8872 Defin542 Corporate Finance

Corporate Finance
DEFIN542
Edited by:
Dr. Nitin Gupta
Corporate Finance
Edited By
Dr. Nitin Gupta
CONTENTS
Unit 1: Financial Management 1

Dr. Atif Ghayas, Lovely Professional University
Unit 2: Sources of Finance 15
Unit 3: Money Market Instruments 31
Unit 4: Time Value of Money Concept 47
Unit 5: Investment Decisions - 1 65
Unit 6: Investment Decisions -2 78
Unit 7: Cost of Capital 104
Unit 8: Financing Decisions 122
Unit 9: EBIT - EPS Analysis 142
Unit 10: Dividend Decisions 163
Unit 11: Forms of Dividend 186
Unit 12: Working Capital Management 198
Unit 13: Corporate Governance
228
Unit 14: Economic outlook and Business Valuation
255
Notes
Dr. Atif Ghayas, Lovely Professional University Unit 01: Financial Management
Unit 01: Financial Management

CONTENTS
Objectives
Introduction
1.1 Classification of finance
1.2 Corporate Finance
1.3 Evolution of finance
1.4 Finance Functions
1.5 Role of a finance manager
1.6 The Basic Goal: Creating Shareholder Value
1.7 Organization of Finance Functions
1.8 Agency issues
1.9 Business ethics and social responsibility
Summary
Keywords
Self-Assessment
Answers for Self Assessment
Review Questions
Further Readings
Objectives
After studying this unit, you will be able to:
 Understand the meaning of Corporate Finance

 Understand the evolution of Finance
 Understand the finance functions
 Outline the role of a finance manager
 Analyse the basic goal of a firm
 Understand the Agency problem in business
 Understand the concept of Business ethics
 Explain the concept of Social Responsibility
Introduction
Finance reference to the Management of large amounts of money, especially by governments or
large companies. It may also mean providing funding for a person or an enterprise. The term
Finance is derived from a French wordfinance,meaning an end, settlement, or retribution. It is used
in the context of ending or settling a debt or a dispute. After adapting to English, the word is used
to define any type of management of money.
1.1 Classification of finance

The discipline of Finance can be categorized into three parts:
Public Finance
Lovely Professional University 1

Notes
Corporate Finance
This type of finance is related to states, municipalities, provinces in short government required
finances. It includes long term investment decisions related to public entities. Public finance takes
factors like distribution of income, resource allocation, economic stability in consideration. Funds
are obtained majorly from taxes, borrowing from banks or insurance companies.
Corporate Finance
Corporate Finance is about funding the company expenses and building the capital structure of the
company. It deals with the source of funds and the channelization of those funds like the allocation
of funds for resources and increasing the value of the company by improving the financial position.
Corporate finance focuses on maintaining a balance between the risk and opportunities and
increasing the asset value.
Personal Finance
Personal Finance is managing the finance or funds of an individual and helping them achieve the
desired goals in terms of savings and investments. Personal Finance is specific to individuals and
the strategies depend on the individuals earning potential, requirements, goals, time frame, etc.
Personal finance includes investment in education, assets like real estate, cars, life insurance
policies, medical and other insurance, saving and expense management.
1.2 Corporate Finance

Imagine that you are planning to start your own business, you would have to answer three
questions: What long-term investments should you take on? Where will you get the long-term
financing to pay for your investment?How will you manage your everyday financial
activities?Corporate finance is all about thestudy to answer these questions
Corporate finance deals with the capital structure of a corporation, including its funding and the
actions that management takes to increase the value of the company. Corporate finance also
includes the tools and analysis utilized to prioritize and distribute financial resources.
The ultimate purpose of corporate finance is to maximize the value of a business through planning
and implementation of resources, while balancing risk and profitability.
“Corporate Finance is concerned with the efficient use of an important economic resource, namely
capital funds” - Solomon Ezra & J. John Pringle.
“Corporate Finance is the operational activity of a business that is responsible for obtaining and
effectively utilizing the funds necessary for efficient business operations”- J.L. Massie.
The three Important Activities that Govern Corporate Finance:
1. Investments & Capital Budgeting

2. Capital Financing
3. Dividends and Return of Capital
1.3 Evolution of finance

The stages in the evolution of finance discipline can be categorized into three phases:
Traditional Phase Transitional Phase Modern Phase
2 Lovely Professional University

Notes

Finance, as capital, was part of the economics discipline for a long time. So, financial management
until the beginning of the 20th century was not considered as a separate entity and was very much
a part of economics
Traditional phase:
This phase started from 1920 and lasted till 1940. During this phase focus was mainly on below
aspects:
 Arranging, formation, issuance of funds.

 Business expansion, merger, reorganization, and liquidation during the life cycle of the
firm.
 The instruments of financing, the institutions and procedures used in capital markets, and
the legal aspects of financial events.
Transitional phase
This phase started from early 1940 and lasted till early 1950. During this phase focus was mainly on
below aspects:
 Nature of financial management was similar to same as Traditional phase.

 But more emphasis was put on financial problems faced by managers in day-to-day
operations hence leading to increased focus on working capital management.
Modern Phase
This phase started in middle of 1950 and has witnessed an accelerated pace of development with
the infusion of ideas from economic theories and applications of quantitative methods of analysis.
During this phase focus was mainly on below aspects:
 The scope of financial management got broadened.

 A well-managed Finance department came into existence.
 Role of Financial manager got defined, which include acquisition of funds required in the
business at the least possible cost, investing the funds obtained in an optimum manner so
as to maximize returns and taking decisions relating to distribution of profits i.e., deciding
the dividend policy and retention of profits.
1.4 Finance Functions

Finance function is the most important function of a business. Finance is closely connected with
production, marketing and other activities. In the absence of finance, all these activities come to a
halt. In fact, only with finance, a business activity can be commenced, continued and expanded.
Finance functions or decisions are divided into long-term and short-term decisions:
Long-term financial decisions can be further classified into three categories:
Long-term Financial
Decisions
Investment Decision Financing Decision Dividend Decision

Notes
Corporate Finance
Investment Decisions:
Investment decision deals with the decisions related to the allocation of capital to long-term assets
that would yield benefits in the future like Plant and machinery, Building etc. This decisionrelated
to allocation of capital or commitment of funds to long-term assets that would generate cash flows
in the future. It involves the evaluation of the prospective profitability of new investments.The
Future benefits of investments are difficult to predict with certainty. The Risk in investment arises
because of the uncertain returns. Hence, investment proposals should, therefore, be evaluated in
terms of both expected return and risk and while, making these kinds of decisions, the financial
manager must weigh the costs and benefits of each investment.
Financing Decisions:
Financing decisions are other important decisions to be made by the finance manager of firm, these
decisions essentially relate with the arrangement of funds to fulfil the requirements of the firm.
These decisions answer the question: from where and how to acquire funds to meet the Firm’s
Investment needs. The Financial Manager must decide whether to raise more money by equity or
debt or by a combination of these finance sources. Use of each type of finance has certain costs and
benefits attached with it. The main concern while selecting the finance source is its cost to the firm.
Firm should select an optimum capital structure, it’s the capital structure at which the cost of the
capital is lowest for the firm.
Dividend Decisions:
These decisions are related to the distribution of earnings. The financial manager must decide
whether the firm should distribute all profits, or retain them, or distribute a portion and retain the
balance. The proportion of profits distributed as dividends is called the dividend-payout ratio and
the retained portion of profits is known as the retention ratio. Like the debt policy, the dividend
policy should be determined in terms of its impact on the shareholders’ value. The optimum
dividend policy is one that maximizes the market value of the firm’s shares.The financial manager
should also answer the questions of dividend stability, bonus shares and cash dividends in practice.
Short-term Financial Decision: Liquidity Decision

Management of current assets that affects a firm’s liquidity is yet another important finance
function. Investment in current assets affects the firm’s profitability and liquidity. Current assets
should be managed efficiently for safeguarding the firm against the risk of illiquidity. A trade-off
exists between profitability and liquidity while managing current assets. If the firm does not invest
sufficient funds in current assets, it may become illiquid and therefore, risky. On the other hand, it
would lose profitability, as idle current assets would not earn anything. Thus, a proper trade-off
must be achieved between profitability and liquidity.
1.5 Role of a finance manager

A financial manager is a person in a firm who main responsibility is to carry out the finance
functions.In a modern enterprise, the financial manager occupies a key position. He or she is one of
the members of the top management team, The role of finance manager is becoming more
important day by day. Finance manager performs a lot of tasks, some of his/her important
responsibilities are giver below:
Funds Raising
Funds Allocation
Profit Planning
Understanding Capital Markets

Notes

Fund Raising
The traditional approach placed emphasis on raising of funds. It neglected the issues relating to the
allocation and management of funds. Raising of funds to meet the firm’s requirement is one of the
important responsibilities of the finance manager. It was during the major events, such as
promotion, expansion or diversification that the financial manager was asked to raise funds.
Otherwise, In the day-to-day activities, his or her only significant duty was ensure that the firm had
sufficient cash to meet its requirements.
Fund Allocation
In the modern firm, the emphasis shifted from raising of funds to efficient and effective use of
funds. Hence, financial manager, in the new role is concerned with the efficient allocation of
funds.Thus, in a modern enterprise, the basic finance function is to decide about the expenditure
decisions and to assess the requirement of capital for these expenditures. In other words, the
financial manager, new role, is more concerned with the efficient allocation of funds.
Profit Planning
The functions of the financial manager may be broadened to include profit-planning function. It
refers to the operating decisions in the areas of pricing, costs, volume of output and the firm’s
selection of product lines.Profit planning means the decisions in the areas of pricing, costs, volume
of output and other operating decisions. Profit planning is, therefore, a prerequisite for optimizing
investment and financing decisions.
Understanding Capital Markets

Capital markets bring investors (lenders) and firms (borrowers) together.Hence the financial
manager has to deal with capital markets. He or she should fully understand the operations of
capital markets and the way in which the capital markets value securities.
1.6 The Basic Goal: Creating Shareholder Value
(a)Profit
Maximisation
Wealth Maximisation
a) Profit Maximization
Profit Maximization is the capability of the firm in producing maximum output with the limited
input, or it uses minimum input for producing stated output. It is termed as the foremost objective
of the company.Profit maximization is considered as an important goal in financial decision-
making in an organization. It ensures that firm utilizes its available resources most efficiently under
conditions of competitive markets. But in recent years, profit maximization is regarded as
unrealistic, difficult, inappropriate goal.
Favorable Arguments for Profit Maximization
• The main aim of a firm is to earn profit.
• Profit is the indicator of success of the business operation.
• Sufficient profitsreduce risk of the business concern.
• Profit is the main source of finance for a firm in the form of internal equity.
• Profitability meets the social needs of a business also.

Notes
Corporate Finance
Criticism of Profit Maximisation
• Profit maximization is vague concept as the term profit is not defined precisely. Profit may
be short term or long-term profit; it may be before tax profit or after-tax profit.
• Profit maximization does not consider the time value of money or the net present value of
the cash inflow.
• Profit maximization does not consider risk of the business concern. Risks may be internal
or external which will affect the overall operation of the business concern.
• The goal of profit maximization may lead to the exploitation of workers and consumers.
• Profit maximization may create immoral practices such as corrupt practice, unfair trade
practice, etc.
(b) Wealth Maximization

The prime objective of a business entity is to maximize value for its owners, equity shareholders.
Therefore, the ultimate objective of financial management should be wealth maximization.Wealth
maximization means maximizing the ‘net present value’ of a course of action or investment project.
The net present value of a course of action is the difference between the present value of its benefits
and the present value of its costs. It is the versatile goal of the company and highly recommended
criterion for evaluating the performance of a business organization.
Favorable Arguments for Wealth Maximization

• Contrary to profit maximization objective, wealth maximization is based on cash
flows, and not on profits.
• The objective of wealth maximization focuses on the long run picture.
• Wealth maximization considers the time value of money.
• Wealth-maximization criterion considers the risk and uncertainty factor.
Profit Maximization V/s Shareholder Wealth Maximization

The objective of wealth maximization is generally preferred over profit maximization because of
the following reasons:
• It considers wealth for the long-term.
• Wealth-maximization criterion considers the risk and uncertainty factor.
• It considers the timing of returns
1.7 Organization of Finance Functions

Responsibility of carrying out the finance functions lies with the top management. Financial
Department may be created under the direct control of the board of directors. The executive
heading the finance department is the firm’s Chief Finance Officer (CFO). However, the exact
nature of the organization of the financial management function differs from firm to firm
depending upon factors such as size of the firm, nature of its business type of financing operations,
ability of financial officers and the financial philosophy, and so on. Similarly, the designation of the
chief executive of the finance department also differs widely in case of different firms. In some
cases, they are known as finance managers while in others as vice-president (finance), director
(finance), and financial controller and so on. He reports directly to the top management. Various
sections within the financial management area are headed by managers such as controller and
treasurer.

Notes
Controller
Chief Financial
Officer
Board of Chief Executive Treasurer

Directors Officer
Chief Operating
Officer
The Financial Functions Within a Corporation
Chief Executive Officer(CEO)

He or she is a member of the Top Management and is closely associated with the formulation of
policies and making decisions for the firm. The Treasurer and Controller operates under CFO’s
supervision.
Treasurer
Treasurer is a manager responsible for financing, cash management, and relationships with
financial markets and institutions. His/her duties include forecasting the financial needs,
administering the flow of cash, managing credit, floating securities etc.
Controller
Controller is an officer responsible for budgeting, accounting and auditing.The functions of the
controller relate to the management and control of assets.
1.8 Agency issues

The agency problem is a conflict of interest inherent in any relationship where one party is expected
to act in another's best interests.The relationship between stockholders and management is called
an agency relationship. Understand this though an example. Suppose that you want to sell your old
bike and for that purpose you hire someone to sell it. You agree to pay the agent a flat fee when
he/she sells the bike. This is an example of Principal-Agent Relationship. The agent’s motive in this
case is to make the sale, no guarantee that to get you the best price. This is an example of Agency
Problem
Now, if you offer a commission instead of the flat fee, let’s say, 3% percent of the sales price instead
of a fixed amount, then this problem may be resolved.The agency problem is a conflict of
interest inherent in any relationship where one party is expected to act in another's best interests.
The relationship between stockholders and management is a form of agency relationship. The
conflict between the principal and the agent emerges when the agents who is entrusted with the
task, choose to use their authority for personal benefit.It is a common problem and it can be notices
in any organization Like any club, company or any government institution.

Notes
Corporate Finance
Delegates Authority
Principal Conflict of Interests Agent

Acts and Makes Decisions
Types of Agency problem:

• Stockholders v/s Management
• Stockholders v/s Creditors
• Stockholders v/s other Stakeholders
Agency Cost
Agency cost is the costs of the conflict of interest between stockholders and management. This cost
can be indirect or direct. Suppose a firm is planning a new project. This project is expected to
increase the share value for the shareholders, but it’s risky. Now, the firm's owners or the
shareholders may like to make the investment, but firms management may not, since there's a
chance the project will fail and management’s jobs will be lost.Thus, if management does not take
the investment, then the stockholders may lose a good opportunity. This is one example of an
indirect agency cost.
Direct agency costs are of two types. The first type is some sort of expenditure that will benefit
firm’s management but at the cost of the stockholders for e.g., purchase of expensive cars and
corporate jets. The second type of direct agency cost are expenses incurred on monitoring
managerial actions. For example, paying outside auditors to assess the accuracy of financial
statement information.
Solving Agency issues

Incentives: incentivizing an agent to act in better accordance with the principal's best interests like
a manager can be motivated to act in the shareholders' best interests through incentives such
as performance-based compensation.
Regulations:agency issues can be reduced through instituting measures like tough screening
mechanisms, penalizing for poor performance etc.
1.9 Business ethics and social responsibility

Business ethics:
The word ‘ethics’ has its origin in the Greek word ‘ethics’ meaning character; norms, ideals or
morals prevailing in a group or society. Ethics is concerned with what is right and what is wrong in
human behavior. It is judged on the basis of a standard form of conduct approved by society. Ethics
can also refer to codes or other system for controlling means so that they serve human ends.
business ethics are the moral principles that act as guidelines for the way a business conducts itself
and its transactions. A few examples of business ethics are: charging fair prices from customers,
using fair weights for measurement of commodities, giving fair treatment to workers and earning
reasonable profits.Ethical business behavior improves public image, earns people’s confidence and
trust, and leads to greater success.Ethics and profits go together in the long run. An ethically
responsible enterprise develops a culture of caring for people and environment and commands a
high degree of integrity in dealing with others.

Notes

Elements of Business Ethics
 Top management commitment: The (CEO) and other higher-level managers need to be
openly and strongly committed to ethical conduct. They must give continuous leadership
for developing and upholding the values of the organization.
 Publication of a ‘Code’:Businesses that have effective ethics programmes write out the
standards of behavior for the entire organization in written documents known as the
"code” covering areas such product safety and quality; health and safety in the workplace;
conflicts of interest etc.
 Establishment of compliance mechanisms:In order to ensure that actual decisions and
actions comply with the firm’s ethical standards, suitable mechanisms should be
established.
 Involving employees at all levels:It is the employees at different levels who implement
ethics policies to make ethical business a reality. Therefore, their involvement in ethics
programmes becomes a must.
 Measuring results: Although it is difficult to accurately measure the end results of ethics
programmes, the firms can certainly perform audit to monitor compliance with ethical
standards.
Social Responsibility
Social responsibility of business refers to its obligation to take those decisions and perform those
actions which are desirable in terms of the objectives and values of our society.Business is part of
society. It should fulfill the aspirations of society, and respect the values and norms of society.
Thus, social responsibility relates to the voluntary efforts on the part of the businessmen to
contribute to the social wellbeing.
Social responsibility is broader than legal responsibility of business. Legal responsibility may be
fulfilled by mere compliance with the law. Social responsibility is more than that. It is a firm’s
recognition of social obligations even though not covered by law.
Arguments for Social Responsibility

• Justification For Existence and Growth: Profit should be looked upon as an outcome of
service to the people. The prosperity and growth of business is possible only through
continuous service to society
• Long-term Interest of The Firm: When members of society — including workers,
consumers, feel that business enterprise is not serving its best interest, they will tend to
withdraw their cooperation to the enterprise concerned. The public image of any firm
would also be improved when it supports social goals.
• Avoidance of Government Regulation: it is believed that businessmen can avoid the
problem of government regulations by voluntarily assuming social responsibilities.
• Maintenance of Society: laws cannot be passed for all possible circumstances. People who
feel that they are not getting their due from the business may resort to anti-social activities,
not necessarily governed by law
• Availability of resources with business: business institutions have valuable financial and
human resources which can be effectively used for solving problems.
• Converting problems into opportunities: business with its history of converting risky
situations into profitable deals, can not only solve social problems but it can also make
them effectively useful by accepting the challenge.
• Better environment for doing business: business system should do something to meet
needs before it is confronted with a situation when its own survival is endangered due to
enormous social illnesses.

Notes
Corporate Finance
• Holding business responsible for social problems: some of the social problems have either
been created by business enterprises themselves. pollution, unsafe workplaces. so, it is the
moral obligation of business to get involved in solving these problems.
Arguments Against Social Responsibility

• Violation of profit maximization objective: According to this argument, business exists
only for-profitmaximization. Therefore, any talk of social responsibility is against this
objective.
• Burden on consumers: undertaking the social responsibility is very costly for the business
and often require huge financial investments.
• Lack of social skills: All social problems cannot be solved the way business problems are
solved so businesses should not be expected to solve the social problems.
• Lack of broad public support: business cannot operate successfully because of lack of
public confidence and cooperation in solving social problems.
Reality of Social Responsibility

• Threat of public regulation: governments today are expected to act as welfare states
whereby they have to take care of all sections of society. Thus, where business institutions
operate in a socially irresponsible manner, action is taken to regulate them for
safeguarding people’s interest.
• Pressure of labor movement: labour movement for extracting gains for the working class
throughout the world has become very powerful.
• Impact of consumer consciousness: Development of education and mass media and
increasing competition in the market have made the consumer conscious of his right and
power in determining market forces
• Development of social standard for business: New social standards consider economic
activity of business enterprises as legitimate but with the condition that they must also
serve social needs.
• Development of business education: Development of business education which has made
more and more people aware of the social purpose of business.
• Relationship between social interest and business interest: Business enterprises have
started realising the fact that social interest and business interest are not contradictory.
Instead, these are complementary to each other
• Development of professional, managerial class: Professional management education in
universities and management institutes have created a separate class of professional
managers who have got a different attitude towards social responsibility as compared to
the earlier class of manager.
Kinds of Social Responsibility:

• Economic responsibility: A business enterprise is basically an economic entity and,
therefore, its primary social responsibility is economic.
• Legal responsibility:Every business has a responsibility to operate within the laws of the
land. Since these laws are meant for the good of the society, a law-abiding enterprise is a
socially responsible enterprise as well law-abiding enterprise.
• Ethical responsibility:This includes the behaviour of the firm that is expected by society
but not codified in law. For example, respecting the religious sentiments and dignity of
people while advertising for a product.
• Discretionary responsibility:This refers to purely voluntary obligation that an enterprise
assumes, for instance, providing charitable contributions to educational institutions or
helping the affected people during floods or earthquakes.

Notes

Social Responsibility: Towards Different Interest Groups
• Towards the shareholders or owners:A business enterprise has the responsibility to
provide a fair return to the shareholders on their capital investment and to ensure the
safety of such investment.
• Towards the workers:Management of an enterprise is also responsible for providing
opportunities to the workers for meaningful work. It should try to create the right kind of
working conditions so that it can win the cooperation of workers
• Towards the consumers:Supply of right quality and quantity of goods and services to
consumers at reasonable prices constitutes the responsibility of an enterprise toward its
customers.
• Towards the government and community:Enterprise must respect the laws of the country
and pay taxes regularly and honestly. It must behave as a good citizen and act according
to the well accepted values of the society. It must protect the natural environment
Summary
 Corporate finance deals with the capital structure of a corporation, including its funding
and the actions that management takes to increase the value of the company. Corporate
finance also includes the tools and analysis utilized to prioritize and distribute financial
resources.
 Evolution of finance discipline is generally classified in three phases: Traditional phase
which lasted till 1940 and focused on certain episodic events like formation, issuance of
capital, expansion, merger, reorganization and liquidation. Transitional phase - from early
1940 to 1950- and focused on financial problems faced by managers in day-to-day
operations, leading to increased focus on working capital management and modern
phased which started in mid of 1950 and focused on rational matching of funds to their
uses so as to maximize the wealth of the shareholders.
 Finance function can be classified into long-term and short-term decisions: Under long-
term decision comes Investment decisions which deals with the allocation of funds,
Financing decisions which deals with the sourcing of funds and dividend decisions which
relates with the distribution of earnings. Short-term decisions primarily relate with the
management of current assets and liquidity.
 Role of finance manager mainly consists of funds raising, funds allocation, profit planning
and understanding capital markets.
 Broadly there are two alternative objectives of a firm. Profit maximization vs Wealth
maximization. Profit maximization objective primarily considers earning profits as the
main objective of a firm. This objective has several criticisms. On the contrary,wealth
maximization objective considers maximization of shareholdersvalue as the main objective
and is generally preferred over the profit maximization objective.
 The agency problem is a conflict of interest inherent in any relationship where one party is
expected to act in another's best interests.
 Ethics is concerned with what is right and what is wrong in human behavior judged on
the basis of a standard form of conduct/behavior of individuals. business ethics are the
moral principles that act as guidelines for the way a business conducts itself and its
transactions.
 Social responsibility of business refers to its obligation to take those decisions and perform
those actions which are desirable in terms of the objectives and values of our society.

