banks Sources of Finance- Short & Long Term Sources of Long Term Finance ( i ) Equity Shares- represents the shareholders’ stake in the company . (ii) Retained earnings- amount of profit a company has after paying all its direct costs, indirect costs, income taxes and its dividends to shareholders.  (iii) Preference shares - Raised from different set of shareholders. This option enables shareholders to receive dividends announced by the company before the equity shareholders. (iv) Debentures - debt instrument that may or may not be secured by any collateral. (v) Loans from banks and other financial institutions

57. Source of Finance-Understanding Debt A debt is the sum of money that is borrowed by an individual or corporate firm for a certain period of time and has to be returned along with the interest. Some of them are: Loans, Mortgages, Credit Card, Personal Loans. Secured Debt : Borrowed amount is secured and backed by the collaterals such as assets and properties of a value good enough to cover the debt. Unsecured Debt : Unsecured debts are not covered by any collateral as a security. Such debts are facilitated only on the basis of the borrower's creditworthiness; hence do not involve any collateral assignment. Mortgage is another form of debt that is often used to buy real estate, such as homes. This is more like a secured debt covered by the subject of real estate. Corporate debt is borrowed for business purposes and the most common instrument is a Bond . A company can raise funds by selling bonds by paying certain rate of interest throughout the investment period, along with the repayment of the face value on the decided maturity date of the bond. Commercial paper is another short term debt instrument.

58. Equity represents the shareholders’ stake in the company and each of them have their rights for their share of profits (dividends) according to the percentage of shares held by them. Also, represents the value that would be returned to a company’s shareholders if all of the assets were liquidated and all of the company's debts were paid off. Shareholders’ Equity=Total Assets−Total Liabilities Sources of Finance-Understanding Equity

59. Venture Capital (VC) financing is a form of private equity and a type of financing that investors provide to startup companies and small businesses that are believed to have long-term growth potential. Egs -Electric Vehicle Manufacturing Companies, Food Processing Industries, Healthcare Services  Sources of Finance-Other forms of Financing (Venture Capital, Crowd Funding) Crowd funding is the use of small amounts of capital from a large number of individuals to finance a new business venture. It makes use of the easy accessibility of vast networks of people through social media . The difference between VC and crowd funding is that crowd funding can be obtained for start up at any stage, where as VC can be received only during the early stage of start up venture.

60. Debenture or Bond Holders Preferred stock holders Common stock holders Sources of finance- Claims on the Revenues/ Profits of the firm

61. Know our Indian Financial System Organisations raise capital for the first time from common public by listing themselves on Primary Markets through Initial Public Offering (IPO) Financial Markets

62. COST OF CAPITAL

63. It is the price of obtaining capital from different sources and also minimum return required by the suppliers (Banks, Investors) of capital required by the firms. It is a compensation for time and risk. Two major sources of capital can be broadly classified into debt and equity . The cost of capital of each source of capital is known as component , or specific, cost of capital. The combined cost of all sources of capital is called overall , or average cost of capital . The component costs are combined according to the weight of each component. Thus, the overall cost is called the weighted average cost of capital (WACC) A company's investment decisions for new projects should always generate a return that exceeds the firm's cost of the capital used to finance the project. Cost of Capital-Concepts

64. Cost of Capital-Cost of Debt Cost of Debt is denoted by symbol k d and also called as Debt capitalisation rate

65. Cost of Capital-Cost of Debt, Problems The Ess Kay Refrigerator Company is deciding to issue Rs.2,000,000 of Rs.1,000, 14 %, 7 year debentures. The debentures will have to be sold at a discount rate of 3 per cent. Further, the firm will pay an underwriting fee of 3 per cent of the face value. Assume a 35 per cent tax rate. Calculate the after-tax cost of the issue. What would be the after-tax cost if the debenture were sold at a premium of Rs.30 Given Data : Debt Capital: Rs.20,00,000 Face Value : Rs.1000 Interest: 14% No.of Years: 7 Discount rate: 30 (3% on 1000) Underwriting Fee: Rs.30 ( 3% on 1000) Tax:35% 2000000/1000=2000 debentures Discount = 30X2000 Rs.60000 Underwriting Fee = 30 X 2000 Rs.60000