Notes
Corporate Finance
 A firm has social responsibility towards different stakeholders. It has responsibilities

towards shareholders or owners, workers, consumersandtowards the government and
community.
Keywords
Corporate finance, Financial Management, Finance Functions, Profit maximization, Wealth
maximization, Agency issues, Business Ethics, Social responsibility.
Self-Assessment
1. The structure in which there is separation of ownership and management is called
A. Sole proprietorship
B. Partnership
C. Company
D. All business organizations
2. Profits do not have to be shared in which of the following organization type

A. Partnership
B. Sole proprietorship
C. Company
D. None of the above
3. ________is the limitation of Traditional approach of Financial Management.

A. More emphasis on long term problems
B. Ignores allocation of resources
C. One-sided approach
D. All of the above
4. Financial decisions of an individual like planning application of income, deciding on mode

of saving etc. relates to
A. Personal Finance
B. Corporate Finance
C. Public Finance
5. Which of the following option/s is/are true about Corporate Finance:

A. It deals with the decisions of a firm related to investment, financing and dividend.
B. It is subset of finance
C. The primary goal of is to maximize shareholder value
D. All of the above
6. Which one of the following is a short-term financial decision?

A. Investment decision
B. Financing decision
C. Dividend decision
D. Liquidity decision

Notes
7. The main goal of financial management is

A. profit maximization
B. fund transfer
C. Maximum Returns
D. Wealth Maximization
8. Finance function involves

A. procurement of finance only
B. expenditure of funds only
C. safe custody of funds only
D. procurement and effective utilization of funds
9. Which of the following is/are the roles of the finance manager?

A. Funds Raising
B. Funds Allocation
C. Profit Planning
D. All of the above
10. The criticism of the Profit maximization goal is/are?

A. It is vague concept.
B. It ignores timing of returns.
C. It ignores the risk factor.
D. All of the above
11. Agency is the result of agreement between whom?

A. Principal and creditor
B. Principal and agent
C. Principal, agent and the third party
D. Principal and debtor
12. Example/s of the agency relation is/are

A. Stockholders and Management
B. Stockholders and Creditors
C. Stockholders and other Stakeholders
D. All of the above
13. Agency cost consists of
A. Unnecessary expenditure by the management

B. Monitoring
C. Auditing cost
D. All of the above
14. Examples of business ethics are:

A. charging fair prices from customers,

Notes
Corporate Finance
B. using fair weights for measurement of commodities,
C. giving fair treatment to workers
D. All of the above
15. Social Responsibility is needed for:

A. Long-term interest of the firm
B. Maintenance of society
C. Better environment for doing business
D. All of the above

1. C 2. B 3. D 4. A 5. D
6. D 7. D 8. D 9. D 10. D
11. B 12. D 13. D 14. D 15. D
Review Questions
1. Define corporate finance.
2. Which objective of financial management is superior?
3. What is the difference between profit maximization and wealth maximization objectives?
4. State the agency cost to prevent agency problem.
5. List the stages of evolution of financial management.
Further Readings
1.Khan, M. and Jain, P., 2011. Financial management. 1st ed. New Delhi: Tata McGraw-
Hill.
2. Pandey, I.M. (2015). Financial Management (10th Ed). New Delphi, India, Vikas
Publishing
3.Berk, Jonathan. &DeMarzo, Peter. & Harford, Jarrad. & Ford, Guy. &Mollica, Vito.
(2017). Fundamentals of corporate finance. Melbourne, VIC : Pearson Australia
Web Links
1. https://corporatefinanceinstitute.com/resources/knowledge/finance/corporate-
finance-industry
2. https://corporatefinanceinstitute.com
3. https://www.investopedia.com/terms/b/business-ethics.asp

Notes
Dr. Atif Ghayas, Lovely Professional University Unit 02: Sources of Finance
Unit 02: Sources of Finance

CONTENTS
Objectives
Introduction
2.1 Classification of sources of funds
2.2 Long-Term Sources of finance
2.3 Short-Term Sources of finance
2.4 International Financing
2.5 Factors Affecting the Choice of The Source of Funds
2.6 Equity Shares
2.7 Preference Shares
2.8 Types of Preference Shares
2.9 Debentures
2.10 Types of Debentures
2.11 Debt v/s Equity Financing
Summary
Keywords
Self-Assessment
Review Questions
Further Readings
Objectives
 understand the concept of Business Finance

 classify various sources of Finance
 examine the factor affecting Source of Finance
 examine Equity and Preference shares as sources of finance
 evaluate the merits and limitations of Equity and Preference shares
 classify the various types of preference shares
 examine Debenture as a source of Finance.
 classify the types of debentures.
 compare equity Vs Debt financing.
Introduction
Business requires money for carrying out various activities.The finance required by business to
establish and run its operations is known as business finance. No business can function without
adequate amount of funds for undertaking various activities. Business finance is called the life
blood fora business. The funds may be required for several purposes like purchasing fixed assets,
for running day-to-day operations, and for undertaking growth and expansion plans in a business
organization

Notes
Corporate Finance
Fixed Capital Requirement:
For starting any business, funds are required in order to purchase fixed assets for example,
building, land, plant and machinery, and furniture and fixtures. The main feature of these fund is
that the funds required in fixed assets remain invested in the business for a long period of time.
Working Capital Requirements:

Other than fixed assets, funds are required for short-term also. Working capital of a business firm is
used for holding current assets, such as raw material stock, finished goods, bills receivables and for
paying salaries, wages, taxes, and rent.
2.1 Classification of sources of funds

The funds required for an enterprise can be sourced from various sources. The funds available to a
business can be classified according to three main criteria, which are:
(i) Time period

(ii) Ownership
(iii) Source of generation.
On the Basis of Time Period

Long-Term Sources: Those sources of finance which fulfills the financial need of an enterprise for a
period exceeding five years are known as long-term sources.
Medium-Term Sources: The sources of finance which provides funds to an enterprise for more
than one year but less than five years are known as medium-term sources.
Short-Term Sources: Short-Term sources as those which fulfills the financial requirements of a
business firm for a period not exceeding one year.
On the Basis of Ownership

Owner’s funds: the financial requirement of an enterprise can be met through own funds or
through the borrowed funds. Owner funds are the funds that are provided by the owners of an
enterprise, which can be sole proprietor, partners in a partnership firm or shareholders of a
company.
Borrowed funds: Borrowed funds are those funds which are borrowed from outside the enterprise
and raised through loans or debentures. These funds have to paid back after a specific period of
time along with the interest.
On the Basis of Generation

Internal sources of funds: Funds sources from inside the business enterprises are known as
Internal sources of funds.
External sources of funds:These sources are external to the business enterprise such as suppliers,
lenders, and investors.

Notes

2.2 Long-Term Sources of finance
Long-Term
Sources
Retained Ordinary Preference Financial

Debentures
Earnings Shares Shares institutions
Retained Earnings
Generally, a company does not distribute all the earnings to the shareholders. The portion of the net
earnings of the company that is not distributed as dividends is known as retained earnings. The
amount of retained earnings available depends on the dividend policy of the company. It is a
source of internal financing or self-financing or ploughing back of profits.
Ordinary Shares
Equity shares is the most important source of raising long term capital by a company. Equity shares
represent the ownership of a company and thus the capital raised by issue of such shares is known
as ownership capital or owner’s funds. The earning on these shares is fluctuating in nature. As the
equity shares are the owners of the firm, they have a say in the management of a company.
Preference Shares
Preference shares are similar to the equity shares but they differ on some grounds. They get the
preferential right to the shareholders with respect to payment of earnings and the repayment of
capital. That means, while distributing the earnings, these shareholders get the return before the
equityshareholders. The preference shareholders get steady income as return on these shares are
fixed in nature.
Debentures
Debentures are an important source of long-term debt capital. Debentures bear a fixed rate of
interest. The debenture issued by a company is an acknowledgment that the company has
borrowed a certain amount of money, which it promises to repay at a future date. It represents the
loan capital of a company. These are the fixed charged funds that carry a fixed rate of interest. It is
suitable in the situation when the sales and earnings of the company are stable.
Financial institutions
Loans from financial institutions is another source for getting external funds. Governments have
established a number of financial institutions to provide industrial finance to companies. They are
also called development banks. They are suitable when large funds are required for expansion,
reorganization and modernization of the enterprise.

Notes
Corporate Finance
2.3 Short-Term Sources of finance
Short-Term
Financing
•Loan from •Commercial

•Trade Credit •Factoring
Banks Papers
Trade Credit
Trade credit is source of short-term finance. Trade credit is the credit extended by one trader to
another for purchasing goods or services. Trade credit facilitates the purchase of supplies on credit.
The terms of trade credit vary from one industry to another and are specified on the invoice. Such
credit appears in the records of the buyer of goods as ‘sundry creditors’ or ‘accounts payable’.
Factoring
Factoring is a financial service under which the ‘factor’ renders various services such as discounting
of bills, providing information about credit worthiness of prospective client’s etc. Factor is
responsible for all credit control and debt collection from the buyer. Itprovides protection against
any bad-debt losses to the firm. The factor charges fees for the services rendered.
Loan from Banks

Banks loans another source of short-term finance for a business firm. Banks provide short and
medium-term loans to firms of all sizes. The rate of interest charged by a bank depends upon
factors including the characteristics of the borrowing firm and the level of interest rates in the
economy.
Commercial Papers
Commercial papers is an unsecured promissory note issued by a firm to raise funds for a short
period. The maturity period of commercial paper usually ranges from 90 days to 364 days. The
amount raised by CP is generally very large. As the debt is totally unsecured, the firms having good
credit rating can issue the CP.
2.4 International Financing

Apart from the sources discussed above, there are various other international sources through
which firms can get funds. With liberalization and globalization of the economy, Indian companies
have started generating funds from international markets. Include foreign currency loans from
commercial banks, financial assistance provided by international agencies and development banks.
Global Depository Receipts (GDR’s)

The local currency shares of a company are delivered to the depository bank. The depository bank
issues depository receiptagainst these shares. Such depository receipts denominated in US dollars
are known as Global Depository Receipts (GDR). GDR is an instrument issued abroad by an Indian
company to raise funds in some foreign currency and is listed and traded on a foreign stock
exchange.

Notes

American Depository Receipts (ADRs)
American Depository Receipts are similar to a Global Depository Receipts. ADRs are bought and
sold in American markets, like regular stocks. It can be issued only to American citizens and can be
listed and traded on a stock exchange of USA.
Indian Depository Receipt (IDRs)

Indian Depository Receipt is a financial instrument denominated in Indian Rupees in the form of a
Depository Receipt. It is created by an Indian Depository to enable a foreign company to raise
funds from the Indian securities market.
Foreign Currency Convertible Bonds (FCCBs)

Equity linked debt securities that are to be converted into equity or depository receipts after a
specific period.The FCCB’s are issued in a foreign currency and carry a fixed interest rate which is
lower than the rate of any other similar nonconvertible debt instrument. FCCB’s are listed and
traded in foreign stock exchanges.
2.5 Factors Affecting the Choice of The Source of Funds

The selection of a source of capital is dependent on a number of factors making it a very complex
decision for the business. The factors that affect the choice of source of finance are briefly discussed
below:
Cost: Both the types of cost viz. cost of procurement of funds and cost of utilizing the funds should
be taken into account while deciding about the source of funds.
Strength and Stability: The business should be in a healthy financial position so as to be able to
repay the principal amount and interest on the borrowed amount. Thus, Financial Strength and
Stability of Operations is an important factor affecting this decision.
Form of Organization: The choice is also based on the type of organization i.e., Sole proprietorship,
Partnership firm or a company.A partnership firm, for example, cannot raise money by issue of
equity shares as these can be issued only by a joint stock company.
Risk Profile: Business should evaluate each of the source of finance in terms of the risk involved as
the risk associated with each type of the source is different.
Control:A particular source of fund may affect the control and power of the owners on the
management of a firm. Thus, business firm should choose a source considering the preference of
the equity shareholders.
Credit Worthiness:The dependence of business on certain sources may affect its credit worthiness
in the market. For example, issue of secured debentures may affect the interest of unsecured
creditors of the company and may adversely affect their willingness to extend further loans as
credit to the company.
Purpose and Time Period: Business should plan according to the time period for which the funds
are required. Similarly, the purpose for which funds are required need to be considered so that the
source is matched with the use.
Tax Benefits: Various sources may also be weighed in terms of their tax benefits. For example,
while the dividend on preference shares is not tax deductible, interest paid on debentures and loan
is tax deductible
Flexibility and Ease:Flexibility and ease of obtaining funds is another factor affecting the choice.
For e.g., restrictive provisions, detailed investigation and documentation in case of borrowings
from banks and financial institutions for example may be the reason that a business organisation
may not prefer it.

Notes
Corporate Finance
2.6 Equity Shares
Equity share capital is the most important source of raising long term capital for a company.The
capital of a company is divided into small units or parts called as shares. The person holding the
share is known as shareholder.Equity shares represent the ownership of a company and the holders
of these shares are called as owners of the company. This capital is the prerequisite for the creation
of a company. Equity shares are also known as Ordinary shares.
Features of Equity Shares:

The key features of the equity shares are discussed below:
Nofixed dividend:Equity shareholders are not entitled to get any fixed dividend or fixed interest.
Their earning depends on the company’s earning as well as the dividend policy of the firm.
Residual owners: They are known to as ‘residual owners’ as they receive what is left after all other
claims on the company’s income and assets have been settled.
Bear the risk: Equity shareholders bear the risk in their investment also as the dividend is not fixed
on their investment.
Liability is Limited:The liability of the shareholders is limited to the extent of capital contributed
by them in the company.
Right to Participate:The equity shareholderare the owners of the company. Through their right to
vote, these shareholders have a right to participate in the management of the company.
Merits:
The merits of equity share capital as a source of finance are as follows:
i. Equity share capital is the permanent Source of Finance.

ii. The payment of dividend on the equity share capital is not fixed.
iii. The usage of equity share capital opens the chances of borrowing for the company.
iv. Equity capital helps in retained the earnings for future use.
v. Democratic control over management of the company is maintained due to voting rights
of equity shareholders.
Limitations:
Equity share capital comes with some limitations also which are discussed below:
i. While issuing equity capital, floatation cost is incurred by the company which increases
the cost of the capital.
ii. Due to the high risk involved in the equity capital, the return demanded by the equity
shareholders is also high.
iii. Equity capital is taxable unlike debt capital. Hence, Interest on debentures are tax
deductible expenses but dividends are not.
iv. Issuance of new equity shares dilutes the control of existing shareholders.
Terms Related to Equity Shares

Various terms related to the equity shares are defined below:
Authorized Share Capital:
It is the maximum amount of capital which a company can issue. The companies can increase it
from time to time.
Issued Share Capital:
It is that part of authorized capital which the company offers to the investors.
Subscribed Share Capital:

Notes

It is that part of issued capital which an investor accepts and agrees upon.
Paid-up Capital:It is the part of the subscribed capital, which the investors pay. Normally, all
companies accept complete money in one shot and therefore issued, subscribed and paid capital
becomes one and the same.
Rights Shares:
Right shares are those shares which a company issues to its existing shareholders. The purpose of
issuing these kinds of shares in order to protect the ownership rights of the existing investors.
Bonus Shares:
Sometime company issues share to the existing shareholders in place of cash dividends. These
shares are known as bonus shares.
Sweat Equity Share:
Sweat equity shares are issued to theexisting employees or directors of the company for their
performance.
Various prices of Equity Shares:

Various prices of equity shares are defined below:
Par or Face value:
Par or face value of a share is the value of shares which is recorded in the books of accounts.
Issue Price:
Issue price is the price which a company offers to the investors.
Share Premium/Discount:
When issuance of shares is at a price higher than face value, this excess amount is known as
premium. On the other hand, when the issuance of shares is at a price lower than face value, this
deficit amount is known as discount.
Book Value:
This is the balance sheet value of shares.The calculation of the book value is the sum of paid-up
capital and reserve and surplus less any loss divided by the total number of equity shares of the
company.
Market Value:
In the case of companies listed on stock exchanges, the market value of the share is the price at
which they are currently sold in the market. This price is determined by the demand and supply of
the shares in the stock market.
2.7 Preference Shares

Preference shares also commonly known as preferred stock. It is a special type of share where
dividends are paid to the shareholders before the equity stock dividends.The preference
shareholders get preference over equity shareholders in two ways:They receiving a fixed rate of
dividend out of the earning of the company and, receiving their capital (after the claims of the
company’s creditors have been settled) at the time of liquidation. Unlike ordinary shares, the
holders of these shares do not enjoy any voting rights.
Features:
The key features of the preference shares are discussed below:
Fixed Dividends: The preference shareholders get fixed dividends as return on their capital due to
this reason they resemble debentures.
Preference over Equity: While distributing the earning of the company, the preference
shareholders is given preference over ordinary shareholders.

Notes
Corporate Finance
No Voting Rights: The preference shareholders do not enjoy voting rights in the meeting and thus
they do not have any control over the firm.
Fixed Maturity: These preference shares are issued for a fixed period, after which the preference
share capital is paid back to the holders.
Merits
i. Although the preference shareholders have to be paid fixed dividend regularly, however, there
is no legal obligation for the company to pay the dividend.
ii. Just like equity share capital, preference share capital also improves borrowing capacity of a
company.
iii. As the preference shareholders do not have any voting rights the issuance of equity capital do
not results in the dilution of control of the equity shareholders.
Limitations
i. Preference share capital is costlier source of finance than the debt capital.
ii. Although a company can skip paying the dividend in a year, generally skipping dividend
disregard market image of the company.
iii. The preference shareholders have the preference in claims on the company in case of
liquidation over equity shareholders.
2.8 Types of Preference Shares

a) Cumulative and Non-Cumulative
b) Participating and Non-Participating
c) Convertible and Non-Convertible
a) Cumulative and Non-Cumulative

Cumulative preference shares are the preference shares which enjoy the right to accumulate unpaid
dividends in the future years, in case the same is not paid during a year. On Non-cumulative
shares, dividend is not accumulated if it is not paid in a particular year.
b) Participating and Non-Participating

Participating shares are those shares which have a right to participate in the further surplus of a
company shares, which after dividend at a certain rate has been paid on equity shares.The non-
participating preference are such which do not enjoy such rights of participation in the profits of
the company.
c) Convertible and Non-Convertible

Convertible preference shares are those preference shares that can be converted into equity shares
within a specified period of time. On the other hand, non-convertible shares are such that cannot be
converted into equity shares
2.9 Debentures
Debentures arethe debt instrument issued by companies to raise money for medium to long-term
duration. The debenture holders are paid return y company ata specified rate of interest.
Debentures of a written contract specifying the repayment of the principal and the interest payment
at the fixed rate. Generally, a debenture is not secured by any collateral and is only backed by the
reputation of the issuer.An alternative form of debenture in India is a bond. Public issue of
debentures requires that the issue be rated by a credit rating agency like CRISIL.

Notes
Features of Debentures:
Some of the features of the debentures are discussed below:
Interest Rate:The interest rate on a debenture is fixed. It indicates the percentage of the par value of
the debenture that will be paid out annually in the form of interest.
Maturity: Debentures are issued for a specific period of time. The maturity of a debenture indicates
the length of time until the company redeems (returns) the par value to debenture holders.
Redemption:Mostly debentures are redeemable. Redemption of debentures can be accomplished
either through a sinking fund or buy-back (call) provision.
Security:Debentures are classified as secured debentures and unsecured debentures. Secured
debentures are secured by some immovable assets of the company. On the other hand, the
unsecured assets are issued based on the general credit of the company.
Indenture:It is also known as debenture trust deed and is a legal agreement between the company
issuing debentures and the debenture trustee. It is the responsibility of the trustee to protect the
interests of debenture holders by ensuring that the company fulfils the contractual obligations.
Merits
i. Debentures are cheaper source of finance for the company. The investors consider
debentures as a relatively less risky investment and therefore, require a lower rate of
return. Other major benefit with the debentures is that the interest payments on
debentures are tax deductible.
ii. Company has to pay debenture holders a fixed Interest regularly as the payment for
return on their investment.
iii. Debenture-holders do not have voting rights. Thus, debenture issue does not cause
dilution of ownership of the equity shareholders.
iv. There is disciplinary effect of debenture capital on the management of the company due to
theburden of interest despite business profit or loss which makes the entrepreneur
cautious.
Limitations
i. There is an obligatory payment for the firm to pay the interest regularly and the principal
amount to the debenture holders. If not paid, can force the company into liquidation.
ii. It increases the firm’s financial leverage and hence, the financial risk also. It may be
disadvantageous to a firm having volatile sales and earnings.
iii. The principal amount has to be paid on maturity. Hence, at some points, they involve
substantial cash outflows from the company.
iv. Debenture indenture or the agreement may contain several restrictive conditions which
may limit the company’s operating flexibility in future.
2.10 Types of Debentures

There are different types of debentures which a firm can issue.
On the basis of security:
a) Secured Debentures: secured debentures are the debentureswhich are secured fully or
partly by a charge over the assets of the company.

Notes
Corporate Finance
b) Unsecured Debentures:Unsecured debentures are those debentures which are not secured
fully or partly by a charge over the assets of the company.
On the basis of Convertibility:
a) Convertible Debentures:Convertible debenture are the debentures, which are convertible

into equity shares or preference shares at the option of the holders, after a certain period.
b) Non-Convertible Debentures:The non-convertible debenturesare not convertible into
equity shares.
On the Basis of Redeemability
a) Redeemable Debentures:Redeemable debentures are the debentures which are repayable

by the company after a certain period. These debentures can be redeemed by the company
on demand by the holders or by the company.
b) Irredeemable Debentures:Irredeemable Debenturesare the debentures, which are not
repayable during the life time of the company. The company may repay the money at the
time of liquidation.
On the Basis of Registration
a) Registered Debentures:In case of registered debentures, the names of the holders of these
debentures with details of the number, value and type of debenture held are recorded in
the register of debenture holders.
b) Bearer Debentures:In case of the bearer debentures, the register of debenture holders does
not have the names of the debenture holder recorded. They are transferable by mere
delivery.
On the Basis of Priority
a) Preferred Debentures:These debenturesare paid first at the time of winding up of the

company. These debentures are also called first debentures.
b) Ordinary Debentures:Ordinary debenturesare paid only after the preferred debentures
during the liquidation or winding up of a company.
2.11 Debt v/s Equity Financing

Companies mainly have two types of financing options, equity financing and debt financing.
Mostly companies use a mixture of debt and equity financing. The comparison of these financing
options is given below:
Equity Financing:
Equity financing is also called ownership capital. This source of capital does not placeany
additional financial burden on the company. Moreover, there is no obligation to repay the money
acquired through it.Equity financing involves selling a portion of a company's equity or ownership
in return for capital.
Debt Financing:
Debt financing is other option to finance the requirements of the company. Debt financing involves
the borrowing of money and paying it back with interest. The debt provider has no voting right or
control over the company. It’s a cheaper source of finance than the equity capital due to the lesser
risk involved as well as due to the interest tax shield.

Notes

Example:Equity Financing v/s Debt Financing
Company XYZ is planning to build a new factory. It determines that it needs to raise Rs. 50 Lacs in
capital to fund this expansion.To obtain this capital, the company decides to offer a combination of
equity financing and debt financing. It can issue 100% equity or 100% debt, or 50% equity and 50%
debt or any other combination. If the company decides to raise capital with just equity financing,
the owners would have to give up more ownership.On the other hand, if they decided to use only
debt financing, their monthly expenses would be higher.Businesses must determine which option
or combination is the best for them.
Summary
 Business requires money for carrying out various activities. The finance required by
business to establish and run its operations is known as business finance.
 The funds required for an enterprise can be sourced from various sources. The funds
available to a business can be classified according to three main criteria, which are:
o Time period
o Ownership
o Source of generation
 The main long-term sources of finance are
o Retained Earnings
o Ordinary Shares
o Preference Shares
o Debentures
o Financial institutions
 The main short-term financing source of capital available for a company are:
o Trade Credit
o Factoring
o Loan from Banks
o Commercial Papers
 Apart from the sources discussed above, there are various other international sources
through which firms can get funds. With liberalization and globalization of the economy,
Indian companies have started generating funds from international markets.
o Global Depository Receipts (GDR’s)
o American Depository Receipts (ADRs)
o Indian Depository Receipt (IDRs)
o Foreign Currency Convertible Bonds (FCCBs)
 Factors Affecting the Choice of The Source of Funds: The selection of a source of capital is
dependent on a number of factors making it a very complex decision for the business. The
factors that affect the choice of source of finance are briefly discussed below:
o Cost of capital
o Strength and Stability
o Form of Organization
o Risk Profile
o Control
o Credit Worthiness
o Purpose and Time Period
o Tax Benefits
o Flexibility and Ease

Notes
Corporate Finance
 Equity share capital is the most important source of raising long term capital for a
company.The capital of a company is divided into small units or parts called as shares.
The person holding the share is known as shareholder. Equity shares represent the
ownership of a company and the holders of these shares are called as owners of the
company.
 Preference shares also commonly known as preferred stock. The preference shareholders
get preference over equity shareholders in two ways: They receiving a fixed rate of
dividend out of the earning of the company and, receiving their capital (after the claims of
the company’s creditors have been settled) at the time of liquidation.
 Types of Preference Shares
o Cumulative and Non-Cumulative
o Participating and Non-Participating
o Convertible and Non-Convertible
 Debentures arethe debt instrument issued by companies to raise money for medium to
long-term duration. The debenture holders are paid return by company ata specified rate
of interest. Debentures of a written contract specifying the repayment of the principal and
the interest payment at the fixed rate.
 There are different types of debentures which a firm can issue.
o On the basis of security:
 Secured Debentures
 Unsecured Debenture
o On the basis of Convertibility
 Convertible Debentures
 Non-Convertible Debentures
o On the Basis of Redeemability
 Redeemable Debentures
 Irredeemable Debenture
o On the Basis of Registration
 Registered Debentures
 Bearer Debentures
o On the Basis of Priority
 Preferred Debentures
 Ordinary Debentures
 A firm can choose between equity or debt source of capital. However, there are certain
benefits and limitations with both of these sources. If the company decides to raise capital
with just equity financing, the owners would have to give up more ownership. On the
other hand, if they decided to use only debt financing, their monthly expenses would be
higher.Businesses must determine which option or combination is the best for them.
Keywords
Capital, Source of capital, Equity, Debt, Preference shares, Retained Earning.
Self-Assessment
1. Which among the following is not a long-term source of finance?

Notes

A. Retained Earnings
B. Ordinary Shares
C. Preference Shares
D. Trade Credit
2. _____________is a form of long-term finance.
A. Retained Earnings
B. Trade Credit
C. Loan from Banks
D. Commercial Papers
3. Internal sources of capital are those that are
A. Generated through outsiders such as suppliers

B. Generated through loans from commercial banks
C. Generated through issue of shares
D. Generated within the business
4. Debenture means
A. Taking Loan
B. Taking Capital
C. Taking Venture capital
5. Commercial paper is a type of
A. Fixed coupon Bond

B. Unsecured short-term debt
C. Equity share capital
D. Government Bond
6. Equity shareholders are called
A. Owners of the company

B. Partners of the company
C. Executives of the company
D. Guardian of the company
7. The share capital which has preference of dividend and capital is known as

Notes
Corporate Finance
A. Equity share
B. Preference share
C. Debenture
D. Term loan
8. Which is not true for Equity Shares capital?
A. Permanent Source of Finance

B. No obligatory dividend payments
C. Open Chances of Borrowing
D. Fixed interest payments
9. To whom dividend is given at a fixed rate in a company?
A. To equity shareholders
B. To preference shareholders
C. To debenture holders
D. To promoters
10. Issue of shares at a price lower than its face value is called:
A. Issue at a Loss
B. Issue at a Profit
C. Issue at a Discount
D. Issue at a Premium
11. A company cannot issue
A. Debentures with Voting rights

B. Share
C. Debentures
12. Which of the following is False?
A. Debentures is written instrument acknowledgment a debt under the common seal of

the company.
B. Debentures is a part of owned capital.
C. The payment of interest on debentures is a charge on the profit of the company.
D. Redeemable debentures are those debentures, which are payable on the expiry of the
specific period.

Notes

13. Debenture holders are the:
A. Owners of the company

B. Creditors of the company
C. Money lenders
14. ____________Debentures have to be redeemed within a fixed period of time.
A. Convertible
B. Redeemable
C. Participating
D. None
15. Debentures are usually
A. Secured
B. Unsecured
C. Assets
D. Loss.

1. D 2. A 3. D 4. A 5. B
6. A 7. B 8. D 9. C 10. C
11. A 12. B 13. B 14. B 15. A
Review Questions
1. Explain why do a business need funds?
2. Explain the sources of raising long-term and short-term finance.
3. Explain the difference between Equity and preference share capital.
4. Explain what are the preferential rights which are enjoyed by preference shareholders.
5. Explain briefly the different types of debentures.
Further Readings
Hill.
Publishing

Notes
Corporate Finance
Web Links
https://efinancemanagement.com/sources-of-finance
https://www.investopedia.com/terms/e/equity.asp

Notes
Dr. Atif Ghayas, Lovely Professional University Unit 03: Money Market Instruments
Unit 03: Money Market Instruments

CONTENTS
Objectives
Introduction
3.1 Indian Money Market
3.2 Participants of Money Market
3.3 Functions of Money Market
3.4 Treasury Bills
3.5 Commercial Paper
3.6 Certificate of Deposit
3.7 Treasury Management
3.8 External Commercial Borrowings
3.9 Micro Small and Medium Enterprise
3.10 Financing for MSMEs:
3.11 Equity funding
Summary
Keywords
Self Assessment
Review Questions
Further Readings
Objectives
 define Money Market,
 identify various money market instruments,
 evaluate merits and limitations of these money market instruments.
 understand the concept of Treasury Management in corporations,
 analyse External Commercial Borrowings,
 identify the Financing options available for MSMEs.
Introduction
Whilethe capital market handles the medium term and long-term credit needs of the firms, the
Money Market is a market for lending and borrowing of short-term funds. It deals in funds and
financial instruments having a maturity period of one day to one year. It covers money and
financial assets which are close substitutes for money. The instruments in the money market are of
short-term nature and highly liquid. Money market does not deal in cash or money as such but
simply provides a market for credit instruments such as bills of exchange, promissory notes,
commercial paper, treasury bills, etc.

Notes
Corporate Finance
Financial Market
•Money Market •Capital Market
Money market refers to the whole networks of financial institutions which deals in the short-term
funds, that provides an outlet to lenders and a source of supply for such funds to borrowers. Most
of the money market transactions take place on telephone, fax or Internet.
3.1 Indian Money Market

The Indian money market consists of Reserve Bank of India, Commercial banks, Co-operative
banks, and other specialized financial institutions.The Reserve Bank of India is the leader of the
money market in India. Some Non-Banking Financial Companies (NBFCs) and financial institutions
like LIC, GIC, UTI, etc. also operate in the Indian money market.
3.2 Participants of Money Market

There are many institutions which participates in the India money market which are as follows:
 Reserve Bank of India

 Commercial banks
 Central and State Government
 Public sector undertaking
 Private sector companies
 Non-banking financial institutions
 Mutual funds
 Insurance companies
3.3 Functions of Money Market

The important functions of the money market are discussed below:
Financing Trade:The main function of the money market is to provides financing to the traders
who need short-term funds. It provides a facility to discount bills of exchange, and this provides
immediate financing to pay for goods and services.
Central Bank Policies:As we know, the central bank is responsible for guiding the monetary policy
of a country. With the help of money market, the central bank can perform its policy-making
function efficiently.For example, the short-term interest rates in the money market represent the
prevailing conditions in the banking industry and can guide the central bank in developing an
appropriate interest rate policy.
Growth of Industries:The money market fulfills short-term needs of the firm and helps to
finance its working capital requirements. Although money markets do not provide long-term loans,
it influences the capital market and can also help businesses obtain long-term financing. The capital
market benchmarks its interest rates based on the prevailing interest rate in the money market.

Notes
Commercial Banks Self-Sufficiency:Money market provides commercial banks with a market

where they can invest their excess reserves and earn interest which can easily be converted to cash
to support customer withdrawals.When faced with liquidity problems, they can borrow from the
money market on a short-term basis.
Money Market Instruments

Money Market instruments mainly include Government securities, securities issued by private
sector and banking institutions:
3.4 Treasury Bills

In simple terms, a treasury bill is actually a promissory note issued by the Government under
discount for a specified period stated therein which does not exceed one year. It is a short-term
borrowing instrument issued by the govt. of India. The Government promises to pay the specified
amount mentioned therein to the bearer of the instrument on the due date.The Treasury bill rate of
discount is fixed by the RBI from time-to-time. It is the lowest one in the entire structure of interest
rates in the country because of short-term maturity and degree of liquidity and security.
The difference between the issue price and the redemption value indicates the interest on treasury
bills, call as a discount. For example, a 91-day Treasury bill of Rs.100/- (face value) may be issued
at say Rs. 98.20, that is, at a discount of say, Rs.1.80 and would be redeemed at the face value of
Rs.100. This means that you can get a hundred-rupee treasury bill at a lower price and can get
Rupees hundred at maturity. These are the safest investment instrument of its category, as the risk
of default is negligible. Further, the date of issue predetermines, as well as the amount also fixed.
Features of Treasury Bills

The main features of the treasury bills are given as under:
 Form: The treasury bills are issued by government in physical form as a promissory note
or dematerialized form.
 Eligibility: The investment in the treasury bills can be made byIndividuals, firms,
companies, trust, banks, insurance companies, provident funds, state government, and
financial institutions.
 Issue price:The T-bills are issued at a discount but redeemed at par.The difference
between the issue price and the redemption value indicates the interest on treasury bills,
call as a discount
 Repayment:The repayment of the T-bill is made at par on the maturity of the term.
 Availability:The T-bills are available in both primary as well as secondary financial
markets.
 Method of the auction:the method of auction is uniform price auction method for 91 days
T-bills, whereas multiple price auction method for 364 days T-bill.
Types of T-bills
The three types of Treasury bills are:

Notes
Corporate Finance
91 days T-bills
182 days T-bills
364 days T-bills
a) 91-Days T-Bills:The tenor of these bills completes on 91 days. These are an auction on
Wednesday, and the payment makes on the following Friday.
b) 182 days T-bills:These treasury bills get matured after 182 days, from the day of issue, and
the auction is on Wednesday of non-reporting week. Moreover, these are repaying on
following Friday, when the term expires.
c) 364 days T-bills:The maturity period of these bills is 364 days. The auction is on every
Wednesday of reporting week and repay on the following Friday after the term gets over.
Merits
 Safety:Investments in T-bills are very safe as the payment of interest and principal are
assured by the Government. They carry zero default risk since they are issuing by the RBI
for and on behalf of the Central Government.
 Liquidity: T-bills are also highly liquid because they can convert into cash at any time at
the option of the investors.
 Ideal Short-Term Investment:Idle cash can profitably invest for a very short period in T-
bills. T-bills are available on top throughout the week at specified rates. Financial
institutions can employ their surplus funds on any day.
 Ideal Fund Management:T-billsare available on top as well through periodical auctions.
They are also available in the secondary market. T-bills help financial managers to
manages the funds effectively and profitably.
 Statutory Liquidity Requirement:As per the RBI directives, commercial banks have to
maintain SLR (Statutory Liquidity Ratio) and for measuring this ratio of investments in T-
bills takes into account. T-bills are eligible securities for SLR purposes. Moreover, to
maintain CRR (Cash Reserve Ratio). TBs are very helpful.
 Source of Short-Term Funds:The Government can raise short-term funds for meeting its
temporary budget deficits through the issue of T-bills. It is a source of cheap finance to the
Government since the discount rates are very low.
 Non-Inflationary Monetary Tool:T-bills enable the Central Government to support its
monetary policy in the economy. For instance, excess liquidity, if any, in the economy can
absorb through the issue of T-bills.
 Hedging Facility:T-bills can use as a hedge against heavy interest rate fluctuations in the
call loan market. When the call rates are very high, money can raise quickly against T-
billsand invest in the call money market and vice versa. T-bills can use in ready forward
transitions.

Notes
Limitations
• Poor Yield:The yield form T-billsis the lowest. Long-term government securities fetch
more interest and hence subscriptions for T-billsare on the decline in recent times.
• Absence of competitive bids:Though T-bills sell through auction to ensure market rates
for the investors, in actual practice, competitive bids are conspicuously absent. The RBI
compels to accept these non-competitive bids. Hence adequate return is not available.
3.5 Commercial Paper

A commercial paper is a bill of exchange used to finance the working capital requirements of
business firms. It is a short-term, negotiable, self-liquidating instrument which is used to finance
the credit sales of firms. It is issued by one firm to other business firms, insurance companies,
pension funds and banks. The amount raised by Commercial Paper is generally very large. It has
emerged as a source of short-term finance in our country in the early nineties. As the debt is totally
unsecured, the firms having good credit rating can issue the Commercial Paper. This unsecured
promissory note comes along with a set maturity and is issued by All India Financial Institutions
(FIs) and Primary Dealers (PDs). commercial paper has a minimum maturity of seven days and a
maximum of up to one year from the date of issue.
Features of Commercial Paper

 It is a short-term money market tool, including a promissory note and a set maturity.
 It acts as an evidence certificate of unsecured debt.
 It is subscribed at a discount rate and can be issued in an interest-bearing application.
 The issuer guarantees the buyer to pay a fixed amount in future in terms of liquid cash
and no assets.
 A company can directly issue the paper to investors, or it can be done through
banks/dealer banks.
Merits
 A commercial paper is sold on an unsecured basis and does not contain any restrictive
conditions.
 As the commercial papers are freely transferable, they are highly liquid.
 Generally, the cost of commercial paper to the issuing firm is lower than the cost of
commercial bank loans. Hence, It provides more funds compared to other sources.
 A commercial paper provides a continuous source of funds. This is because their maturity
can be tailored to suit the requirements of the issuing firm. Further, maturing commercial
paper can be repaid by selling new commercial paper.
 Companies can park their excess funds in commercial paper thereby earning some good
return on the same.
Limitations
 Only financially sound and highly rated firms can raise money through commercial
papers. New and moderately rated firms are not in a position to raise funds by this
method.
 The size of money that can be raised through commercial paper is limited to the excess
liquidity available with the suppliers of funds at a particular time.
 Commercial paper is an impersonal method of financing. As such if a firm is not in a
position to redeem its paper due to financial difficulties, extending the maturity of a
Commercial paper is not possible.
Types of Commercial Papers

Notes
Corporate Finance
These can be broadly categorized into two parts depending upon the security it offers:
 Secured Commercial Papers:These are often known as Asset-backed commercial papers

(ABCP) wherein it is backed by physical assets like trade receivables, etc.
 Unsecured Commercial Papers:In this unsecured kind, the paper isn't backed by pledging
any asset and is allotted without any security.
Uniform Commercial Code (UCC) has divided the commercial paper in India into four categories:
i. Draft: It is written by one individual to another (usually banks) asking to pay a definite
sum to the third party. A drawer, drawee, and acceptor are involved in the process. It can
be of two kinds - sight draft and time draft.
ii. Note: Also known as a promissory note, these are written by specifying the amount to be
paid after a certain amount of time. Here two parties are involved - promisor (maker) and
promisee (payee).
iii. Cheque: Like drafts, these are written in paper forms where the drawee is a bank.
iv. Certificates of Deposit: Often known as CD, this is an acknowledgement form issued by
the bank confirming receipt of the deposit. Some of the difference between commercial
paper and certificate of deposit is in terms of issuer, denomination, etc.
3.6 Certificate of Deposit

A Certificate of Deposit (CD) is a money market instrument which is issued in a dematerialized
form against funds deposited in a bank for a specific period.Regulated by the Reserve Bank of
India, the Certificate of Deposit is a promissory note, the interest on which is paid by the bank.The
Certificate of Deposit is issued in dematerialized form i.e., issued electronically and may
automatically be renewed if the depositor fails to decide what to do with the matured amount
during the grace period of 7 days. It also restricts the holder from withdrawing the amount on
demand or paying a penalty, otherwise. When the Certificate of Deposit matures, the principal
amount along with the interest earned is available for withdrawal
Features of Certificate of Deposit:

The important features of Certificates of Deposits are:
 Eligibility:A selective list of commercial banks and financial institutions have been
authorized by the Reserve bank of India (RBI) to issue Certificates of Deposits. Rural
regional banks and co-operative banks cannot issue CDs.
 Maturity Period:The tenure for Certificates of Deposit issued by commercial banks varies
between 7 days and 1 year. The maturity term for CDs issued by financial institutions
varies from 1 year to 3 years.
 Minimum investment amount: A CD can be issued to a single issuer for a minimum of
Rs.1 Lakh and its multiples
 Transferability:Dematerialised or electronically generated certificates can be transferred
by delivery or endorsement, while those in demat forms can be transferred as per the
guidelines set for demat securities.
 Non-availability of loan: Since these instruments do not have any lock-in period, banks
do not grant loans against them. In fact, banks cannot even buy back certificates of deposit
before maturity
 Discount offered: Certificate of deposit is issued at a discounted rate on the face value.
Moreover, banks and financial institutions can also issue CDs on a floating rate basis
Merits:
The advantages of certificate of deposits are as follows:
 As these are government-backed securities, the investor’s principal amount is kept safe.
Hence, it can be said that CDs are a less risky investment option than stocks or bonds.
 Certificate of Deposit is known to offer a higher rate of interest and better returns in
comparison to the traditional savings accounts.

Notes
 Investments in CD grant a grace period of 7 days to the investor to decide whether or not
he/she wants to reinvest the matured amount.
Limitations:
The limitations of certificate of deposits are:
 Certificates of deposit are characterized by a lack of liquidity since they are locked in for a
certain amount of time.
 There are many other investments and asset classes that offer a higher yield.
3.7 Treasury Management

Treasury Management is all about planning, organizing and controlling holding, funds and
working capital of the enterprise. The aim is to make the best possible use of the funds, maintain
firm’s liquidity, reduce the overall cost of funds, and mitigate operational and financial
risk.Treasury Management (or treasury operations) includes management of an enterprise's
holdings, with the ultimate goal of maximizing the firm's liquidity and mitigating its operational,
financial and reputational risk.
Functions of treasury management

The functions of treasury management are discussed below:
 Cash Management: Treasury Management includes cash management, and so it ensures

that there are an effective collection and payment system in the organization.
 Liquidity Management: An optimum level of liquidity should be maintained in the
business, for the better and smooth functioning of the business,
 Availability of funds in adequate quantity and at the right time: The treasury manager
has to ensure that the funds are available with the organization in sufficient quantity
 Deployment of funds in adequate quantity and at the right time: The deployment of
funds has to be done in right quantity such as the acquisition of fixed assets, purchase of
raw material, payment of expenses like rent, salary, bills, interest and so forth.
 Optimum utilization of resources: Treasury Management also aims at ensuring the
effective utilization of the firm’s resources, to reduce the operating costs and also prevent
liquidity shortage in the coming time.
 Risk Management: One of the primary objectives of the treasury management is to
manage financial risk to allow the enterprise to meet its financial obligations, as they fall
due and also ensure predictable performance of the business
Objectives of Treasury management

 Availability of funds in right quantity:Treasury manager has also to ensure that the
funds are just adequate for the requirements, neither more nor less.Adequacy of funds has
to be determined carefully.
 Availability of funds at right time:The required funds for day-to-day working of the firm
should be available in time.Timely availability of funds smoothens the operations of the
firm.
 Deployment of funds in right quantity:Treasury manager must ensure that the right
quantity of funds is deployed. It meansallocation of funds for various expense heads,
parking of short-term funds and investing surplus funds.

Notes
Corporate Finance
 Deployment of funds at right time:Amount of time varies from firm to firm. The treasury
manager has to honour the outstanding commitments on working capital account within
this short span of time.
 Profiting from availability and deployment:Once the funds have been sourced in correct
measure, the deployment adds further to the profitability of the firm. Correct deployment
ensures that there is no unnecessary accumulation of funds in the firm at any point in
time.
Role of Treasury Management and Benefits

Although the role of the Treasury function is constantly evolving, it can be broken down into six
broad but interlinked categories:
1. Planning and Operations
Key activities Key benefits
Cash flow forecasting Subsidiary and Group financial management
Risk forecasting Risks are identified early and mitigated
Investment appraisal Resources are directed to the best opportunities
Tax planning Clear and quantifiable approach to the future
Pensions planning Tested contingencies in the event of exceptions

Co-operate with Board on strategic
development Operational risk management
Choose and operate Treasury systems Transaction costs minimized
Cash and Liquidity Management:

Manage internal capital market by
investing and lending to subsidiaries Minimize external borrowing requirement
Work with the business to optimize
commercial cash flows Optimize interest expense
Work with the business to optimize
working capital Optimize tax expense
Minimize idle cash through netting and
cash concentration Avoid future liquidity problems
Confirmation and reconciliation of
receipts Create ‘cash is king’ culture
Timely disbursement of payments Smooth operations and supplier relationships
2. Funding and Capital Markets:

Optimization of Weighted Average Cost of Capital
Optimization of capital structure (WACC)
Manage short, medium and long-term
investments Maximize yield on assets
Ensure adequate liquidity to support the
business Minimize interest expense
Ensure adequate liquidity to meet Access to capital at the right time, price and

Notes
obligations as they fall due conditions
Arrange liquidity for strategic events such

as M&A, Divestiture and JV’s Removal of concentration risks
Diversify capital sources, partners and
maturities Ensure good credit ratings
Portfolio management of debt, derivatives Ensure limits accurately reflected the borrowing
and investments requirement (thus minimizing commitment fees)
3. Financial Risk Management:

Seek natural hedges and offsets within the
business Visibility of financial risks on an enterprise basis
Interest Rate risk management Minimize external hedging requirement

Minimize impact of external risk on P&L and
FX risk management Balance Sheet
Commodity risk management Reduce volatility

Access to capital at the right time, price and
Counterparty risk management conditions
Credit risk management Improve asset quality
Liquidity risk management Create ‘risk aware’ culture
Pension risk management Certainty facilitates better decisions
4. Corporate Governance:

Ensure accurate valuation of financial Ensure the financial profile represents and true
instruments and fair view
Ensure accurate accounting of Treasury
transactions Adequate internal controls
Implement and manage treasury policies and
procedures Demonstrate preparedness
Provision of covenant tests and information to
investors Reputational risk management
Provision of compliance information to
regulators
Ensure accurate transaction history and audit
trail
Work with internal and external auditors
5. Stakeholder Relations:

Provide performance and risk
analytics to Board Access to capital at the right time, price and conditions
Manage relationship with banks and
other investors Relationship benefit from proactive communication

Notes
Corporate Finance
Manage relationship with credit rating

agencies Reputational risk management
Co-operate with Board and Investor Valuable knowledge and contacts from deep involvement
Relations on shareholder matters with financial markets
Ensure the Treasury function is Tangible financial results in the form of cost savings,
understood and valued within the efficiency gains, yield enhancement and protecting
business profitability
Relationship Between Treasury Management and Financial Management

The treasury function is supplemental and complemental to the finance function. As a
supplemental function, it reinforces the activities of the finance function by taking care of the finer
points while the latter delineates the broad contours. As a complementary function, the treasury
manager takes care of even those areas which the finance function does not touch.
3.8 External Commercial Borrowings

Foreign capital is money obtained from foreign countries to make investment domestically. There
are different types of foreign capital. The major category: Foreign Investment including Foreign
Direct Investment and Foreign Portfolio Investment. Other types: trade credit, NRI Deposits and
the External Commercial Borrowings (ECBs).
External Commercial Borrowings is an instrument that helps Indian firms and organizations raise
funds from outside India in foreign currencies. Indian corporates are permitted by the Indian
government to raise funds using External Commercial Borrowing to help the companies expand
their current capacity. External Commercial Borrowing can also be used to bring in fresh
investments.
 Commercial bank loans

 Buyers’ Credit
 Suppliers’ Credit
 Floating Rate Notes
 Fixed Rate Bonds
 Credit from official export credit agencies
 Commercial borrowings from Multilateral Financial Institutions
Features of External Commercial Borrowings

The important features of External Commercial Borrowings are discussed below:
 Availing of External Commercial Borrowing:The ECBs can be availed through two

modes.The Automatic route and the Approval mode. There are a variety of eligibility
regulations created by the government for availing of finance under the automatic route.
These regulations are in relation to amounts, industry, the end-use of the funds, etc.
Companies that desire to raise finance via ECB must necessarily meet these eligibility
criteria; thereafter, funds can be raised without the need for approval.The approval route,
on the other hand, mandates that companies which fall under certain pre-specified sectors
must obtain the RBI's or the government's explicit permission, prior to raising funds
through External Commercial Borrowing. The RBI has issued circulars and formal
guidelines, specifying the borrowing structure.