66. Debt Capital Received = (2000000 – 60000-60000) Rs.18,80,000 Interest Expenses = 14% (2000000) =Rs.2,80,000 Using the following formula the cost of debt is calculated. Cost of Capital-Cost of Debt, Problems k d : Before-tax cost of debt, i : Coupon rate of interest, B : Issue price of the bond (debt) F : Face Value, INT: Amount of interest. Substituting the values in the above equation we get k d =15.31 The after tax cost of debt would be = 15.31 X (1-.35) = 9.95%

67. It is slightly difficult to arrive at the cost of equity compared to the cost of debt-Interest payments and return of the principal are contractual obligations for debt. As maximising share holder’s wealth is one of the main objectives of financial management, the same needs to be achieved- This affects the market value of shares. So, shareholders expect certain rate of returns on their investments and not all of them have same expectations. Thus, Cost of equity capital (k e ) is the minimum rate of return a firm must earn on their equity shareholders’ investment. It is also called as Equity capitalisation rate. Cost of Capital-Cost of Equity

68. Cost of Capital-Cost of Equity, Two Approaches for measurement, Dividend valuation Approach, Determining “k e ” The concept of Time value of Money is applied here

69. Dividend Valuation approach Cost of equity is calculated on the basis of required rate of returns- Future dividends to be paid to shareholders. It is the discount rate which equates all expected future dividends per share with the current market price of the share. Cost of Capital-Cost of Equity, Two Approaches for measurement k e is cost of Equity D 1 is expected dividend per share P is market price of the share or net proceeds from sale of share g is growth in expected dividends

70. Problem 1: Mr.X has to decide regarding whether he should invest in equity share of “XYZ Limited”. He expects the Market Price to be is Rs.300 and a dividend of Rs.45 after an year. Also, he expects 25% rate of return per annum. Determine the current equity price. Cost of Capital-Cost of Equity, Two Approaches for measurement, Example Problem

71. Problem 2 : Suppose the dividend per share of a firm is expected to be Re.1 per share next year and it is expected to grow at 6% perpetually. If the market price is Rs.25, determine the equity cost of capital. Substituting the values in the above equation, we get 10 % as the cost of equity capital. Cost of Capital-Cost of Equity, Two Approaches for measurement, Example Problem + 0.06 The dividend valuation approach helps to find out the expected market price of the share. In the above example, the market price of the share by the first year and second year end would be (P 1 and P 2 are the market prices at the year end 1 and 2. = Rs.26.50 = Rs.28

72. Do It Yourself (DIY) : XYZ limited is consistently growing in terms of its share price and the dividends. This growth rate is 10% per annum. The current price is Rs.200. Rs.36 is expected to be declared as dividend. Calculate the expected rate of return of the shareholder using dividend valuation model. Cost of Capital-Cost of Equity, Two Approaches for measurement, Example Problem

73. (b) Capital Asset Pricing Model Approach Describes the risk- return trade off for securities. This approach models the asset’s sensitivity to market risk, Expected Return from the market and also expected return from risk free asset. Cost of Capital-Cost of Equity, Two Approaches for measurement k e = Cost of Equity Capital; R f = Required rate of return on risk free asset, is the interest earned on more secured assets like government bonds. R m = Required rate of return on the market portfolio; β = Systematic risk, is the percentage change in a security’s return for one percentage change in the market return. Cost of equity capital = Risk free return + Premium for risk When β is 1 asset or security is as riskier as market When β is less than 1 asset or security is less riskier compared to market When β is more than 1 asset or security is more riskier compared to market

74. Problem : The following particulars relate to A Ltd. 1. Risk free return is 10 %; 2. Beta co-efficient (beta) of “A” is 1.5 Compute the (a) cost of equity capital using Capital Asset Pricing Model (CAPM) if the expected market return is 14 %. (b) Also calculate the cost of equity if beta raises to 2. (a)Cost of equity capital = Risk free return + Premium for risk k e = Risk free return + (market return – Risk free return) k e = 10 + 1.5 (14 – 10) k e = 10 + 1.5 (4) = 16 % (b) Cost of equity capital, if beta increases to 2 Cost of equity capital k e = 10 + 2 (14 – 10) k e = 10 + 2 (4) = 18 % Cost of Capital-Cost of Equity, Two Approaches for measurement, Example Problem