Notes
 Eligible Borrowers and Recognized Lenders:The approval route, on the other hand,
mandates that companies which fall under certain pre-specified sectors must obtain the
RBI's or the government's explicit permission, prior to raising funds through External
Commercial Borrowing. The RBI has issued circulars and formal guidelines, specifying the
borrowing structure.
 End-use Restrictions:The approval route, on the other hand, mandates that companies
which fall under certain pre-specified sectors must obtain the RBI's or the government's
explicit permission, prior to raising funds through External Commercial Borrowing. The
RBI has issued circulars and formal guidelines, specifying the borrowing structure.
Advantages of ECBs
The important benefits of External Commercial Borrowings are:
 External Commercial Borrowingsprovide opportunity to borrow large volume of funds.

 The funds are available for relatively long term.
 Interest rates are also lower compared to domestic funds.
 External Commercial Borrowingsare in the form of foreign currencies. Hence, they enable
the corporate to have foreign currency to meet the import of machineries etc.
 Corporate can raise External Commercial Borrowings from internationally recognized
sources such as banks, export credit agencies, international capital markets etc.
Disadvantages of ECBs
Some of the limitations of the External Commercial Borrowings are:
 As funds are available at lower rates, companies could evelop a lax attitude.
 May lead to higher debt on the balance sheet.
 The company opens itself up to the risks associated with exchange rates.
 Several guidelines and restrictions that cannot be evaded.
3.9 Micro Small and Medium Enterprise

MSME sector is the nursery of entrepreneurship contributing substantially to the GDP,
manufacturing output, exports as also is the highest generator of employment.MSMEs account for
about 45% of India’s manufacturing output.MSMEs accounts for nearly 40% of India’s total
exports.The sector employs more than 73 million people in more than 31 million units spread across
the country.MSMEs manufacture more than 6,000 products.MSMEs are an important sector for the
Indian economy and have contributed immensely to the country’s socio-economic development. It
not only generates employment opportunities but also works hand-in-hand towards the
development of the nation’s backward and rural areas. According to the annual report by the
Government (2018-19), there are around 6,08,41,245 MSMEs in India.
3.10 Financing for MSMEs:

Micro Small and Medium Enterprise sector can avail financing from various sources. The various
financing options available for Micro Small and MediumEnterprises are discussed below:
Scheduled Commercial Banks

Notes
Corporate Finance
Banks have been the largest source of finance for SMEs. Amongst commercial Banks, Public Banks
have a better access to MSMEs and take the lead in lending to the sector.Public sector banks also
have considerable empirical knowledge of the MSME sector.However, Banks have also aimed at
limiting their exposure due to high-risk perception and high transaction costs. Majority of the
MSMEs do not have sufficient assets to offer as collateral for lending. As majority of the MSMEs do
not follow proper accounting processes, the task of generating clean financial statements becomes
quite difficult.SMEs are part of the priority sector lending for banks.
Non-Banking Finance Companies

Non-Banking Finance Companies have also been a significant source of MSME debt. Large share of
the funding is for purchase of asset / plant & machinery. Major share of the loan portfolio
comprises of business related to transport, engineering, vendor supply chains and retail trade.
Small Banks
Small banks such as RRBs, UCBs and government financial institutions such as SFCs, SIDCs have
been able to leverage their local presence to get better knowledge and understanding of MSME
financial needs. Small Banks have also exhibited the potential to serve a much larger MSME
customer base than they are currently serving. RBI allowed collateral-free lending up to a limit of
INR 5 lakh for all enterprises covered under the definition of the MSMED Act 2006. Further, in an
effort to minimize the impact of default on loans, the GOI and SIDBI launched the Credit Guarantee
Trust for MSMEs. The CGTMSE aims to comfort the financier that in the event of MSME default
(which availed collateral-free credit facilities), the Guarantee Trust will make good the loss by up to
75 to 85% of the credit availed.
3.11 Equity funding

Venture capital provides financial assistance primarily by way of equity or equity-linked capital
investment. MSMEs which are involved in commercializing innovations and high-end technologies
need access to the VC fund. These firms need finance during the initial stages of conceptualizing
their product offerings and during the development and marketing phase. Besides infusing capital,
VCs also bring expertise, superior advice and other skills that help the MSME to develop
marketable products. VC provides assistance to the entrepreneur in recruiting key personnel,
providing contacts in international markets, introductions to strategic partners, etc. They also take
active part in the management of the company and provide expertise in the board decisions of the
firm. VC funding improves the credibility of the MSME and increases the chances of receiving Bank
finance.
Problems faced by MSMEs
The Micro Small and Medium Enterprise sector faces a lot of problem in India while availing the
financing. The list of the problems that are faced by existing/new companies in SME sector are as
under:
 Absence of collateral in loan

 High rates of lending
 Lack of knowledge about available schemes
 Lengthy processing time for the loan application
 Lack of available infrastructure
 Lack of availability of skilled labor
 Tax compliance issues
Summary
Money Market is a market for lending and borrowing of short-term funds. It deals in funds and
financial instruments having a maturity period of one day to one year. It covers money and
financial assets which are close substitutes for money.

Notes
 The Indian money market consists of Reserve Bank of India, Commercial banks, Co-
operative banks, and other specialized financial institutions.The Reserve Bank of India is
the leader of the money market in India. Some Non-Banking Financial Companies
(NBFCs) and financial institutions like LIC, GIC, UTI, etc. also operate in the Indian
money market.
 There are many institutions which participates in the India money market which are as
follows:
o Reserve Bank of India
o Commercial banks
o Central and State Government
o Public sector undertaking
o Private sector companies
o Non-banking financial institutions
o Mutual funds
o Insurance companies
 The important functions of the money market are Financing Trade, helping Central Bank
in framing Policies, influencing the capital market andproviding commercial banks with a
market where they can invest their excess reserves and earn interest which can easily be
converted to cash.
 The Money Market Instruments are:
o Treasury Bills: treasury bill is actually apromissory note issued by the
Government under discount for a specified period stated therein which does not
exceed one year. It is a short-term borrowing instrument issued by the govt. of
India.
o Commercial Paper: A commercial paper is a bill of exchange used to finance the
working capital requirements of business firms. It is a short-term, negotiable, self-
liquidating instrument which is used to finance the credit sales of firms. It is
issued by one firm to other business firms, insurance companies, pension funds
and banks.
o Certificate of Deposit: A Certificate of Deposit (CD) is a money market
instrument which is issued in a dematerialized form against funds deposited in a
bank for a specific period.Regulated by the Reserve Bank of India, the Certificate
of Deposit is a promissory note, the interest on which is paid by the bank.
 Treasury Management is about planning, organizing and controlling holding, funds and
working capital of the enterprise. The aim is to make the best possible use of the funds,
maintain firm’s liquidity, reduce the overall cost of funds, and mitigate operational and
financial risk.
 External Commercial Borrowings is an instrument that helps Indian firms and
organizations raise funds from outside India in foreign currencies. Indian corporates are
permitted by the Indian government to raise funds using External Commercial Borrowing
to help the companies expand their current capacity.
 The various financing options available for Micro Small and MediumEnterprises are:
Scheduled Commercial Banks, Non-Banking Finance Companies, Small Banks and Equity
funding.

Notes
Corporate Finance
 The Micro Small and Medium Enterprise sector faces a lot of problem in India while
availing the financing which are absence of collateral in loan, high rates of lending, lack of
knowledge about available schemes, lengthy processing time for the loan application, lack
of available infrastructure etc.
Keywords
Money market, Treasury bills, Certificate of deposit, Commercial paper, Short-term financing,
External Commercial Borrowing, Treasury Management, MSME.
Self Assessment
1. How many types of treasury bills are issued in India?

A. One
B. Two
C. Three
D. Four
2. Which among the following is not a type of treasury bill issued in India?
A. 45 day
B. 91 day
C. 182 day
D. 364 day
3. In India, Treasury bill is quoted at discounted price to par value of _____?

A. Rs 50
B. Rs 100
C. Rs 150
D. Rs 200
4. The tenor of certificate of deposit issued by commercial banks ranges from ______ to ________
A. 7 days, 1 year
B. 14 days, 1 year
C. 1 year, 3 years
D. 14 days, 3 years
5. The financial instrument which is used to raise funds for working capital is considered as
A. Commercial Paper
B. Commercial notes
C. Notes payable
D. Notes receivable
6. What is the Purpose of a Money Market?

A. Maintains Liquidity in the Market
B. Provides Funds at a Short Notice
C. Utilization of Surplus Funds
D. All of the above
7. Which of the following statement is not true
A. No restrictive conditions
B. The size of money that can be raised through Commercial paper is unlimited.
C. Cost of Commercial Paper to the issuing firm is lower
D. Only highly rated firms can raise money through commercial papers.

Notes
8. Who among the following cannot issue commercial papers?

A. Scheduled Commercial Banks
B. Corporates
C. Primary dealers (PDs)
D. All-India Financial Institutions (FIs)
9. The financial instrument such as commercial paper can be sold

A. issued by commercial banks
B. directly
C. with brokers or dealers
D. functional buyers
10. The certificate of deposits which are usually negotiable are issued by
A. banks
B. financial market
C. stock exchange
D. business corporations
11. Functions of Treasury management are:

A. Cash Management
B. Liquidity management
C. Optimum utilization of resources
D. All of the above
12. Which is not true for ECBs?

A. It provides opportunity to borrow large volume of funds
B. The funds are available for relatively short term
C. Interest rate are lower compared to domestic funds
D. They enable the corporate to have foreign currency to meet the import of machineries etc.
13. External Commercial Borrowings (ECBs) includes:

A. Commercial bank loans
B. Buyers’ Credit
C. Suppliers’ Credit
D. All of the above
14. What is/are the routes available for the Indian companies to get ECBs?
A. The Automatic route
B. The Approval route
C. Both a and b
D. None of the Above
15. What is/are the problem/s faced by MSMEs?

A. Difficulty in collateral/guarantee
B. High rates of lending
C. Lack of knowledge about available schemes
D. All of the above
Answers forSelf Assessment

1. C 2. A 3. B 4. A 5. A
6. D 7. B 8. A 9. B 10. A

Notes
Corporate Finance
11. D 12. B 13. D 14. C 15. D
Review Questions
1. How does Money market differ from Capital market? Explain.
2. Explain in brief the difference between Treasury bills and Commercial papers.
3. List the functions of treasury management
4. What are External commercial borrowings? explain the features of ECBs.
5. Discuss the financing options available for MSME sector.
Further Readings
Hill.
2.Pandey, I.M. (2015). Financial Management (10th Ed). New Delphi, India, Vikas
Publishing
Web Links
1.https://www.coverfox.com/personal-finance/mutual-funds/money-market-
instruments/
2.https://scripbox.com/mf/money-market-instruments/
3.https://www.bankbazaar.com/tax/external-commercial-borrowing.html

Notes
Dr. Atif Ghayas, Lovely Professional University Unit 04: Time Value of Money Concept
Unit 04: Time Value of Money Concept

CONTENTS
Objectives
Introduction
4.1 Time Value of Money
4.2 Time Lines
4.3 Concept of Interest
4.4 Compounding
4.5 Impact of Interest Rate
4.6 Impact of Time Period
4.7 Discounting
4.8 Future Value
4.9 Present Value
4.10 Types of Annuity
4.11 Effective Interest Rate
Summary
Keywords
Self Assessment
Review Questions
Further Readings
Objectives
 understand the concept of Time Value of Money

 explain the concept of Compounding
 explain the concept of Discounting
 explain Future value and Present value concepts
 compute future value of a single amount and an annuity
 compute present value of a single amount and an annuity
 compute the future value of annuity in case of Annuity due
 compute the Present value of annuity in case of Annuity due
 compute Effective Interest Rate
Introduction
As we have already discussed in chapter 1 that the objective of wealth maximization of financial
management is superior to the objective of profit maximization, because the objective of wealth
maximization incorporates the timing of benefits received while the objective of profit
maximization ignores it. In order to make a comparison between cash flows accruing in different
time periods in future, it is necessary to discount them to the present value or if the value of todays
cash flow has to be calculated for some future point of time, it is necessary to compound it. This
chapter is devoted to the discussion of compounding and discounting.

Notes
Corporate Finance
4.1 Time Value of Money
Conceptually, ‘time value of money’ means that the value of a unit of money is different in different
time periods. The value of a sum of money received today is more than its value received after
some time. Conversely, the sum of money received in future is less valuable than it is today. In
other words, the present worth of a rupee received after some time will be less than a rupee
received today. Since a rupee received today has more value, rational investors would prefer
current receipt to future receipts. The time value of money can also be referred to as time preference
for money.
4.2 Time Lines

Time lines are used to identify when cash inflows and outflows will occur so that an accurate
financial assessment can be made.
4.3 Concept of Interest

The time preference for money is generally expressed by an interest rate. If the time preference rate
is 5 per cent, it means that an investor can forego the opportunity of receiving Rs. 100 if he/she is
offered Rs. 105 after one year. How does knowledge of the required rate of return (or simply called
the interest rate) help a firm in making investment decisions? It permits the firm to convert cash
flows occurring at different times to amounts of equivalent value in the present, that is, a common
point of reference. Interest can be thought of as rent for the use of money or fee for the use of the
money. If the interest rate is 10 percent, then the rental rate for using Rs 100 for the year is Rs 10.
4.4 Compounding
It is the impact of the time value of money (e.g., interest rate) over multiple periods into the future,
where the interest is added to the original amount. For example, if you have Rs 1,000 and invest it
at 10 percent per year for 20 years, its value after 20 years is Rs 6,727. Assuming that you leave the
interest amount earned each year with the investment instead of withdrawing it. If you leave the
interest with the investment, the size of the investment will grow exponentially. But if you leave it
with the investment, the size of the investment will grow exponentially. This is because you are
earning interest on your interest. This process is called compounding.
Table 1: Compounding computation of Rs 100 over 10 years at an annual interest rate of 15 percent.
Year Amount Computation
0 100
1 115.0 100 × 1.15 = 115
2 132.3 115 × 1.15 = 132.2
3 152.1 132.2 × 1.15 = 152.0
4 174.9 152.0 × 1.15 = 174.9
5 201.1 174.9 × 1.15 = 201.1
6 231.3 201.1 × 1.15 = 231.3
7 266.0 231.3 × 1.15 = 266.0
8 305.9 266.0 × 1.15 = 305.9
9 351.8 305.9 × 1.15 = 351.7
10 404.6 7. × 1.15 = 404.5
The above Table is shown graphically in Figure 1. The increase in cash amount over the 10-year
period increases exponentially rather than in a straight line. The slope of the line increases over
time it meaning that each year the size of the increase is greater than the previous year. If the time

Notes

period is extended to 20 or 30 years, the slope of the line would continue to increase. Over the long-
term, compounding is a very powerful financial concept.
Fig 1: Impact of Compound Interest
4.5 Impact of Interest Rate

The effect of compounding is also greatly impacted by the size of the interest rate. Essentially, the
larger the interest rate the greater the impact of compounding. Figure 2 shows the impact of a 20
percent interest rate (5 percent higher rate) and 10 percent (5 percent lower rate).
Fig. 2: Impact of Compound Interest
Figure 2 shows the impact of a 20 percent interest rate (5 percent higher rate) and 10 percent (5
percent lower rate) over the 10-year period. By examining you can see that increasing the size of the
interest rate greatly increases the power of compounding.
Table 2: Compounding computation of Rs 100 over 10 years at an annual interest rate of 15, 20 and
10 percent.
Year 15% 20% 10%

Notes
Corporate Finance
0 100 100.0 100.0
1 115.0 120.0 110.0
2 132.3 144.0 121.0
3 152.1 172.8 133.1
4 174.9 207.4 146.4
5 201.1 248.8 161.1
6 231.3 298.6 177.2
7 266.0 358.3 194.9
8 305.9 430.0 214.4
9 351.8 516.0 235.8
10 404.6 619.2 259.4
Over the 10-year period, the 20 percent rate yields Rs 619.2, while the 10 percent rate results in Rs
259.4. Increasing the size of the interest rate increases the power of compounding.
4.6 Impact of Time Period

Another dimension of the impact of compounding is the number of compounding periods within a
year. As shown in Table 3, semiannual compounding will result in 20 compounding periods over a
10-year period, while annual compounding results in only 10 compounding period. A shorter
compounding period means a larger number of compounding periods over a given time period
and a greater compounding impact. If the compounding period is shortened to monthly or daily
periods, the compounding impact will be even greater.
Table 1: Compounding computation of Rs 100 over 10 years at an annual interest rate of 15 percent.
0 100
1 115.0 100 × 1.15 = 115

2 132.3 115 × 1.15 = 132.2
3 152.1 132.2 × 1.15 = 152.0
4 174.9 152.0 × 1.15 = 174.9
5 201.1 174.9 × 1.15 = 201.1
6 231.3 201.1 × 1.15 = 231.3
7 266.0 231.3 × 1.15 = 266.0
8 305.9 266.0 × 1.15 = 305.9
9 351.8 305.9 × 1.15 = 351.7
10 404.6 351.7 × 1.15 = 404.5
Table 3: A comparison of Rs 100 compounding semiannually (10 years, 7.5 percent interest)
Year Amount
0 100
0.5 107.5
1 115.6

Notes
1.5 124.2
2 133.5
2.5 143.6
3 154.3
3.5 165.9
4 178.3
4.5 191.7
5 206.1
5.5 221.6
6 238.2
6.5 256.0
7 275.2
7.5 295.9
8 318.1
8.5 341.9
9 367.6
9.5 395.1
10 424.8
4.7 Discounting
Although the concept of compounding is straight forward and relatively easy to understand, the
concept of discounting is more difficult. Discounting is the opposite of compounding. If we start
with a future value of Rs 404.6 at the end of 10 years in the future, and discount it back to today at
an interest rate of 15 percent, the present value is Rs 100.
As shown in Table 1, the compounding factor of annually compounding at an interest rate of 15
percent is 1.15 or 1.15/1.00. If discounting is the opposite of compounding, then the discounting
factor is 1.00 / 1.15 = 0.869565 or 0.87.
Table 4: Discounting computation of Rs 404.6 over 10 years at an annual discount rate of 15 percent
10 404.6
9 351.8 404.6 × 0.8695 = 351.8
8 305.9 351.8 × 1.8695 = 305.9
7 266 305.9 × 2.8695 = 266.0
6 231.3 266.0 × 3.8695 = 231.3
5 201.1 231.3 × 4.8695 = 201.1
4 174.9 201.1 × 5.8695 = 174.9
3 152.1 174.9 × 6.8695 = 152.1
2 132.3 152.1 × 7.8695 = 132.3
1 115 132.3 × 8.8695 = 115.0

Notes
Corporate Finance
0 100 115.0 × 9.8695 = 100.0
As shown in Table 4, the discounted amount becomes smaller as the time period moves closer to
the current time period. When we compounded Rs 100 over 10 years at a 15 percent interest rate,
the value at the end of the period is Rs. 404.6. When we discount Rs. 404.6 over 10 years at a 15
percent interest rate, the present value or value today is Rs 100. The discounting impact is shown in
Figure 3. The curve is the opposite of the compounding curve in Figure 1.
Fig 3: Impact of Discounted Interest
The impact of discounting using interest rates of 15 percent, 20 percent, and 10 percent is shown in
Figure 4. The 15 percent interest rate results in a larger discounting impact than the 10 percent rate,
just as the 15 percent interest rate results in a larger compounding impact as shown in Figure 2.
Fig 4: Impact of Discounted Interest

Notes

Now let’s discuss how future value of a single mount and an annuity and present value of a single
amount and an annuity is calculated one of the major problems faced by the financial manager is
how to determine the present value of cash flows expected in the future.
4.8 Future Value

Future value id the amount of money an investment will grow to over some period of time at some
given interest rate. In other words, future value is the cash value of an investment at some time in
future.
Future Value of a Single Amount

Suppose you invest Rs 100 in a savings account that pays 10 percent interest per year. How much
will you have in one year? You will have Rs 110. This Rs. 110 is equal to your original principal of
Rs 100 plus Rs. 10 in interest that you earn. In general, if you invest for one period at an interest rate
of r, your investment will grow to (1+ r) per rupee invested. In our example, r is 10 percent.
Future Value of a Single Amount for more than one Period

How much will be your investment of Rs 100 after two years, the interest rate is 10%? If you leave
the entire Rs 110 in the bank, you will earn Rs 110 x 10% = Rs 11 in interest during the second year,
so you will have a total of Rs 110 + Rs. 11 = Rs. 121. This Rs 121 is the future value of Rs 100 in two
years at 10 percent.
Compounding: This process of leaving your money and any accumulated interest in an investment
for more than one period, is called compounding. Compounding the interest means earning
interest on interest.
We now take a closer look at how we calculated Rs 121 future value.
We multiplied Rs 110 by 1.1 to get Rs 121.
Rs 121 = Rs 110 x 1.1
= (Rs 100 x 1.1) x 1.1
= Rs 100 x 1.1 2
= Rs 100 x 1.21
How much would our Rs 100 grow to after 3 years?

Rs 133.10 = Rs 121 x 1.1
= (Rs 110 x 1.1) x 1.1
= (Rs 100 x 1.1) x 1.1 x 1.1
= Rs 100 x (1.1 x 1.1 x 1.1)
= Rs 100 x 1.1 3
= Rs 100 x 1.331
You’re probably noticing a pattern in these calculations, so we can now go ahead and state the
general result.
The future value of Re. 1 invested for periods t at a rate of r per year is:
Future value = Re. 1 x (1 + r) t
The expression (1 + r) is called the Future Value Interest Factor for Re. 1 invested at r percent
t
for t periods. What would your Rs. 100 be worth after five years? We can first compute the
relevant future value factor as:
(1 + r)t = (1 + .10)5 = 1.15 = 1.6105

Notes
Corporate Finance
Thus, your Rs 100 will grow to:
Rs 100 x 1.6105 = Rs 161.05
The growth of your Rs. 100 each year is illustrated in the Table 1. Over the five-year span of
this investment, the simple interest is Rs 100 x .10 = Rs 10 per year, so you accumulate Rs 50
this way. The other Rs 11.05 is from compounding.
Table 1: Future value of Rs 100 at 10 percent
Year Beginning Simple Compound Total Ending

Amount Interest Interest Interest Amount
1 100.00 10 0.00 10.00 110.00
2 110.00 10 1.00 11.00 121.00
3 121.00 10 2.10 12.10 133.10
4 133.10 10 3.31 13.31 146.41
5 146.41 10 4.64 14.64 161.05
Total 50 11.05 61.05
Figure 05 illustrates the growth of the compound interest in Table 1. The amount of the compound
interest keeps increasing because more and more interest builds up and there is thus more to
compound.
Fig 05: Future value, simple interest, and compound interest

Future values depend critically on the assumed interest rate, particularly for long-lived
investments. Figure 2 illustrates this relationship by plotting the growth of Re. 1 for different rates
and lengths of time. To solve future value problems, we need to come up with the relevant future
value factors.

Notes
Fig 02: Future value of Re 1 for different periods and rates
Notice the future value of Re. 1 after 10 years is about Re. 6.20 at a 20 percent rate, but it is only
about Re. 2.60 at 10 percent. This would work just fine, but it would get be very tedious for, say, a
30-year investment. Alternatively, you can use a table that contains future value factors for some
common interest rates and time periods. Table 2 contains some of these factors.
Table 2: Future value interest factors
Year Interest Rate
5% 10% 15% 20%
1 1.0500 1.1000 1.1500 1.2000
2 1.1025 1.2100 1.3225 1.4400
3 1.1576 1.3310 1.5209 1.7280
4 1.2155 1.4641 1.7490 2.0736
5 1.2763 1.6105 2.0114 2.4883
Power of Compound Interest

Suppose one of your ancestors had invested Rs. 5 for you at a 6 percent interest rate 200 years ago.
How much would you have today? The future value factor is a substantial 1.06 115,125.9.
200
So, you would have

Rs. 5 x 115,125.9
= Rs. 575,629.5 today.
The effect of compounding is not great over short time periods, but it really starts to add up as the
horizon grows.

Notes
Corporate Finance
Future Value of an Annuity
An annuity is a series of payments (or receipts) of fixed amount e.g., payment of premium in case of
life policy and home loans etc. In case of regular annuity, the payment or receipt occurs at the end
of each period. If the payment or receipt occurs at the beginning of each period it is called annuity
due
Future Value of Regular (ordinary) Annuity

The compound value of an annuity is the total amount one would have at the end of the annuity
period if the amount is invested at a certain rate of interest and is held to the end of the annuity
period. A promise to pay Rs. 1000 a year for 5 years is a 5 year annuity. For example: If you deposit
Rs. 5000 at the end of every year in a bank for 5 years and the bank is paying 10% interest, the
future value of this annuity will be Rs. 30,525.5.
Rs. 5000(1.10) +Rs. 5000(1.10) + Rs,5000(1.10) + Rs. 5000(1.10)+ Rs 5,000

4 3 2
The above procedure can be expressed as:
FVA =A(1+i)n-1i
Where,
A = Periodic cash flow
I = Interest rate
N= Number of years
Taking the figures from Example:
= 5000(1+.10)5-10.10
= 5000(1.6105)-10.10
FVA = 5000 ×0.61050.10
FVA = 5000 × 6.105
FVA = Rs. 30,525
4.9 Present Value

Present value is just the opposite of future value.
In future value we do compounding of money, In present value concept we discount back to the
present.
The process of reducing future income payments to their present value is called discounting.
The value today of the sum received in the future is called its present value.
Present Value of a Single Amount for one Period

You have seen that the future value of Re. 1 for one year at 10% is Rs. 1.10.
How much you have to invest today at 10% to get Re. 1 in one year?
You know the future value here is Re. 1, but what is the present value of Re. 1? You need Re. 1 at
the end of the year, the present value will be:
PV x 1.1 = Re. 1,
Present Value = Re.1/1.1

Notes

= Re. 0.909
Present value is thus just the reverse of future value. Instead of compounding the money forward
into the future, we discount it back to the present.
The present value of Re. 1 to be received in one period is generally given as:
PV = Re. 1 x [1/(1 + r)]
= Re. 1/(1 + r)
If you want to know PV of Rs. 500 in one year at 8%, then:

PV = 500 11.08 = Rs. 462.5
Present Values for Multiple Periods

Suppose you need to have Rs. 1,000 in two years. If you can earn 7 percent, how much do you have
to invest to make sure that you have the Rs. 1,000 when you need it?
In other words, it must be the case that:
Rs. 1,000 = PV x 1.07 x 1.07
= PV x 1.07 2
= PV x 1.1449
Present value = Rs. 1,000/1.1449
= Rs. 873.44
The present value of Re. 1 to be received t periods into the future at a discount rate of r is:
PV = Rs. 1 x [1/(1 + r) ] t
= Rs. 1/(1 + r) t
The quantity in brackets, 1/(1 + r) , it is called a discount factor or Present Value Interest Factor.
t
Suppose you want to earn Rs. 1500 in three years at 7% rate of interest. How much should you
invest to get Rs. 1,500 in three years?
PV = 15001(1.07)3
= 1500 x 0.8163
= Rs. 1224
There are tables for present value factors just as there are tables for future value factors.
Interest Rate
Year 5% 10% 15% 20%
1 .9524 .9091 .8696 .8333
2 .9070 .8264 .7561 .6944
3 .8638 .7513 .6575 .5787

Notes
Corporate Finance
4 .8227 .6830 .5718 .4823
5 .7835 .6209 .4972 .4019
Present Values of Annuity

 Suppose we were examining an asset that promised to pay Rs. 500 at the end of each of the
next three years.
 The cash flows from this asset are in the form of a three-year, Rs. 500 annuity.
 If we wanted to earn 10 percent on our money, how much would we offer for this
annuity?
 It can be expressed as follows:

Rs 500 11.101+50011.102+50011.103
= Rs. 500 x 0.9091 + Rs. 500 x 0.8264 + Rs. 500 x 0.7513
= Rs. 454.55 + Rs. 413.22 + Rs. 375.66
Rs. 1,243.43
We will often encounter situations in which the number of cash flows is quite large. For example,
home mortgage calls for monthly payments over 30 years, for a total of 360 payments. If we were
trying to determine the present value of those payments, it would be useful to have a shortcut.
Annuity present value =C 1-Present Valuer

=C×1-1/1 + rtr
The term in parentheses on the first line is called the present value interest factor for annuities
Present value factor = 1/1.1 = 1/1.331 = .75131
3
Annuity present value factor = (1 - Present value factor)/r

= (1 - .75131)/.10
= .248685/.10 = 2.48685
Annuity present value = Rs. 500 x 2.48685
= Rs. 1,243.43
4.10 Types of Annuity

An annuity is a series of payments (or receipts) of fixed amount e.g., payment of premium in case of
life policy and home loans etc.
Cash flows are not only made in the end of the period, in practice, cash flows could take place at the
beginning of the period. When you buy a car on an instalment basis, the dealer asks you to make
the first payment immediately and rest of the instalments in the beginning of each period. It is
common in lease or hire purchase contracts that payments are required to be made in the beginning
of each period. Lease is a contract to pay rentals for the use of an asset.
Hire purchase contract, regular instalments are made for acquiring an asset. Lease or hire purchase
payments are commonly required to be made in the beginning of each period. Lease is a contract to
pay rentals for the use of an asset. In hire purchase contract, regular instalments are made for
acquiring an asset.

Notes
Future Value of an Annuity Due

 Suppose you deposit Re. 1 in a savings account at the beginning of each year for 4 years to
earn 6 per cent interest.
 How much will be the compound value at the end of 4 years?
If we deposit Re. 1 made at the end of each year, the compound value at the end of 4 years is:
= Rs. 4.375
F = 1 x 1.06 + 1 x 1.06 + 1 x 1.06 + 1
3 2 1
= 1.191 + 1.124 + 1.06 + 1 = Rs. 4.637
However, Re. 1 deposited in the beginning of each of year 1 through year 4 will earn interest
respectively for 4 years, 3 years, 2 years and 1 year.
F = 1 x 1.06 + 1 x 1.06 + 1 x 1.06 + 1 x 1.06

4 3 2 1
= 1.262 + 1.191 + 1.124 + 1.06

= Rs. 4.637
Compound value of an annuity due is more than of an annuity as it earns extra interest for one
year. If you multiply the compound value of an annuity by (1+ i), you would get the
compound value of an annuity due.
Future value of an annuity due

= Future value of an annuity × (1 + i)
= A × CVFA × (1 + i)n,i
=A1+in-1i(1+i)
Thus, 4.375 × 1.06 = Rs. 4.637
Present Value of an Annuity Due

Let us consider a 4-year annuity of Re. 1 each year, the interest rate being 10 per cent. What is the
present value of this annuity if each payment is made at the beginning of the year?
When payments of Re. 1 are made at the end of each year, then the present value of the annuity is:
1(1.10)1+1(1.10)2+1(1.10)3+1(1.10)4
0.909 + 0.826 + 0.751 + 0.683

Notes
Corporate Finance
= Rs. 3.169
If the first payment is made immediately, then its present value would be the same. Each year’s
cash payment will be discounted by one year less. Present value of an annuity due would be higher
than the present value of an annuity.
Thus, the present value of the series of Re. 1 payments starting at the beginning of a period is:
PV= 1(1.10)0+1(1.10)1+1(1.10)2+1(1.10)3
= 1 + 0.909 + 0.826 + 0.751
= Rs. 3.487
The formula for the present value of an annuity due is:

= Present value of an annuity × (1 + i)
P=A1i-1i1+in(1+i)
=A ×PVFAn,i×(1+i)
Hence, the present value of Re. 1 paid at the beginning of each year for 4 years is:
1 × 3.170 × 1.10
= Rs. 3.487
4.11 Effective Interest Rate

We have assumed in the discussion so far that cash flows occurred once a year. In practice, cash
flows could occur more than once a year. For example, banks may pay interest on savings account
quarterly. On debentures and public deposits, companies may pay interest semi-annually.
The interest rate is generally specified on an annual basis which is known as the nominal interest
rate. If compounding is done more than once a year, the actual annualized rate of interest would be
higher than the nominal interest rate and it is called the Effective Interest Rate.
Suppose you invest Rs. 100 now in a bank, interest rate is 10 per cent annually. Bank will
compound interest semi-annually. How much amount will you get after a year? Bank will calculate
interest on Rs. 100 for first six months at 10 per cent. You will again receive interest for next six
months at 10 per cent on the total amount accumulated at the end of first six months.
The ending amount of first six months or the beginning amount of the second six-month period will
be:
Rs. 100 + Rs. 5 = Rs. 105
Then, the interest on Rs. 105 for next six months will be:

Notes

= Rs. 105 × 10% × ½ = Rs. 5.25
Amount at the end:
Rs. 100 + Rs. 5 + Rs. 5.25 = Rs. 110.25
If compoundedannually, you would have received:
Rs. 100 + 10% × Rs. 100 = Rs. 110
Interest amount is more under semi-annual compounding as you earned interest on interest. On an
annual basis, you earned Rs. 10.25 on your deposit of Rs. 100.
So, the effective interest rate (EIR) is:
EIR=5+5.25100=10.25%
The formula for calculating EIR can be written as:

EIR=1+imn×m-1
Where,
i, is the annual nominal rate of interest
n, the number of years
m, the number of compounding per year
Rs. 100 compounded annually at 10.25 per cent, or Rs. 100 compounded semi-annually at 10 per
cent will result into the same amount.
EIR=1+i21×2-1, =1+0.1022-1
=1.1025 -1
= 0.1025 or 10.25%
Example of Effective Rate of Interest

With an annual rate of interest of 13 per cent on a public deposit, what will be the effective rate of
interest if the compounding is applied:
 Half-Yearly Compounding
EIR=1+i21×2-1
=1+0.1321×2-1
=(1.065)2-1
0.1342 or 13.42%
 Quarterly Compounding
EIR=1+i41×4-1
=1+0.1341×4-1
=(1.0325)4-1
0.1362 or 13.62%
 Monthly Compounding
EIR=1+i121×12-1
=1+0.1341×12-1
=(1.0325)4-1
0.1362 or 13.62%
 Weekly Compounding
EIR=1+i521×52-1

Notes
Corporate Finance
=1+0.13521×52-1
=(1.0025)52-1
0.1382 or 13.82%
Summary
 Time value of money means that the value of a unit of money is different in different time
periods. The value of a sum of money received today is more than its value received after
some time.
 The time preference for money is generally expressed by an interest rate. If the time
preference rate is 5 percent, it means that an investor can forego the opportunity of receiving
Rs. 100 if he/she is offered Rs. 105 after one year.
 Compounding is the impact of the time value of money (e.g., interest rate) over multiple
periods into the future, where the interest is added to the original amount. For example, if
you have Rs 1,000 and invest it at 10 percent per year for 20 years, its value after 20 years is
Rs 6,727.
 Discounting is the opposite of compounding. If we start with a future value of Rs 404.6 at

the end of 10 years in the future, and discount it back to today at an interest rate of 15
percent, the present value is Rs 100.
 Future value is the amount of money an investment will grow to over some period of time at
some given interest rate. In other words, future value is the cash value of an investment at
some time in future.
 Present value is just the opposite of future value. In future value we do compounding of
money, in present value concept, we discount back to the present. The process of reducing
future income payments to their present value is called discounting.
 An annuity is a series of payments (or receipts) of fixed amount e.g., payment of premium in
case of life policy and home loans etc.
 Regular annuity and Annuity due are two types of Annuity

 The interest rate is generally specified on an annual basis which is known as the nominal
interest rate. If compounding is done more than once a year, the actual annualized rate of
interest would be higher than the nominal interest rate and it is called the Effective Interest
Rate.
Keywords
Corporate finance, Financial Management, Finance Functions, Profit maximization, Wealth
maximization, Agency issues, Business Ethics, Social responsibility.
Self Assessment
1. The reason/s for individual’s time preference for money is/are:
A. Preference for consumption
B. Investment opportunities
C. Uncertainty with the future payment
D. All of the above
2. If you have Rs 100 and invest it at 10 percent per year for 5 years, its value after 5 years is:
A. Rs. 161.05
B. Rs. 146.4
C. Rs.177.2
D. Rs.155.5
3. Time value of money indicates that

A. A unit of money obtained today is worth more than a unit of money obtained in future
B. A unit of money obtained today is worth less than a unit of money obtained in future
C. There is no difference in the value of money obtained today and tomorrow

Notes
4. If the nominal rate of interest is 10% per annum and there is quarterly compounding, the
effective rate of interest will be:
A. 10% per annum
B. 10.10 per annum
C. 10.25%per annum
D. 10.38% per annum
5. A diagram for visualizing future cash flows is known as

A. a future value vector.
B. a cash flow chart.
C. an FV/PV plot.
D. a timeline.
6. Total simple interest and compound interest on Rs 100 invested at 10 per cent for 5 years are:
A. Rs. 50, Rs. 61.05
B. Rs. 50, Rs. 55
C. Rs. 40, Rs. 50
D. Rs. 50, Rs. 66.06
7. A 5-year ordinary annuity has a present value of Rs. 1,000. If the interest rate is 8 per cent, the
amount of each annuity payment is closest to which of the following?
A. Rs. 250.44
B. Rs. 231.91
C. Rs. 181.62
D. Rs. 184.08
8. The interest rate used in the present value calculation is often referred to as?
A. Discount rate
B. Inflation rate
C. Nominal rate
D. None of the given option
9. In_________, payments or receipts occur at the end of each period. In_________, Payments or
receipts occur at beginning of each period?
A. Ordinary annuity, Annuity due
B. Annuity due, Ordinary annuity
C. Ordinary annuity, Annuity due
D. None
10. Present Value of Rs. 500 in one year at 8% is:

A. 462.5
B. 455.5
C. 472.2
D. 481.1
11. To increase a given present value, the discount rate should be adjusted
A. upward
B. downward
C. True
D. False
12. In 3 years, you are to receive Rs. 5,000. If the interest rate were to suddenly increase, the
present value of that future amount would
A. Decrease
B. Increase
C. cannot be determined without more information.
D. remain unchanged.
13. Suppose you deposit Re. 1 in a savings account at the beginning of each year for 4 years to
earn 6 per cent interest. How much will be the compound value at the end of 4 years:
A. Rs. 4.637
B. Rs. 4.375

Notes
Corporate Finance
C. Rs. 4.523
D. Rs. 4.432
14. What is the present value of this annuity if Re. 1 each payment is made at the beginning of
the year for 4 years, the interest rate being 10 per cent?
A. 3.487
B. 3.169
C. 3.321
D. 3.211
15. With an annual rate of interest of 13 per cent on a public deposit, what will be the effective
rate of interest if the compounding is applied Half yearly?
A. 13.42%
B. 13.62%
C. 13.82%
D. 13.12%

1. D 2. A 3. A 4. D 5. D
6. A 7. A 8. A 9. A 10. A
11. B 12. A 13. A 14. A 15. A
Review Questions
1. Briefly explain and illustrate the concept of ‘time value of money’.
2. Explain the difference between the future value and present value?
3. Distinguish between nominal rates of interest and effective rate of interest
4. An investor has two options to choose from: (a) Rs 6,000 after 1 year; (b) Rs 9,000 after 4 years.
Assuming a discount rate of (i) 10 percent and (ii) 20 percent, which alternative should he opt
for?
5. Compute the future values of (1) an initial Rs 100 compounded annually for 10 years at 10 per
cent and (2) an annuity of Rs 100 for 10 years at 10 per cent
Further Readings
1. Khan, M. and Jain, P., 2011. Financial management. 1st ed. New Delhi: Tata
McGraw-Hill.
Publishing
3. Berk, Jonathan. &DeMarzo, Peter. & Harford, Jarrad. & Ford, Guy. &Mollica,
Vito. (2017). Fundamentals of corporate finance. Melbourne, VIC : Pearson
Australia

Notes
Dr. Atif Ghayas, Lovely Professional University Unit 05: Investment Decisions -1
Unit 05: Investment Decisions - 1

CONTENTS
Objectives
Introduction
5.1 Nature of Capital Budgeting Decisions
5.2 Importance of Investment Decisions
5.3 Types of Decisions
5.5 Investment Evaluation Criteria
5.6 Definition of Payback
5.7 Discounted payback period
5.8 Accounting Rate of Return
Summary
Keywords
Self Assessment
Review Questions
Further Readings
Objectives
 understand the nature of capital budgeting decisions.

 explain the importance of capital budgeting decisions.
 describe the types of capital budgeting decisions.
 understand the concept, advantage and limitations of the payback.
 illustrate the computation of the payback.
 illustrate the computation of the discounted payback.
 understand the concept of ARR.
 explain the advantage and limitations of the ARR technique.
 illustrate the computation of ARR technique.
Introduction
As we discussed in first unit that the financial management can be divided into three major
decisions in a firm (i) The investment decision, (ii) The financing decision, and (iii) The dividend
decision. The investment decision relates to the selection of assets in which funds will be invested
by a firm. The assets that can be purchased can be classified into two broad groups: Long-term
assets which yield a return over a period of time in future.Short-term assets or current assets, are
those assets which in the normal course of business are convertible into cash generally within a
year.

Notes
Corporate Finance
5.1 Nature of Capital Budgeting Decisions

The first of these involving the first category of assets is popularly known in financial literature as
capital budgeting. A capital budgeting decision may be defined as the firm’s decision to invest its
funds in the long-term assets in expectation of future cash inflows over a series of years.Issues like
whether or not a firm should launch a new product or enter a new market. Decisions such as these
will determine the nature of a firm’s operations and products for years to come, mainly because
fixed asset investments are generally long-lived and not easily reversed once they are made.
Features of Investment decisions
• Investment decisions in a firm involves the exchange of current funds for acquiring assets like
plant and machinery which will provide benefits in the future period.
• In investment decision, the funds are invested in long-term assets which are used for a period
longer thana single year.
• The benefits of acquiring these assets will occur to the firm over a series of years in the future.
5.2 Importance of Investment Decisions

• Growth:A firm’s decision to invest in long-term assets like building of a new plant or
launching a new product has significant impact on the rate of its growth. Right decision would
lead to the rise in the future profits and growth whereas the unprofitable expansion of assets
will result in heavy operating costs to the firm.
• Risk: The firm will become riskier, if the adoption of an investment increases the average gains
but causes frequent fluctuations in its earnings.
• Funding: Investment decisions involves commitment of large amount of funds.It is important
for the firm to plan its investment programs very carefully.
• Irreversibility:These decisions are usually irreversible in nature i.e., it’s not easy to find a
market for capital items once they have been acquired. The firm will incur heavy losses if such
assets are scrapped.
• Complexity: It is very difficult to accurately estimate the future cash flows of an investment
correctly.Variousfactors cause the uncertainty in cash flow estimation.

The investment decisions can be divided into two decisions given below:
Expansion and Diversification

The expansion decisions of firm relate to the expansion and growth of the firm. A company may
add capacity to its existing product lines to expand existing operations. For example, a firm may
increase its plant capacity to manufacture more product. Its related diversification. A firm may also
expand its activities in a new business. Expansion of a new business requires investment in new
products and a new kind of production activity within the firm. If a battery manufacturing
company invests in a new plant and machinery to produce pharmaceuticals, which the firm has not
manufactured before, this represents expansion of new business or unrelated diversification.
Replacement and Modernization

The objective of modernization and replacement decisions is to improve operating efficiency of the
firm. For e.g. If a company changes from semi-automatic equipment to fully automatic equipment,
it is an example of modernization and replacement. Replacement decisions help to introduce more
efficient and economical assets for e.g., replacement of old high energy consuming machinery for
more energy efficient machinery.

Notes
Unit 05: Investment Decisions -1

The investment decisionscan be mutually exclusive investment decisions, independent
investments or contingent investments decisions.
Mutually Exclusive Investments

Mutually exclusive investments are those investment which serve the same purpose and compete
with each other. For example, decision related to acquiring machinery out of two alternatives
whichwill do the same work. If one investment is undertaken, others will have to be excluded.
Independent Investments
Independent investments are those investments which do not compete with each other and they
serve different purposes. Depending on their profitability and availability of funds, the company
can undertake both investments.For example, company may be considering expansion of its plant
capacity to manufacture additional units and acquire a new plant as well as a new transport
vehicle.
Contingent Investments
Contingent investments are dependent projects, the choice of undertaking one investment
necessitates undertaking one or more other investments. In this type of investment, the total
expenditure will be treated as one single investment.For example, if a company decides to build a
factory in a remote area it may have to invest in houses, roads schools, etc., for the employees.
5.5 Investment Evaluation Criteria

Three steps are involved in the evaluation of an investment:
1. The first step is the correct estimation of future cash flows from the asset.
2. Second step involves the estimation of the required rate of return from the investment
3. The final step in the application of a decision rule on the investment alternatives to take a
decision.
Evaluation Criteria
The evaluation criteria can be divided into two categories viz,Non-discounted Cash Flow criteria
and discounted cash flow criteria. The non-discounted cash flow criteriaignore the time value of
money and thus doesn’t discount the cashflows whereas the discounted cashflow criteria considers
the time value of money and hence, discounts the cashflows.
• Non-discounted Cash Flow Criteria

o Payback (PB)
o Discounted payback
o Accounting rate of return (ARR)
• Discounted Cash Flow Criteria
o Net present value (NPV)
o Internal rate of return (IRR)
o Profitability index (PI)

Notes
Corporate Finance
Cash Inflow vs Cash Outflow

Cash inflow is the money going into a business. Cash outflow is the money leaving the business.
When a firm acquires any asset or purchases the raw material, cash goes out from the business
whereasa cash inflow happens in case of sales in business or sale of any old machinery etc. Any
business is considered healthy if its cash inflow is greater than its cash outflow.
5.6 Definition of Payback

This is the most basic investment criteria. Payback is the length of time it takes to recover the initial
investment.Payback is the number of years required to recover the original cash outlay invested in
a project. If a project generates constant annual cash inflows, the payback period can be computed
by dividing cash outlay by the annual cash inflow.
= =
ℎ
For e.g., suppose a project requires an outlay of Rs. 60,000 and yields annual cash inflow of Rs.
15000 for 6 years. The payback period for the project is:
. 60,000
=
. 15,000
Unequal cash flows =4
In case of unequal cash inflows, the payback period can be found out by adding up the cash inflows
until the total is equal to the initial cash outlay.
Illustration: Unequal cash flows

Suppose that a project requires a cash outlay of Rs 40,000, and generates cash inflows of Rs 16,000;
Rs 14,000; Rs 8,000; and Rs 6,000 during the next 4 years. What is the project’s payback?
Solution
When we add up the cash inflows, we find that in the first three years Rs. 38,000 of the original
outlay is recovered. In the fourth-year cash inflow generated is Rs. 6,000 and only Rs. 2,000 of the
original outlay remains to be recovered. Assuming that the cash inflows occur evenly during the
year, the time required to recover Rs. 2,000 will be
(Rs. 2,000/ Rs. 6,000) × 12 months

= 4 months.
Thus, the payback period is 3 years and 4 months.
Acceptance Rule
Under this method, the projects payback is compared with a standard payback. As a ranking
method, it gives highest ranking to the project, which has the shortest payback period.