75. It is the amount of money the company pays out in a year divided by the lump sum they got from issuing the stock. The cost of preferred stock to a company is effectively the price it pays in return for the income it gets from issuing and selling the stock. Cost of Capital- Cost of Preferred Stock = k p = Cost of Preferred Capital; D =Dividend P = Current Market Price

76. A company has preferred stock that has an annual dividend of $3. If the current share price is $25, what is the cost of preferred stock? Given Data: D= $3 P = $25 Substituting the values in the formula 3/25 x 100 = 12% k p = 12% Cost of Capital- Cost of Preferred Stock, Example

77. WACC - Weighted average cost of capital (WACC) represents a firm’s average after-tax cost of capital from all sources, including common stock, preferred stock, bonds, and other forms of debt. WACC is the average rate that a company expects to pay to finance its assets. Cost of Capital- Weighted Average Cost of Capital (WACC) X ( 1-Tc) E = Market value of the Equity D = Market Value of the Debt Tc = Corporate Tax Rate K e = Cost of Equity K d = Cost of Debt

78. EPS can be defined as the company's profit allocated to each outstanding equity share. For instance, a company that earned Rs.10 crore last year and has 1 crore shares outstanding (with a face value of Rs.10 each) will report a EPS of Rs.10 (Rs. 10 Cr/Re.1 Cr). The profits that are used to calculate EPS are the profits that are left after paying interest to debt holders, taxes and dividend on preference shares. EPS is considered to be a key figure in evaluating a share's outlook. The Concept of Earnings per Share (EPS)

79. Capital Structure

80. Capital structure is the particular combination of debt and equity used by a company to finance its overall operations and growth. Equity capital arises from owners who held the shares of a company, who have their claims for future cash flows and profits. Debt capital comes in the form of bond issues or loans. A firm that finances its assets by equity and debt is called a levered firm (geared firm). On the other hand, a firm that uses no debt and finances its assets entirely by equity is called an unlevered firm (ungeared firm). Capital Structure

81. Capital Structure-Understanding Operating Leverage Leverage is a company’s capacity to utilise new resources or assets to make better returns or to diminish costs. The concept can be understood with an example given here

82. Capital Structure theories and certain assumptions Assumptions Firms have perpetual life. Business risk is constant over time. Firm’s total financing remains constant. Only 2 kinds of funds used by firms-Debt & Equity Total Assets are given Taxes are not considered Dividend Pay out ratio is 100% Theories explain the relationship between Cost of Capital ( CoC ), Capital Structure and the Value of the firm.

83. According to NI approach the value of the firm is calculated as Value of the Firm (V) = E + D E= Market value of Equity ; D = Market value of Debt (a) Value of Equity = Discounted value of net income (b) Value of debt = Discounted value of interest   Capital Structure theories – Net Income (NI) Approach

84. Capital Structure theories – Net Operating Income Approach This approach believes the decisions about capital structure are irrelevant as overall cost of capital (k o ) is independent of degree of leverage. Cost of debt (k d ) is comparatively cheaper and increase in use of debt ( cost of debt) would be offset by increase in cost of equity (k e ) as equity shareholders expect higher returns because of higher risk they take.

85. This approach provides behavioural justification for constant overall cost of capital which NOI approach fail to provide Capital Structure theories – Modigliani - Miller Approach Assumptions All investors are rational. There are no corporate tax. Capital Markets are perfect, that is, all information are freely available. Firms can be grouped into” Equivalent Risk Classes” based on their business risk.

86. Banking Professional Advisory Wealth Management Mutual Funds Insurance Stock Market Treasury/Debt Instruments Tax/Audit Consulting Capital Restructuring Portfolio Management Know our Indian Financial System Financial Services

87. Wishing you all a wonderful learning and successful Career ahead. BEST OF LUCK!