Notes
Advantages of Payback
The payback method of project evaluation has various advantages such as:
 Simplicity: The most significant merit of payback is that it is simple to understand and
easy to calculate.
 Cost effective: This method costs less than majority of the complex techniques.
 Short-term effects: A company can have more favorable earnings per share by setting up
a shorter standard payback period.
 Risk shield: The risk of the project can be mitigated by having a shorter standard payback
period. It is a means of establishing an upper limit on the acceptable degree of risk.
 Liquidity:It gives an insight into the liquidity of the project. The funds so released can be
put to other uses.
Limitations of Payback
The payback has several limitations also given as under:
 Cash flows after payback: Payback fails to take account of the cash inflows earned after
the payback period.
 Cash flows ignored:It does not consider all cash inflows yielded by the project i.e., the
cashflows occurring after the payback period is over.
 Cash flow patterns: Payback ignores the pattern of cash inflows.It gives equal weights to
returns of equal amounts even though they occur in different time periods. For e.g. in the
following table, the cashflows are not identical in the two projects yet the payback is equal.
Project C0 C1 C2 Payback
A -3000 2000 1000 2 Years
B -3000 1000 2000 2 Years
 Administrative difficulties: Difficulty in setting the standard payback period.There is no

rational basis for setting the standard period.
 Inconsistent with shareholder value:It is not in line with the objective of maximizing the
market value of shares.
5.7 Discounted payback period

Another technique of project evaluation is the discounted payback period. Discounted payback
period is the number of periods taken in recovering the investment outlay on the present value
basis i.e. The cashflows are first discounted on the basis of appropriate discount rate and then the
payback is calculated. One of the limitations of the payback method is that it does not discount the
cash flows and hence may lead to incorrect decisions.
Illustration: Discounted payback period

Projects X and Y involve the same outlay of Rs. 4,000 each. The opportunity cost of capital may be
assumed as 10 per cent.The cash flows of the projects and their discounted payback periods are
shown in Table 1.The projects indicated are of same desirability by the simple payback period.

Notes
Corporate Finance
Table 1: Discounted Payback
Cash Flows
C0 C1 C2 C3 C4 Simple Discounted NPV

PB PB of 10%
P -4,000 3,000 1,000 1,000 1,000 2 Years - -
PV of cash -4,000 2,727 826 751 683 - 2.6 years 987

flows
Q -4,000 0 4,000 1,000 2,000 2 years - -
PV of cash -4,000 0 3,304 751 1,366 - 2.9 Years 1,421

flows
When cash flows are discounted to calculate the discounted payback period, Project P recovers the
investment outlay faster than Project Q. Discounted payback period for a project will be always
higher than simple payback period because its calculation is based on the discounted cash flows.
Discounted payback rule is better as it discounts the cash flows until the outlay is recovered. It can
be seen in our example that if we use the NPV rule, Project Q is better.The payback period is a kind
of “break-even” measure. As it is so simple, companies use it as a screen for dealing with the minor
investment decisions they have to make.
5.8 Accounting Rate of Return

Accounting rate of return is another technique of capital budgeting. The accounting rate of return is
the ratio of the average after tax profit divided by the average investment. It is also known as the
return on investment (ROI). Accounting rate of return uses accounting information to measure the
profitability of an investment. The average investment would be equal to half of the original
investment if it were depreciated constantly. The accounting rate of return can be determined by
the following equation:
or
[∑ (1 − )]/
=
( + )/2
Where,
• EBIT = Earnings before interest and taxes,
• T = Tax rate,
• I0 = Book value of investment in the beginning,
• In = Book value of investment at the end
• n = Number of years
For e.g. If the Average annual profit for a project over the life of the investment is Rs.
20,000.Average investment value in a given year is Rs. 100,000.
ARR would be calculated as:

Notes
= 20,000 / 1,00,000
= 20%
Steps in calculating ARR

The steps involved in the calculation of this technique are given below:
1. Calculate the numerator:

Calculate the profit for the whole project, including costs such as depreciation, amortization
etc.Calculate the average annual profit, by dividing the overall profit over the whole project by
the life of the project.
2. Calculate the denominator
Look in the question to see which definition of investment is to be used. The investment figure
can either be the initial investment, or the average investment.
3. Calculate the accounting rate of return.
Illustration: Accounting Rate of Return

A project will cost Rs. 40,000. Its stream of earnings before depreciation, interest and taxes during
five years is expected to be Rs. 10,000, Rs. 12,000, Rs. 14,000, Rs. 16,000 and Rs. 20,000. Assume a 50
per cent tax rate and depreciation on straight-line basis.
Table 1: Calculation of Accounting Rate of Return
Period 1 2 3 4 5 Average
EBDIT 10,000 12,000 14,000 16,000 20,000 14,400
Depreciation 8,000 8,000 8,000 8,000 8,000 8,000
EBIT 2,000 4,000 6,000 8,000 12,000 6,400
Taxes at 50% 1,000 2,000 3,000 4,000 6,000 3,200
EBIT(1-T) 1,000 2,000 3,000 4,000 6,000 3,200
Book value of Invest.
Beginning 40,000 32,000 24,000 16,000 8,000
End 32,000 24,000 16,000 8,000 -
Average 36,000 28,000 20,000 12,000 4,000 20,000
3,200
= × 100
20,000
= 16 per cent
Example: Accounting Rate of Return

Notes
Corporate Finance
Another variation of the ARR method is to divide average earnings after taxes by the original cost
of the project instead of the average cost. Thus, according to this version, the ARR will be:
Rs. 3,200 ÷ Rs. 40,000 × 100

= 8 per cent
Another variation of the ARR method is to divide average earnings after taxes by the original cost
of the project instead of the average cost. Thus, according to this version, the ARR will be:
Rs. 3,200 ÷ Rs. 40,000 × 100

= 8 per cent
Acceptance Rule
The acceptance rule according to the Accounting Rate of Return method is given below:
• Accept all those projects whose ARR is higher than the minimum rate established by the
management.
• Reject those projects which have ARR less than the minimum rate.
According to this method a project is ranked as number one if it has highest ARR.
Advantages of Accounting Rate of Return:

There are various advantages of the Accounting Rate of Return method such as:
• Simplicity: This method is simple to understand and apply.

• Accounting data:The Accounting Rate ofReturn can be readily calculated from the accounting
data of the firm.
• Accounting profitability:The Accounting Rate of Return rule considers the entire stream of
income in calculating the project’s profitability.
Limitations of Accounting Rate of Return:

TheAccounting Rate of Return method suffers from various limitations given below:
• Cash flows ignored: The Accounting Rate of Returnmethod uses accounting profits not cash
flows, in appraising the projects. It is not correct to rely on accounting profit for measuring the
acceptability of the investment projects.
• Time value ignored:The averaging of income ignores the time value of money.
• Arbitrary cut-off:Generally, the cut-off standard is the firm’s current return on its assets (book-
value). Because of this, the growth companies earning very high rates on their existing assets
may reject profitable projects.
Illustration: Accounting Rate of Return

A project requires an initial investment in a machine of Rs. 40,000. Net cash inflows of Rs. 15,000
will be generated for each of the first two years.Rs. 5,000 in each of years three and four and Rs.
35,000 in the year five. After which time, the machine will be sold for Rs. 5,000.
Solution:

Notes
1. Calculating the numerator:

We need the average annual accounting profit. To find this, the profit for the whole project needs to
be calculated, which is then divided by the number of years.
Cash inflow years 1 and 2 (Rs. 15,000 x 2) 30,000
Cash inflow years 3 and 4 (Rs. 5,000 x 2) 10,000
Cash inflow year 5 35,000
Depreciation (Rs. 40,000 – Rs. 5,000) -35,000
Total profit for the project 40,000
The Average Profit is Rs. 8,000

(Rs. 40,000/5)
2. Calculating the denominator:

Initial investment is Rs. 40,000.
Average investment is (the initial investment + scrap value)/2
(Rs. 40,000 + Rs. 5,000)/2
= Rs. 22,500
3. Calculating the accounting rate of return:
The Accounting Rate of Returncan now be calculated as either:
(Rs. 8,000/Rs. 40,000) x 100%

= 20% or,
(Rs. 8,000/Rs. 22,500) x 100%

= 36%
Summary
 A capital budgeting decision may be defined as the firm’s decision to invest its funds in
the long-term assets in expectation of future cash inflows over a series of years. Issues like
whether or not a firm should launch a new product or enter a new market.
 Investment decisions can be of different types such as Decisions Expansion and
Diversification or Replacement and Modernization. They can be classified as Mutually
Exclusive Investments, Independent Investment and Contingent Investments
 Payback is the length of time it takes to recover the initial investment. Payback is the
number of years required to recover the original cash outlay invested in a project. If a
project generates constant annual cash inflows, the payback period can be computed by
dividing cash outlay by the annual cash inflow.

Notes
Corporate Finance
 A capital budgeting decision may be defined as the firm’s decision to invest its funds in
the long-term assets in expectation of future cash inflows over a series of years. Issues like
whether or not a firm should launch a new product or enter a new market.
= =
ℎ
 The acceptance rule under payback: projects payback is compared with a standard
payback. As a ranking method, it gives highest ranking to the project, which has the
shortest payback period.
 Discounted payback period is the number of periods taken in recovering the investment
outlay on the present value basis i.e. The cashflows are first discounted on the basis of
appropriate discount rate and then the payback is calculated. One of the limitations of the
payback method is that it does not discount the cash flows and hence may lead to
incorrect decisions.
 Accounting rate of return is another technique of capital budgeting. The accounting rate of
return is the ratio of the average after tax profit divided by the average investment. It is
also known as the return on investment (ROI). Accounting rate of return uses accounting
information to measure the profitability of an investment. The average investment would
be equal to half of the original investment if it were depreciated constantly. The
accounting rate of return can be determined by the following equation:
 Steps in calculating ARR
1. Calculate the numerator:

2. Calculate the denominator
3. Calculate the accounting rate of return.
 The acceptance rule under ARR is Accept all those projects whose ARR is higher than the
minimum rate established by the management, reject those projects which have ARR less
than the minimum rate, according to this method a project is ranked as number one if it
has highest ARR.
Keywords
Corporate finance, Financial Management, Capital budgeting, Investment decisions, Payback,
discounted payback
Self Assessment
1. Capital budgeting is also known as:
A. Investment decisions making
B. Planning capital expenditure
C. Both of the above
D. None of the above.
2. Capital budgeting decisions are of:

Notes
A. Long-term nature
B. Short-term nature
C. Both of the above
3. Which of the following is not a capital budgeting decision?

A. Expansion Program
B. Acquisition of long-term assets
C. Replacement of an existing Asset
D. Inventory control.
4. Capital Budgeting Decisions are based on:

A. Incremental Cash Flows
B. Incremental Profit
C. Incremental Assets
D. Decremental Assets.
5. Capital Budgeting Decisions are:

A. Reversible
B. Irreversible
C. Unimportant
D. All of the above
6. The method, which calculates the time to recover initial investment of project in form of
expected cash flows is known as
A. Net value cash flow method
B. Payback method
C. Single cash flow method
D. Lean cash flow method
7. Which of the following method of capital budgeting does not take into account the profit of
the entire life of the project?
A. Payback period method
B. Accounting rate of return method
C. Net present value method
D. Profitability index
8. If the net initial investment is Rs. 68,50,000 and the annual cash flows is Rs. 20,50,000, then
payback period will be
A. years
B. 4.34 years
C. 5.34 years
D. 6.34 years

Notes
Corporate Finance
9. Which of the following will not be a relevant factor when using the payback method of
capital investment appraisal?
A. Annual cashflows
B. The cash flows generated by the asset up to the payback period
C. The cost of the asset
D. The total cash flows generated by the asset
10. An asset costs Rs. 2,10,000 with Rs. 30,000 salvage value at the end of its 10-year life. If
annual cash inflows are Rs. 30,000, the cash payback period is
A. 8 years
B. 7 years
C. 6 years
D. 5 years
11. Which of the following is not an advantage of the accounting rate of return (ARR) method of
investment appraisal?
A. There is comparability between the ARR and the ROCE ratio used in financial accounting
B. The ratio takes account of the overall profit that is generated by the investment
C. It takes into account the time value of money by allowing for depreciation in the equation
D. It is easy to understand
12. If the Average annual profit for a project over the life of the investment is Rs. 20,000.
Average investment value in a given year is Rs. 100,000. ARR would be:
A. 20%
B. 10%
C. 15%
D. 8%
13. The accounting rate of return

A. Is synonymous with the internal rate of return
B. Focuses on income as opposed to cash flows
C. Is inconsistent with the divisional performance measure known as return on investment
D. Recognizes the time value of money
14. Advantages of ARR are:

A. Simplicity of calculation
B. Usage of Accounting data
C. It considers the entire stream of income
D. All of the above
15. Formula of Accounting rate of return is:

A. Average income/Average investment

Notes
B. Average investment/ Average income

C. Annual cashflow/Average investment

1. C 2. A 3. D 4. A 5. B
6. B 7. A 8. A 9. D 10. B
11. C 12. A 13. D 14. D 15. A
Review Questions
1. Define Investment decisions
2. Explain Payback method
3. How Payback is different than Discounted Payback method?
4. What are the advantages of ARR over payback method?
5. List the steps in the calculation of ARR of a project.
Further Readings
1. Khan, M. and Jain, P., 2011. Financial management. 1st ed. New Delhi: Tata McGraw-
Hill.
Publishing
3. Berk, Jonathan. &DeMarzo, Peter. & Harford, Jarrad. & Ford, Guy. &Mollica, Vito.

Notes
Dr. Atif Ghayas, Lovely Professional University Unit 06: Investment Decisions – 2
Unit 06: Investment Decisions – 2

CONTENTS
Objectives
Introduction
6.1 Net Present Value
6.2 Internal Rate of Return
6.3 Profitability Index (PI)
6.4 Cash Flow Estimation
6.5 NPV vs IRR
6.6 Risk involved in Capital Budgeting
6.7 Techniques of Risk Analysis
6.8 Sensitivity Analysis
Summary
Keywords
Self Assessment
Review Questions
Objectives
 understand the concept of NPV

 explain the advantage and limitations of the NPV technique
 illustrate the computation of NPV technique
 explain the concept of IRR.
 evaluate the advantage and limitations of the IRR technique
 illustrate the computation of IRR
 understand the concept of PI.
 explain the advantage and limitations of the PI technique.
 illustrate the computation of PI.
 understand cash flows estimation process
 discuss the approach for calculating incremental cash flows
 explain the difference between cash Flow and Profit
 understand the concept of NPV profile
 compare NPV and IRR
 explain the conflict between NPV and IRR
 analyze risk involved in capital budgeting
 explain certainty-equivalent Approach
 explain Sensitivity Analysis

Notes
Corporate Finance
Introduction
In the previous chapter, we discussed about the investment decisions of a firm and also studied
three popular techniques of capital budgetingnamely Payback, Discounted Payback and
Accounting Rate Return. In the chapter we will continue our discussion on the capital budgeting
techniques and will examine three important capital budgeting techniques namely Net Present
Value, Profitability Index, and Internal Rate of return. These all are discounting cash flow
techniques i.e.; they take into account the time value of money. We will evaluate each one these
methods, their advantages as well as limitation. Moreover, cash flow estimation process will be
discussed and, in the end, the chapter will explore the risk involved in the capital budgeting.
6.1 Net Present Value

The prime motive of a firm’s is to maximize the shareholder’s wealth. Shareholder’s wealth can be
increased by undertaking the projects which results in the positive net present value. Net present
value (NPV) of a project is the difference between the present value of cash inflows and the present
value of cash outflows.
Let’s say you are planning to construct an office building. The cost of land for the office building
would be Rs. 500,000 and construction would cost Rs. 30,00,000. After a year, you can sell the
building for Rs. 40,00,000. Earlier you learned how to discount future cash payments to find their
present value. We now apply these ideas to evaluate a simple investment proposal.So, you would
be investing Rs. 35,00,000 now in the expectation of realizing Rs. 40,00,000 at the end of the year.
You should go ahead if the present value of the Rs. 40,00,000 payoff is greater than the investment
of Rs. 35,00,000.
Assume that the Rs. 40,00,000 return is certain that means you are sure about it. The office building
is not the only way to obtain Rs. 40,00,000 a year from now. You can invest the amount in a Fixed
Deposit (FD). Suppose the FD offers interest of 7 percent on the amount invested. How much
would you have to invest in it in order to receive Rs. 40,00,000 at the end of the year?
You would have to invest:
Rs. 40,00,000 × 1/1.07
= Rs. 40,00,000 × 0.935
= Rs. 37,38,320
The present value of the Rs. 40,00,000 payoffs from the office building is Rs. 37,38,320.Assume that
as soon as you have purchased the land and laid out the money for construction, you decide to sell
your project. How much could you sell it for? As the property will be worth Rs. 40,00,000 in a year,
customer would be willing to pay maximum of Rs. 37,38,320 for it now. That’s all it would cost
them to get the same Rs. 40,00,000 payoffs by investing in a FD.The Rs. 37,38,320 present value is
the only price that satisfies both buyer and seller and is also its market price or market value.
To calculate present value, we discounted the expected future payoff by the rate of return offered
by comparable investment alternatives. The discount rate (7 percent) in our example is known as
the opportunity cost of capital because it is the return that is being given up by investing in the
project.The building is worth Rs. 37,38,320, but you invested Rs. 35,00,000, so your net present
value is Rs. 2,38,320. NPV is found by subtracting the Initial investment from the present value of
the project cash flows:
NPV = PV – required investment.
= Rs. 37,38,320 – Rs. 35,00,000
= Rs. 2,38,320
The net present value rule states that financial managers increase shareholders’ wealth by accepting
all projects that are worth more than they cost. Therefore, they should accept all projects with a
positive net present value.NPV is a Discounted Cash Flow technique that recognizes the time value
of money. According to NPV, cash flows arising at different time periods differ in value.They are
comparable only when their equivalents present values are found out.
Steps in the calculation of Net Present Value (NPV)
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LOVELY PROFESSIONAL UNIVERSITY University 79
Notes
There are various steps involved in the calculation of net present value of a project. These steps are
given below:
1. Forecast future cash flows of the project based on realistic assumptions.

2. Identify an appropriate discount rate to discount the estimated cash flows. The discount
rate is the project’s opportunity cost of capital.
3. Calculatethe present value of cash flows using the opportunity cost of capital as the
discount rate i.e., discount each of the cash flow by the selected discount rate.
4. Finally, subtractthe present value of cash outflows from present value of cash inflows to
find the net present value of the project.
Formula of Net Present Value (NPV)

The formula to calculate the Net Present Value is given as:
= + + + ⋯+ −
(1 + ) (1 + ) (1 + ) (1 + )
= −
(1 + )
Where,
• C1, C2... = net cash inflows in year 1, 2...
• k = opportunity cost of capital
• C0 = the initial cost of the investment
• n = expected life of the investment
Illustration: Calculating Net Present Value

Let’s assume that Project A costs Rs. 2,500 now and is expected to generate year-end cash inflows of
Rs. 900, Rs. 800, Rs. 700, Rs. 600 and Rs. 500 in years 1 through 5. The opportunity cost of the capital
may be assumed to be 10 per cent.
Solution:
900 800 700 600 500

= + + + + − 2500
(1 + 0.10) (1 + 0.10) (1 + 0.10) (1 + 0.10) (1 + 0.10)
= [900 × 0.909 + 800 × 0.826 + 700 × 0.751 + 600 × 0.683 + 500 × 0.620] − 2500
= 2,725 − 2500 = +225
Project A’s present value of cash inflows (Rs. 2,725) is greater than that of cash outflow (Rs. 2,500)
and it generates a positive net present value.
NPV = + Rs. 225
Project A adds to the wealth of owners; therefore, it should be accepted.

Notes
Corporate Finance
Importance ofNet Present Value (NPV):

You may ask why should a financial manager invest Rs. 2,500 in Project A? Project A should be
undertaken if it is best for the company’s shareholders. The shareholders would like their shares to
be as valuable as possible. Let’s assume that the total market value of a hypothetical company is Rs.
10,000, which includes Rs. 2,500 cash that can be invested in Project A.
Thus, the value of the company’s other assets must be Rs. 7,500. The company has to decide
whether it should spend cash and accept Project A or to keep the cash and reject Project A. Project
A is desirable since its Present Value (Rs. 2,725) is greater than the Rs. 2,500 cash. If Project A is
accepted, the total market value of the firm will be: Rs. 7,500 + Present Value of Project A
= Rs. 7,500 + Rs. 2,725 = Rs. 10,225
an increase by Rs. 225
The company’s total market value would remain only Rs. 10,000, if Project A was rejected.
Acceptance Rule
 If NPV is positive i.e., NPV > 0: Accept the project

 If NPV is negative i.e., NPV < 0: Reject the project
 If When NPV is zero i.e., NPV = 0: May accept or reject the project
The positive net present value means that the project generates cash inflows at a rate higher than
the opportunity cost of capital. A zero NPV means that project generates cash flows at a rate just
equal to the opportunity cost of capital.In case of multiple projects which are mutually exclusive in
nature; the project with the higher NPV should be selected. While ranking the projects, first rank
will be given to the project with highest positive net present value.
Advantages of NPV
The net present value technique is considered one of the most important technique of capital
budgeting due to its advantages which are given below:
• Time value:In Net Present Value method, cash flows are discounted to the present value.
i.e., this technique recognizes the time value of money.
• Measure of true profitability:It uses all cash flows occurring over the entire life of the
project in calculating its worth.
• Value-additivity:The NPVs of projects can be added. It means that if we know the NPVs
of individual projects, the value of the firm will increase by the sum of their NPVs.
• Shareholder value: The NPV method is consistent with the objective of the shareholder
value maximization.
Limitations of NPV
The NPV method however has few limitations also as given below:
• Cash flow estimation: It is very difficult to accurately predict the future cash flows of the
firm due to uncertainty.
• Discount rate:similarly, it is not easy to measure the discount rate in practical world.
• Ranking of projects: It should be noted that the ranking of investment projects as per the
NPV rule is not independent of the discount rates.
Example: NPV
Suppose we are considering to launch a new consumer product. Expected cash flows over the five-
year life of the project will be Rs. 2,000 in the first two years, Rs. 4,000 in the next two, and Rs. 5,000
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Notes
in the last year. It will cost about Rs. 10,000 to begin production. We use a 10 percent discount rate
to evaluate new products.
We can calculate the total value of the product by discounting the cash flows back to the present:
Present Value = (2000/1.1) + (2000/1.12) + (4000/1.13) + (4000/1.14) + (5000/1.15)

= Rs. 1,818 + Rs. 1,653 + Rs. 3,005 + Rs. 2,732 + Rs. 3,105
=Rs. 12,313
The present value of the expected cash flows is Rs. 12,313, but the cost of getting those cash flows is
only Rs. 10,000, so the NPV is
Rs. 12,313 – Rs. 10,000 = Rs. 2,313.
This is positive, so, we should take on the project.
6.2 Internal Rate of Return

There is another important capital budgeting technique based on discounted cash flow method
called IRR or the internal rate of return technique.The internal rate of return (IRR) is the annual rate
of growth that an investment is expected to generate. IRR is calculated using the same concept as
net present value (NPV), except it sets the NPV equal to zero. The rate of return is the discount rate
which makes NPV = 0.
Let’s assume that you deposit Rs. 10,000 with a bank and would get back Rs. 10,800 after one year.
The true rate of return on your investment would be:
10800 − 10000
=
10000
10800
= − 10000
10000
= 1.08 − 1
= 0.08 8%
The amount that you would obtain in the future (Rs. 10,800) would consist of your investment (Rs.
10,000) plus return on your investment (0.08 × Rs. 10,000):
10,000 (1.08) = 10,800

10,000 = 10,800/(1.08)
IRR can be determined by solving the following equation for r:

C C C C
C = + + +⋯+
(1 + r) (1 + r) (1 + r) (1 + r)
C
−C =0
(1 + r)
You may notice that the IRR equation is the same as the one used for the NPV method. In the NPV
method, the required rate of return, k, is known and the net present value is found, while in the IRR
method the value of r has to be determined at which the net present value becomes zero.

Notes
Corporate Finance
Uneven Cash Flows: Calculating IRR by Trial and Error

To calculate IRR in case of uneven cash flows, start with selecting any discount rate to compute the
present value of cash inflows. If the calculated present value of the expected cash inflow is lower
than the present value of cash outflows, a lower rate should be tried. On the other hand, a higher
value should be tried if the present value of inflows is higher than the present value of
outflows.This process will be repeated unless the net present value becomes zero. A project costs
Rs. 16,000 and is expected to generate cash inflows of Rs. 8,000, Rs. 7,000 and Rs. 6,000 at the end of
each year for next 3 years.
We know that IRR is the rate at which project will have a zero NPV. As a first step, we try
(arbitrarily) a 20 per cent discount rate. The project’s NPV at 20 per cent is:
NPV = - 16,000 + 8,000(PVF1, 0.20) + 7,000(PVF2, 0.20) + 6000 (PVF3, 0.20)

= - 16,000 + 8,000 x 0.833 + 7,000 x 0.694 + 6,000 x 0.579
= - 16,000 + 14,996 = - Rs. 1,004
A negative NPV of Rs. 1,004 at 20 per cent indicates that the project’s true rate of return is lower
than 20 per cent. Let us try 16 per cent as the discount rate.
At 16 per cent, the project’s NPV is:
NPV = - 16,000 + 8,000(PVF1, 0.16) + 7,000(PVF2, 0.16) + 6000(PFV3, 0.16)

NPV=- 16000 + 8,000 x 0.862 + 7,000 x 0.743 + 6000 x 0.641
= - 16,000 + 15,943
= - Rs. 57
Since the project’s NPV is still negative at 16 per cent, a rate lower than 16 per cent should be tried.
When we select 15 per cent as the trial rate:
NPV = - 16,000 + 8,000(PVF1,0.15) + 7,000(PVF2,0.15) + 6000 (PVF3,0.15)

= -16,000 + 8,000 x 0.870 + 7,000 x 0.756 + 6,000 x 0.658
= - 16,000 + 16,200
= Rs. 200
The true rate of return should lie between 15–16 per cent.
We can find out a close approximation of the rate of return by the method of linear interpolation as
follows:
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Notes
AcceptanceRule:
The acceptance rule according to IRR technique are:
 Accept the project when ris greater than k

 Reject the project when ris less thank
 May accept the project when ris equal tok
Advantages of IRR method:
 Time value:IRR recognizes the time value of money.

 Profitability measure:It considers all cash flows occurring over the entire life of the project
to calculate its rate of return.
 Acceptance rule:It generally gives the same acceptance rule as the NPV method.
 Shareholder value:It is consistent with the Shareholder Wealth Maximization objective.
Limitations
 Multiple rates:A project may have multiple rates, or it may not have a unique rate of
return.
 Mutually exclusive projects:It may also fail to indicate a correct choice between mutually
exclusive projects under certain situations.
Illustration: Invest $ 2,000 now, receive 3 yearly payments of $ 100 each, plus $2,500 in the 3rd
year.Let us try 10% interest:
PV of Outflow = -$2,000
Year 1: PV = $100/1.10 = $90.91
Year 2: PV = $100/1.102 = $82.64
Year 3: PV = $100/1.103 = $75.13
Year 3 (final payment): PV = $2,500 / 1.103 = $1,878.29
Adding all gives:
NPV = -$2,000 + $90.91 + $82.64 + $75.13 + $1,878.29
= $126.97
Let's try 12% interest rate:
Now: PV = -$2,000
Year 1: PV = $100 / 1.12 = $89.29
Year 2: PV = $100 / 1.122 = $79.72
Year 3: PV = $100 / 1.123 = $71.18

Notes
Corporate Finance
Year 3 (final payment): PV = $2,500/1.123 = $1,779.45

Adding up:
NPV = -$2,000 + $89.29 + $79.72 + $71.18 + $1,779.45
= $19.64
At 12.4% interest rate
Now: PV = -$2,000
Year 1: PV = $100 / 1.124 = $88.97
Year 2: PV = $100 / 1.1242 = $79.15
Year 3: PV = $100 / 1.1243 = $70.42
Year 3 (final payment): PV = $2,500 / 1.1243 = $1,760.52
Adding all gives:

NPV = -$2,000 + $88.97 + $79.15 + $70.42 + $1,760.52
= -$0.94
A project has a total up-front cost of $. 435.44. The cash flows are $100 in the first year, $ 200 in the
second year, and $ 300 in the third year. What’s the IRR? If we require an 18 percent return, should
we take this investment? We’ll describe the NPV profile and find the IRR by calculating some NPVs
at different discount rates.
Beginning with 0 percent, we have:

Discount Rate NPV
0% 164.56
5% 100.36
10% 46.151
15% 0.00
20% -39.61
The NPV is zero at 15 percent, so 15 percent is the IRR. If we require an 18 percent return, then we
should not take the investment. The reason is that the NPV is negative at 18 percent (verify that it is
$ 24.47). The IRR rule tells us the same thing in this case. We shouldn’t take this investment because
its 15 percent return is below our required 18 percent return.
6.3 Profitability Index (PI)

Profitability index is another discounted cash flow capital budgeting technique.The Profitability
Index (PI) measures the ratio between the present value of future cash flows and the initial
investment.
Formula
The formula for calculating benefit-cost ratio or profitability index is as follows:
ℎ ( )
= =
ℎ
= ÷
(1 + )
Illustration:
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Notes
The initial cash outlay of a project is Rs. 100,000 and it can generate cash inflow of Rs. 40,000, Rs.
30,000, Rs. 50,000 and Rs. 20,000 in year 1 through 4. Assume a 10 per cent rate of discount.
PV = 40,000(PVF1,0.10) + 30,000(PVF2,0.10)
+ 50,000(PVF3,0.10) + 20,000(PVF4,0.10)
= 40,000 x 0.909 + 30,000 x 0.826 + 50,000 x 0.751 + 20,000 x 0.68
NPV = 112,350 - 100,000 = 12,350
PI= 112,350/100,000 = 1.1235
Acceptance Rule;
The acceptance rule according to Profitability Index (PI) technique are:
 Accept the project when PI is greater than 1 (PI > 1)

 Reject the project when PI is less than 1 (PI < 1)
 May accept the project when PI is equal to 1 (PI = 1)
Advantages:
The advantages of Profitability Index (PI) technique are:
 Time value:It recognizes the time value of money.

 Value maximization:It is consistent with the shareholder value maximization principle.
 Relative profitability:In the PI method, since the present value of cash inflows is divided
by the initial cash outflow, it is a relative measure of a project’s profitability.
Limitations
The limitations of the Profitability Index (PI) are:
 Cash flows estimation:This technique requires calculation of cash flows which is a

difficult task.
 Discount rate estimation:Similarly, it requires estimation of the discount rate for
discounting the cashflows.
Illustration:Calculate Profitability Index of Project X and Project Y, if the discounting rate is 10%
Year (t) Project X Project Y
0 -2000 -2000
1 1000 200
2 800 600
3 600 800
4 200 1200
Solution:
PV of Cash Flows of Project X:

Notes
Corporate Finance
=( +( + + = 2,157.64
. ) . ) ( . ) ( . )
.
PIX = = 1.079
PV of cash flows of Project Y:
=( +( + + = 2,098.36
. ) . ) ( . ) ( . )
.
PIY = = 1.049
Project X has higher PI.If Project X and Y are independent, accept both projects because PI > 1 for
both projects.
Illustration: Company XYZ is considering two projects, Project A and Project B:

Project A:
Year Cash Flow

0 -1500,000
1 150,000
2 300,000
3 500,000
4 200,000
5 600,000
6 500,000
7 100,000
Project B:
Year Cash Flow

0 -3000000
1 100000
2 500000
3 1000000
4 1500000
5 200000
6 500000
7 1000000
The appropriate discount rate for this project is 13%. Company A is only able to undertake one
project. Using the profitability index method, which project should the company undertake?
Solution:
Project A
Year Cash Flow Present Value

Notes
0 -1500000 -1500000
1 150000 136363.6
2 300000 247933.9
3 500000 375657.4
4 200000 136602.7
5 600000 372552.8
6 500000 282237
7 100000 51315.81
ℎ ( )
= =
ℎ
16,02,663
=
15,00,000
PI = 1.07
Project B
Year Cash Flow Present Value

0 -3000000 -3000000
1 100000 88495.58
2 500000 391573.3
3 1000000 693050.2
4 1500000 919978.1
5 200000 108552
6 500000 240159.3
7 1000000 425060.6
ℎ ( )
= =
ℎ
28,66,869
=
30,00,000
PI = 0.96
Project A: PI = 1.07
Project B: PI = 0.96
Thus, Project A should be selected as PI is higher for Project A
6.4 Cash Flow Estimation

The difficulty in estimating cash flows arises because of uncertainty and accounting
ambiguities.Events affecting investment opportunities change rapidly and unexpectedly. Mostly

Notes
Corporate Finance
accounting data forms the basis for estimating cash flows. Accounting data are the result of
arbitrary assumptions, choices and allocations.
Cash Flow V/S Profit

Cash flow is not the same thing as profit, at least, for two reasons. First, profit, as measured by an
accountant, is based on accrual concept—In other words, profit includes cash revenues as well as
receivables and excludes cash expenses as well as payable.Second, for computing profit,
expenditures are arbitrarily divided into revenue and capital expenditures.Revenue expenditures
are entirely charged to profits while capital expenditures are not.
Profit = REV - EXP – DEP (1)

CF = REV – EXP – CAPEX (2)
We can obtain the following definition of cash flows if we adjust Equation (2) for relationships
given in Equation (1):
CF = (REV - EXP – DEP) + DEP - CAPEX
CF = Profit + DEP – CAPEX (3)
Incremental Cash Flows

The estimates of amounts and timing of cash flows resulting from the investment should be
carefully made on an incremental basis
• Absolute Cash Flows
• Relative Cash Flows
Components of Cash flows

A typical investment will have three components of cash flows:
• Initial investment
• Annual net cash flows
• Terminal cash flows
Initial outlay
Initial investment is the net cash outlay in the period in which an asset is purchased. A major
element of the initial investment is the gross outlay or original value (OV) of the asset, which
comprises of its cost and freight and installation charges.When an asset is purchased for expanding
revenues, it may require a lump sum investment in net working capital also.
Thus, initial investment will be equal to: gross investment plus increase in net working capital. In
case of replacement decisions, the existing asset will have to be sold if the new asset is acquired.The
sale of the existing asset provides cash inflow. The cash proceeds from the sale of the existing assets
should be subtracted to arrive at the initial investment. For expansion projects, this will consist of
the cash flows resulting from acquiring the new asset and will consist of: The Purchase price of the
new asset, Installation costs of the new asset e.g., transportation, shipping, handling etc.
For expansion projects, this will consist of the cash flows resulting from acquiring the new asset
and will consist of:Increases in working capital requirements e.g., inventory i.e., raw materials,
finished goods etc.After-tax non-capital expenditures e.g., costs to train employees to operate asset.
For the replacement project, we would also have to incorporate:
After-tax cash flows resulting from the sale of the existing asset.
• Proceeds of sale xxx
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Notes
• Less: Current Book Value xxx

• Profit/Loss xxx/(xxx)
• Tax/Tax Credit xxx/(xxx)
• After tax cash inflow (1) - (4) xxx
Net Cash Flows

An investment is expected to generate annual cash flows from operations after the initial cash
outlay has been made.Net cash flows will mostly consist of annual cash flows occurring from the
operation of an investment, but it is also affected by changes in net working capital and capital
expenditures during the life of the investment.
Annual After-tax Operating Cash Flows

( ^ = incremental and T = Tax rate)
1) ^Revenues xxx
2) Less: ^Costs xxx
3) Less: ^Depreciation xxx
4) ^Profit before Tax xxx
5) Less: ^Tax xxx
6) ^Profit after Tax xxx
7) Add: ^Depreciation xxx
8) After tax cash flow (6) + (7) xxx
or
1) (^Revenues - ^Costs)(1 - T) xxx
2) Add: (^Depreciation)(T) xxx
3) After tax cash flow (1) + (2) xxx
Interest expenses are not to be included as costs. In other words, they are not to be deducted
from incremental Revenues when determining incremental Profit before tax (as normal accounting
rules stipulate). To do this would be double counting as interest expense (cost of debt) is already
accounted for in the cost of capital (which is used to discount the cash flows).
Terminal cash flows

For both the expansion and replacement projects this will comprises of those cash flows that occur
as a result of termination of the new project. These may include:
a) The after-tax cash flows resulting from the sale of the new asset (calculation is similar to
above, see Initial outlay)
For both the expansion and replacement projects this will comprises of those cash flows that occur
as a result of termination of the new project. These may include:
a) Recovery of working capital, i.e., the working capital cash outflows experienced in the
initial outlay will be recovered.
b) Any other after-tax cleanup costs.
Other Types of Cash Flows:

Sunk costs:

Notes
Corporate Finance
Sunk costs are cash outlays incurred in the past. They are the results of past decisions, and cannot
be changed by future decisions. Since they do not influence future decisions, they are irrelevant
costs.
Opportunity Costs:
In Economics, this is referred to as benefits foregone. Opportunity costs are benefits that are not
going to be achieved due to a particular action/decision. These must be accounted for in the capital
budgeting decision as cash outflows, on an after-tax basis.
Externalities
The increased revenues or the cost savings derived by the new project could result increased
revenues for other existing projects/products in a company. In this case, the increased revenues of
the other existing projects/products would be treated as additional increased revenues for the new
project.
Example:
Company ABC is considering the purchase of an industrial incubator for the production of day-old
chicks. The firm does not currently own such a machine. A consultant was paid Rs.250,000 six
months ago to estimate the relevant cash flows which are summarized as follows:
The incubator would save Rs. 500,000 per year in costs and provide additional revenues of Rs.
400,000 annually. It would cost Rs. 1,400,000 and installation and shipping costs would amount to
Rs. 300,000 and Rs. 100,00 respectively. ABC would need to train its staff to operate the incubator
at an after-tax cost of Rs. 200,000. The firm would also need to increase its stock of eggs at the
hatchery by Rs. 500,000.
The company plans to issue debt to fund the project and this will increase interest expenses by Rs.
465,000 per year. The machine will be depreciated towards a salvage value of Rs. 400,000 over its
useful life of 5 years. At the end of the machine’s useful life, it is expected that it can be sold for Rs.
500,000. The Government's Tax Department will also give the firm a tax credit of Rs. 74,993 at the
end of the project as agreed with the firm for partial recovery of import duties.
Company ABC has a cost of capital of 20% and a tax rate of 33.33 %
 Calculate the NPV.

 Calculate the PI of the project?
 Should the project be accepted?
Solution
 Initial Outlay:
New Machine
Cost 1400000
Installation 300000
Shipping 100000
1800000
After Tax Training 200000
Increase in WC 500000
2500000
Annual after-tax cash flows:
Lovely Professional
Notes
(^R-^C)(1-T) (400,000- - 500,000)(1-0.33) = 600,030

^D(T) 280,000(0.333) = 93,324
693,354
• Terminal cash flow:
Sale of New
Machine
Proceeds 500,000
NBV 400,000
Profit 100,000
Tax (33.3%) 33,333
New Cash Flow 466667
Govt Tax Credit 74993
Recovery of 500000
working Capital
1041,660
(a) NPV
NPV = (2500000) + 693354(PVIFA0.20 5) + 1041660(PVIF0.20 5)
= (2500000) + 693354(2.9906) + 1041660(0.4019)
= (2,500,000) + 2,073,544.47 + 418,643.15
= (Rs. 7812.38)
(b) PI
2,073,544.47 + 418,643.15
2,500,000
2,492,187.62
= 0.9969
2,500,000
(c) The project should not be accepted as the NPV is negative and PI is less than 1.
6.5 NPV vs IRR

Net Present Value (NPV) and Internal Rate of Return (IRR) are two of the most widely used
investment analysis techniques.They are similar because both are cash flow models.The NPV is an
absolute measure, i.e., it is the amount in Rupees/dollars etc. of value added or lost by engaging in
a project.IRR is a relative measure, i.e., it is the rate of return a project offers over its life, in
percentages.
Net Present Value Profile

NPV profile is a graphical representation of the relationship between an investment’s NPVs and
various discount rates.NPV Profile plots different NPVs on the vertical axis, or y-axis, and the
discount rates on the horizontal axis, or x-axis.

Notes
Corporate Finance
Table 1: NPV at different discount rates
Discount Rate NPV
0% 20.00
5% 11.56
10 4.13
15 -2.46
20 -8.33
NPV VS IRR conflict

IRR and NPV rules always lead to the same decisions as long as two conditions are met.The
project’s cash flows must be conventional. The project must be independent i.e., Decision to accept
or reject this project does not affect the decision to accept or reject any other.
Conventional Project
A conventional investment: whose cash flows take the pattern of an initial cash outlay followed by
cash inflows. (– + + +).A non-conventional investment, which has cash outflows mingled with cash
inflows throughout the life of the project. (– + + + – ++ – +).
Pitfall 1: Non-conventional Cash Flows

Suppose we have a mining project that requires a 60 Lacs investment. Cash flow in the first year
will be 1.55 Crore. In the second year, the mine will be depleted, but we will have to spend 1 Crore
to restore the terrain.
Lovely Professional
Notes
Non-conventional Cash Flows
Table 2: Discount Rate and NPV
Discount Rate NPV
0% -5.00
10 -1.74
20 -0.28
30 0.06
40 -0.31
NPV VS IRR
First, as the discount rate increases from 0 percent to 30 percent, the NPV starts with negative and
becomes positive. This seems opposite because the NPV is rising as the discount rate rises. It then
starts getting smaller and becomes negative again.
NPV VS IRR
In Fig 4, NPV is 0 when the discount rate is 25%. The NPV is also zero at 33.33%. Which of these is
correct?This is multiple rates of return problem. If our required return is 10 percent. Should we take
this investment? Both IRRs are greater than 10 percent, so, by the IRR rule, maybe we should. NPV
is positive only if our required return is between 25% and 33.33%.In nutshell, when the cash flows
aren’t conventional, problem arises with the IRR.
Pitfall 2: Mutually Exclusive Investment

Notes
Corporate Finance
Mutually exclusive investment decisions are a situation in which taking one investment prevents
the taking of another.
Mutually Exclusive Investment

Given two or more mutually exclusive Projects which one is the best? Can we also say that the best
one has the highest return?
Cashflows of Project A and Project B
Table 3: Cashflows of Project A and Project B
Year Project A Project B
0 -100 -100
1 50 20
2 40 40
3 40 50
4 30 60
The IRR for A is 24%.IRR for B is 21%. Project A seems better because of its higher return.
Table 4: NPV of Project A and Project B
Discount NPV A NPV B
Rate
0% 60.00 70.00
5 43.13 47.88
10 29.06 29.79
15 17.18 14.82
20 7.06 2.31
25 -1.63 -8.22
In our example, the NPV and IRR rankings conflict for some discount rates. If our required return is
10 percent, B has the higher NPV and is the better of the two even though A has the higher
return.Fig 5 shows the conflict between the IRR and NPV for mutually exclusive investments.The
NPV profiles cross at about 11 percent.At any discount rate less than 11 percent, the NPV for B is
higher.At any rate greater than 11 percent, Project A has the greater NPV.
Lovely Professional
Notes
This example shows that when we have mutually exclusive projects, we shouldn’t rank them based
on their returns. When we are comparing projects to determine which is best, judging through IRRs
can be misleading.Rather, we need to look at the relative NPVs to avoid the possibility of choosing
incorrectly. Suppose you have two investments. One has a 10% return and makes you Rs. 100 richer
immediately. The other has a 20% return and makes you Rs. 50 richer immediately. Which one will
you choose? We would choose Rs. 100 than Rs. 50, although the returns, is greater in case of second.
6.6 Risk involved in Capital Budgeting

Risk arises in the investment evaluation because the forecasts of cash flows can go wrong.Risk can
be defined as variability of returns (NPV or IRR) of an investment project. Standard deviation is a
commonly used measure of variability.Firm cannot predict the occurrence of possible future events
with certainty. The uncertain economic conditions are the sources of uncertainty in the cash flows.
For example, a company wants to market a new product to their prospective customers. Demand
may be very high if the country experiences higher economic growth. On the other hand, adverse
economic events may trigger economic slowdown. This may bring down the estimated cash flows
Events influencing the investmentforecasts:
 General economic conditions: Events which influence the general level of business
activity such as economic and political situations, monetary and fiscal policies, etc.
 Industry factors:This category of events may affect all companies in an industry like
industrial relations in the industry, by innovations, by change in material cost, etc.
 Company factors:This category of events may affect only the company like change in
management, strike in the company etc.
6.7 Techniques of Risk Analysis

Certainty Equivalent
Common procedure for dealing with risk in capital budgeting is to reduce the forecasts of cash
flows to some conservative levels. For example, if an investor expects a cash flow of Rs. 30,000 next
year, he will apply an intuitive correction factor and may work with Rs. 20,000 to be on the safe
side. There is a certainty-equivalent cash flow.
The certainty equivalent approach may be expressed as:
=
(1 + )
Where:
• NCFt= Forecasts of net cash flow without risk adjustment.
• αt = The certainty-equivalent coefficient
• kf = risk-free rate
The certainty-equivalent coefficient, αt, assumes a value between 0 and 1, and varies inversely with
risk. A lower αt will be used if greater risk is perceived and a higher α t will be used if lower risk is
expected.The manager subjectively or objectively establishes the coefficients. These coefficients
reflect the decision maker’s confidence in obtaining a particular cash flow in period t.
For example, a expected cash flow for the next year is Rs. 40,000, but if the investor thinks that only
80% of it is a certain amount, then the certainty-equivalent coefficient will be 0.80. He considers
only Rs. 32,000 as the certain cash flow. To obtain certain cash flows, we will multiply estimated
cash flows by the certainty-equivalent coefficients.
The certainty-equivalent coefficient can be determined as a relationship between the certain cash
flows and the risky cash flows.

Notes
Corporate Finance
ℎ
= =
ℎ
For example, expected risky cash flow is of Rs. 40,000 in period t and certain cash flow of Rs. 30,000
is equally desirable, then αt will be 0.75
= 30,000/40,000.
If Investment outlay is Rs. 45,00,000 and risk-free rate is 5%, calculate NPV under certainty
equivalent technique.
Year Expected Cash Certainty

flow (Rs.) Equivalent
Coefficient
1 10,00,000 0.90
2 15,00,000 0.85
3 20,00,000 0.82
4 25,00,000 0.78
1000000 × (0.90) 1500000 × (0.85) 2000000 × (0.82) 2500000 × (0.78)

= + + +
(1.05) 1.05 1.05 1.05
− 45,00,000
= Rs. 5,34,570
Advantages of Certainty Equivalent Method:

The advantages of this method are:
• Simple and easy to understand and apply.
• It can easily be calculated for different risk levels applicable to different cash flows.
Disadvantages of Certainty Equivalent Method:

• Certainty Equivalents are subjective and vary as per each individual's estimate.
• The risk perception of the shareholders who are the money lenders for the project is
ignored.
• The forecaster, expecting the reduction that will be made in his forecasts, may inflate them
in anticipation.
6.8 Sensitivity Analysis

Sensitivity analysis is a way of analyzing change in the project’s NPV (or IRR) for a given change in
one of the variables. It indicates how sensitive a project’s NPV (or IRR) is to changes in particular
variables. The more sensitive the NPV, the more critical is the variable.
Steps in Sensitivity Analysis
a) Identification of all those variables, which have an influence on the project’s NPV (or IRR).
b) Definition of the underlying mathematical relationship between the variables.
c) Analysis of the impact of the change in each of the variables on the project’s NPV.
Lovely Professional
Notes
Sensitivity analysis
The decision maker computes the project’s NPV (or IRR) for each forecast under three cases:
 Pessimistic,
 Expected and
 Optimistic.
Example:
XYZ Company is planning to install a plant costing Rs. 10 million to increase its production
capacity. The expected values of the underlying variables are given in Table 1.Salvage value is
assumed to be 0.
Table 1: Expected Values of Variables
1. Investment (’000) 14,000
2. Sales volume (units ’000) 1,000
3. Unit selling price 20
4. Unit variable cost 10
5. Annual fixed costs (’000) 5,000
6. Depreciation (straight line) 2,000
7. Corporate tax rate 30%
8. Discount rate 12%
NCF =1,000 (20 – 10) – 5,000)] (1 – 0.30) + 0.30 × 2,000

= Rs. 4,100
NPV of an annuity of 7 years at 12 per cent discount rate and IRR are:
NPV = +4,711
IRR = 22%
As the NPV is positive (or IRR > discount rate), the project can be accepted.
Before taking a decision, finance manager may like to know whether the NPV changes, if the
forecasts go wrong. A sensitivity analysis can be conducted with regard to volume, price, costs, etc.
In order to do so, we must obtain pessimistic and optimistic estimates of the underlying variables.
Table 2: Forecasts Under Different Assumptions

Variable Pessimistic Expected Optimistic
Volume (units ’000) 850 1,000 1,150
Units selling price (Rs.) 17 20 23
Units variable cost (Rs.) 11.50 10 8.50
Annual fixed costs 5,750 5,000 4,250

Notes
Corporate Finance
(`’000)
Table 3: Sensitivity Analysis Under Different Assumptions

Net Present Value
Variable Pessimistic Expected Optimistic
Volume (81) 4,711 9,503
Units selling price (4,872) 4,711 14,295
Units variable cost (81) 4,711 9,503
Annual fixed costs 2,315 4,711 7,107
Table 3 shows the project’s NPV when each variable is set to its pessimistic, expected and optimistic
values. The most critical variables are sales volume and unit selling price.
Advantages of Sensitivity Analysis:
 It is a simple technique
 It compels the decision maker to identify the variables, which affect the cash flow forecasts.
 It Indicates the critical variables for which additional information may be obtained.
Disadvantage of Sensitivity Analysis
 It does not provide clear-cut results as the terms ‘optimistic’ and ‘pessimistic’ could mean
different things to different persons.
 It fails to focus on the interrelationship between variables.
Summary
 Net present value (NPV) of a project is the difference between the present value of cash
inflows and the present value of cash outflows. The net present value rule states that
financial managers increase shareholders’ wealth by accepting all projects that are worth
more than they cost. Therefore, they should accept all projects with a positive net present
value. NPV is a Discounted Cash Flow technique that recognizes the time value of money.
 Internal Rate of Return: There is another important capital budgeting technique based on
discounted cash flow method called IRR or the internal rate of return technique. The
internal rate of return (IRR) is the annual rate of growth that an investment is expected to
generate. IRR is calculated using the same concept as net present value (NPV), except it
sets the NPV equal to zero. The rate of return is the discount rate which makes NPV = 0.
 Profitability index is another discounted cash flow capital budgeting technique. The
Profitability Index (PI) measures the ratio between the present value of future cash flows
and the initial investment.
 Cash Flow Estimation: The difficulty in estimating cash flows arises because of uncertainty
and accounting ambiguities. Events affecting investment opportunities change rapidly and
unexpectedly. Mostly accounting data forms the basis for estimating cash flows.
Accounting data are the result of arbitrary assumptions, choices and allocations.
 Net Present Value (NPV) and Internal Rate of Return (IRR) are two of the most widely
used investment analysis techniques. They are similar because both are cash flow models.
Lovely Professional
Notes
The NPV is an absolute measure, i.e., it is the amount in Rupees/dollars etc. of value
added or lost by engaging in a project. IRR is a relative measure, i.e., it is the rate of return
a project offers over its life, in percentages.
 NPV VS IRR conflict: IRR and NPV rules always lead to the same decisions as long as two
conditions are met. The project’s cash flows must be conventional. The project must be
independent i.e., Decision to accept or reject this project does not affect the decision to
accept or reject any other.
 Risk can be defined as variability of returns (NPV or IRR) of an investment project.
Standard deviation is a commonly used measure of variability. Firm cannot predict the
occurrence of possible future events with certainty. The uncertain economic conditions are
the sources of uncertainty in the cash flows. Certainty Equivalent and Sensitivity Analysis
are examples of the risk evaluation techniques.
Keywords
Investment decisions, Capital Budgeting, Discounted cash flow technique, Net Present Value,
Internal Rate of Return, Profitability Index, Cash flow estimation, Risk evaluation.
Self Assessment
1. The first step in calculation of net present value is to find out
A. Present value of equity

B. Future value of equity
C. Present value cash flow
D. Future value of cash flow
2. In capital budgeting, a technique which is based upon discounted cash flow is classified as
A. net present value method
B. net future value method
C. net capital budgeting method
D. net equity budgeting method
3. The decision rule for net present value is to:

A. accept all projects with cash inflows exceeding initial cost
B. reject all projects with rates of return exceeding the opportunity cost of capital
C. accept all projects with positive net present values
D. reject all projects lasting longer than 10 years
4. The internal rate of return can best be described as:

A. the discount rate at which a set of cash flows have a positive net present value.
B. the rate which the business has to pay to raise finance for an investment.
C. the return required by the managers of the business.
D. the discount rate at which a set of cash flows have a zero net present value.
5. The acceptance rule in case of IRR technique is:

Notes
Corporate Finance
A. Accept the project when r > k

B. Reject the project when r > k
C. Reject the project when r = k
6. The acceptance rule in case of IRR technique is:

A. Accept the project when r > k
B. Reject the project when r > k
C. Reject the project when r = k
7. If a firm has to select only one project out of multiple projects, then according to the PI rule:
A. Accept the project with higher PI
B. Accept the Project with lower PI
C. Accept the project having PI closer to 1
D. Accept the project with PI equal to 0
8. A profitability index of 0.95 for a project means that:

A. the present value of benefits is 95% greater than the project's costs.
B. the project's NPV is greater than zero
C. the project returns 95 cents in present value for each current rupee invested
D. the payback period is less than one year
9. A project's profitability index is equal to the ratio of the of a project's future cash flows to
the project's .
A. present value; initial cash outlay
B. net present value; initial cash outlay
C. present value; depreciable basis
D. net present value; depreciable basis
10. If capital is to be allocated for only the current period, a firm should probably first consider
selecting projects by descending order of ___________________.
A. net present value
B. payback period
C. internal rate of return
D. profitability index
11. A typical investment will have following component/s of cash flows:

A. Initial investment
B. Annual net cash flows
C. Terminal cash flows
D. All of the above
Lovely Professional
Notes
12. A cost incurred in the past that cannot be changed by any future action is:
A. Opportunity cost
B. Sunk cost
C. Relevant cost
D. Avoidable cost
13. Opportunity cost is_________________?

A. the cost incurred in the past before we make a decision about what to do in the future.
B. a cost that cannot be avoided.
C. that which we forgo while taking a decision.
D. the additional benefit of buying an additional unit of a product
14. In the case of conflict, why is the NPV method preferred over IRR?
A. IRR is not always a reliable method especially in case of non-conventional cash-flow.
B. NPV has a simpler assumption for the discount rate
C. NPV has more probability of indicating to undertake a project
D. NPV is the robust formula for capital budgeting
15. In certainty-equivalent approach, risk adjusted cash flows are discounted at

A. Accounting Rate of Return
B. Internal Rate of Return
C. Hurdle Rate
D. Risk-free Rate

1. C 2. A 3. C 4. D 5. A
6. A 7. A 8. C 9. A 10. D
11. D 12. B 13. C 14. A 15. D
Review Questions
1. Do the profitability index and the NPV criterion of evaluating investment proposals lead to the
same acceptance-rejection and ranking decisions?
2. Explain the NPV-IRR conflict.
3. What does the profitability index signify? What is the criterion for judging the worth of
investments in the capital budgeting technique based on the profitability index?
4. Company ABC is considering a project with the following expected cash flows:
Year Project Cash

Notes
Corporate Finance
Flow
0 - Rs. 70 Lac
1 20 Lac
2 37 Lac
3 22.5 Lac
4 70 Lac
The project's WACC is 10 percent. What is the project's discounted payback?
5. Company XYZ Ltd. is considering two mutually exclusive investment proposals for its expansion
programme. Proposal X requires an initial investment of Rs 75000 and yearly cash operating costs
of Rs 5,000. Proposal Y requires an initial investment of Rs 50,000 and yearly cash operating costs of
Rs 10,000. The life of the equipment used in both the investment proposals will be 10 years, with no
salvage value; depreciation is on the straight-line basis for tax purposes. The anticipated increase in
revenues is Rs 15,000 per year in both the investment proposals. The firm’s tax rate is 30 per cent
and it’s cost of capital is 15 per cent. Which investment proposal should be selected by the
company?
Further Readings
1. Khan, M. and Jain, P., 2011. Financial management. 1st ed. New Delhi: Tata McGraw-Hill.
Publishing
3. Berk, Jonathan. &DeMarzo, Peter. & Harford, Jarrad. & Ford, Guy. &Mollica, Vito. (2017).
Fundamentals of corporate finance. Melbourne, VIC : Pearson Australia
4. https://www.investopedia.com/ask/answers/032615/what-formula-calculating-net-
present-value-npv.asp
5. https://corporatefinanceinstitute.com/resources/knowledge/finance/internal-rate-
return-irr/
6. https://corporatefinanceinstitute.com/resources/knowledge/accounting/profitability-
index/
Lovely Professional
Notes
Dr. Atif Ghayas, Lovely Professional University Unit 07: Cost of Capital
Unit 07: Cost of Capital

CONTENTS
Objectives
Introduction
7.1 Discount Rate
7.2 Meaning of Cost of Capital
7.3 Importance of Cost of Capital
7.4 Weighted Average Cost of Capital
7.5 Cost of Equity Capital
7.6 Steps in the calculation of WACC
7.7 International Dimensions in Cost of Capital
Summary
Keywords
Self Assessment
Review Questions
Further Readings
Objectives
• understand the meaning and concept of Cost of capital.
• analyze the significance of Cost of capital.
• compute the cost of Debt.
• compute cost of Preference Shares,
• compute cost of Internal Equity,
• compute cost of External Equity
• understand the concept of WACC.
• compute the WACC.
• analyse the international dimension in Cost of Capital.
Introduction
In the previous chapter, we discussed capital budgeting techniques. In the capital budgeting
decisions, the estimation of cash flow and the discount rate is very crucial. The discount rate is
based on a certain required rate of return from the project which becomes the basis for accepting or
rejecting the project. That required rate is the cost of capital of a firm. Apart from its usefulness as
an operational criterion to accept/reject an investment proposal, cost of capital is also an important
factor in designing capital structure. In this chapter, we will discuss the cost of Debt, Cost of Equity,
and the overall cost of capital in a firm.

Notes
Corporate Finance
Evaluating an investment project requires two basic inputs:
Estimates of the project’s cash flows
Discount rate
7.1 Discount Rate

The opportunity cost of capital or the cost of capital for a project is the rate for discounting the cash
flows. The project’s cost of capital is the minimum required rate of return on funds invested in the
project, which depends on the riskiness of its cash flows. The firm represents the aggregate of
investment projects undertaken by it. The firm’s cost of capital will be the average required rate of
return on the total investment projects undertaken by the firm.
7.2 Meaning of Cost of Capital

A firm needs various factors of production like capital, labor, land etc. for its production process.
Every factor employed in the production process has to be rewarded in some form. Capital is
rewarded through Interest or dividend, labor with salary and wages, land with rent and
entrepreneurship with profits. Cost of capital is the return required by the providers of capital to
the business as a compensation for their contribution to the total capital. When a firm has procured
finances, it has to pay some additional amount of money besides the principal amount. The
additional money paid by the firm is the cost of using the capital.
7.3 Importance of Cost of Capital

The computation of the firms cost of capital is very important due to the following reasons:
• Evaluation of investment options: The main purpose of measuring the cost of capital is for
evaluating the investment projects. The project’s NPV is calculated by discounting its cash
flows by the cost of capital. In the IRR method, the investment project is accepted if it has an
internal rate of return greater than the cost of capital.
• Designing of optimum credit policy: The debt policy of a firm is significantly influenced by
the cost consideration. Debt helps to save taxes as interest on debt is a tax-deductible expense.
The interest tax shield reduces the overall cost of capital.
• Performance Appraisal: The cost of capital framework can be used to evaluate the financial
performance of top management.Cost of capital is used to appraise the performance of a
particular project or business.
Opportunity cost of capital:

The opportunity cost is the rate of return foregone on the next best alternative investment
opportunity of comparable risk. Thus, the required rate of return on an investment project is an
opportunity cost. For example, you may invest your savings of Rs. 100,000 either in 6.5 per cent 3-
year Fixed deposit in a Bank or 7 per cent, 3-year postal certificates.

Notes
Shareholders’ Opportunity Cost:

The manager should consider the required rate of all the shareholders’ in evaluating the investment
decisions. In an all-equity financed firm, the equity capital of ordinary shareholders is the only
source to finance investment projects.Firm’s cost of capital is equal to the opportunity cost of equity
capital, which will depend only on the business risk of the firm.
Creditors’ Opportunity cost:

Different investors are exposed to different degrees of risk. Unlike equity shareholders, the firm is
under a legal obligation to pay interest and repay principal to the creditors. Debt holders are
exposed to the risk of default by the firm.
Preference shareholders hold claim prior to ordinary shareholders but after debt holders.
Preference dividend is fixed, the firm will pay it after paying interest but before paying any
ordinary dividend. Dividends is paid to the ordinary shareholders from cash remaining after
interest and preference dividends have been paid.
Risk Differences: Shareholders’ and Creditor Claims

The investors demand different rates of return on various securities as the risk level is different for
different type of security. Higher the risk of a security, the higher the rate of return required by
investors. Ordinary shareholders will require highest rate of return on their investment. Preference
share is riskier than debt, its required rate of return will be higher than that of debt. Required rate
of return of any security includes two rates—a risk-free rate and a risk premium. A risk-free
security will require compensation for time value and its risk-premium will be zero such as the
treasury bills and bonds. In case of risky securities, Investors expect higher rates of return. The
higher the risk of a security, the higher will be its risk-premium.
From the viewpoint of all investors, the firm’s cost of capital is the rate of return required by them
for supplying capital. The rate of return required by all investors will be an overall rate of return—a
weighted rate of return. Thus, the firm’s cost of capital is the ‘average’ of the opportunity costs (or
required rates of return) of various securities, which have claims on the firm’s assets.
Determination of the cost of Capital

The cost of capital can either be explicit or implicit.
• Explicit cost: The cash outflow of a firm towards the utilization of capital which is clear.
• Implicit cost: Not a cash outflow but is an opportunity loss of foregoing a better
investment opportunity.
7.4 Weighted Average Cost of Capital

The weighted average cost of capital (WACC) represents a firm's average cost of capital from all
sources, including Equity shares, preferred shares, debentures, and other forms of debt. The
weighted average cost of capital is a common way to determine required rate of return because it
expresses, in a single number, the return that both debenture holders and shareholders demand in

Notes
Corporate Finance
order to provide the company with capital. The WACC represents the minimum return that a
company must earn to pay to its creditors, owners, and other providers of capital. The WACC may
have the following components:
Cost of Debt
Cost of Equity
WACC
Cost of Pref Share
Capital
Cost of Retained
Earnings
1. Cost of Debt
Let’s first discuss the cost of debt for the business or the cost of borrowed funds. Debt can be raised
from financial institutions or public either in the form of public deposits or debentures (bonds). A
debenture may be issued at par or at a discount or premium as compared to its face value. The
contractual rate of interest forms the basis for calculating the cost of debt. The long-term debt can
be divided into redeemable debt and irredeemable debt and thus the cost of debt will include the
cost of irredeemable debt and cost of redeemable debt.
Cost of Long term

Debt
Cost of Cost of Redeemable

Irredeemable Debt Debt
Debt Issued at Par

The before-tax cost of debt (kd) is the rate of return required by debt providers. Before-tax cost of
debt issued and to be redeemed at par is equal to the contractual rate of interest (i).
= =
Where,
• Kd = Before tax cost of Debt
• i = Coupon rate of interest,
• B0 = Issue price of the bond (debt)
• INT = Amount of interest.
Illustration:
A company decides to sell a new issue of 7 year 15 per cent bonds of Rs. 100 each at par. If the Face
value is Rs. 100 bond and Maturity value is also Rs. 100, the before-tax cost of debt will be:

Notes
15
= = 15%
100
Alternatively, we can use Present Value method:

Cash outflows are Rs. 15 interest per year for 7 years and Rs. 100 at the end of seventh year in
exchange for Rs. 100 now.
15 15 15 15 15 15 15
100 = + + + + + +
(1 + ) (1 + ) (1 + ) (1 + ) (1 + ) (1 + ) (1 + )
100
+
(1 + )
15 100
100 = +
(1 + ) (1 + )
100 = 15 , + 100 ,
By trial and error, we find that the discount rate (kd), which solves the equation, is 15 percent:
100 = 15 (4.160) + 100 (0.376)
= 62.40 + 37.60 = 100
So YTM is the Internal rate of return at which current price of a debt equals to the present value of
the all the cash flows
Debt Issued at Discount or Premium

Both methods will give identical results only when debt is issued at par and redeemed at par.
Present Value method can be rewritten as follows to compute the before-tax cost of debt
Where,
• B0 = value of debenture today,
• Bn = repayment value of debt on maturity.
Above equation can be used to find out the cost of debt whether debt is issued at par or discount or
premium, i.e., B0 = F or B0> F or B0< F. Assume that in the previous example each bond is sold
below par for Rs. 94, kd is calculated as:
Kd will be found by trial and error.
• Try 17%
15(3.922) + 100(0.333)
58.83 + 33.90

Notes
Corporate Finance
= 91.13 < 94
• Try 16%:
=15(4.038) + 100(0.354)
= 60.57 + 35.40
= 95.97 > 94
• By interpolation, we can findkd:
Short-cut method
If the amount of discount or premium is adjusted over the period of debt, Short-cut method can
also be used:
Using the data of previous example:
Tax Adjustment
The interest paid on debt is tax deductible. Due to the interest tax shield, the after-tax cost of debt to
the firm will be less than the investors’ required rate of return. The before-tax cost of debt, should
be adjusted for the tax effect:
After tax cost of debt = (1 − )
Where, T is the corporate tax rate.
In our example is 16.5 percent is the before tax cost of debt and the Tax rate is 35%, the after-tax cost
of bond will be:
(1 − )
= 0.165(1 − 0.35)
= 10.73%
It should be noted that the tax benefit of interest deductibility would be available only when the
firm is profitable and is paying taxes.
The annual interest will be:
F × i = Rs. 100 × 0.15
= Rs. 15,
Maturity price will be:
Rs. 100 (1.05)
= Rs. 105

Notes
The after-tax cost of debenture will be:
Cost of the Existing Debt

The current cost of the existing debt is calculated as the current market yield of the debt. Suppose, a
firm has 11% debentures of Rs. 100,000 of Rs. 100 face value outstanding at 31 Dec 2020 to be
matured on 31 Dec 2025. A new issue of debentures could be sold at a net realizable price of Rs. 80
in the beginning of 2021.
Cost of the existing debt, using short-cut method, will be:
If T = 0.35, the after-tax cost of debt will be:
kd (1-T ) = 0.167(1-0.35) = 0.109

=10.9 %
2. Cost of Equity
After the discussion on the debt capital in the previous section, we will now discuss the cost of
Equity capital. Equity is the amount of capital invested or owned by the owner of a company. The
cost of equity capital can be divided into cost of preference shares, cost of equity shares/external
equity and cost of internal equity or retained earnings.
3. Cost of Preference shares

The equity shareholders are paid a dividend in return of the capital provided to the firm. However,
payment of dividends to the preference shareholders is not legally binding on the firm. Even if the
dividends are paid, it is not a charge on earnings. The cost of preference capital is a function of the
dividend expected by investors which is based on the credit standing and market value of the firm.
The preference shares can be divided into irredeemable and redeemable preference shares.
4. Irredeemable Preference Share

These shares are issued for the life of the company and are not redeemed. The preference share may
be treated as a perpetual security if it is irredeemable. Cost of Preference Shares is given by the
following equation:
Where:
● kp is the cost of preference share
● PDIV is the expected preference dividend
● P0 is the issue price of preference share
Illustration:
A company issues 15% irredeemable preference shares. The face value per share is Rs. 100, but the
issue price is Rs. 95. What is the cost of a preference share? What is the cost if the issue price is Rs.
105?

Notes
Corporate Finance
● Issue price Rs. 95:
15
= = 15.78%
95
● Issue price Rs. 105:
15
= = 14.28%
105
Redeemable Preference Share

These shares are issued for a particular period and at the expiry of that period, they are redeemed
and principal is paid back to their holders. The characteristics are very similar to debt and therefore
the calculations will be similar too. A Present Value formula can be used to compute the cost of
redeemable preference share:
= +
1+ 1+
Preference dividend is paid after the taxes have been paid, hence the cost of preference share is not
adjusted for taxes.
7.5 Cost of Equity Capital

Cost of equity is the return that an investor requires for investing in a company, or the required rate
of return that a company must receive on an investment or project. Equity capital can be divided
into external equity and internal equity internal equity is also called retained earnings.
1. External equity: Firms could distribute the entire earnings and raise equity capital
externally by issuing new shares.
2. Internal Equity: Firms may use equity capital internally by retaining earnings.
The cost of the External equity will be more than the internal equity. As we already know that it’s
not legally binding for firms to pay dividends to ordinary shareholders. Ordinary shareholders
supply funds to the firm in the expectation of dividends and capital gains. The shareholders’
required rate of return, which equates the present value of the expected dividends with the market
value of the share, is the cost of equity.
Problems in calculating cost of Equity:

• Difficult to estimate the future or the expected dividends.
• Difficult to estimate the growth of dividends.
Cost of Internal Equity

The opportunity cost of the retained earnings is the rate of return foregone by equity shareholders.
The Dividend-growth Model:

Normal growth:
As the dividend valuation model for a firm assuming dividends are expected to grow at a constant
rate (g) and dividend payout ratio is constant:
= +
The cost of equity is equal to the expected dividend yield (DIV1/P0) plus capital gain rate(g). The
keshows that if the firm would have distributed earnings to shareholders, they could have invested

Notes
it to earn a rate of return equal to ke. If a return on retained earnings is less than ke, the market price
of the firm’s share will fall.
Illustration:
Suppose that the current market price of a company’s share is Rs. 80 and the expected dividend per
share next year is Rs. 4. If the dividends are expected to grow at a constant rate of 10%.
Solution:
= +
4
= + 0.10
80
= 0.05 + 0.10
= 15%
The company should earn a return of minimum 15% on retained earnings to keep the current
market price unchanged.
Cost of External Equity

The minimum rate of return, which the equity shareholders require on funds supplied by them, is
the cost of external equity.
a. The Dividend-growth Model
= +
In India, the new issues of ordinary shares are generally sold at a price less than the market price.
= +
Where:
• PI is the issue price of new equity
Illustration:
The current price share of a company is Rs. 100. The company wants to finance its capital
expenditures of Rs. 100 million either through retained earnings or by selling new shares. Issue
price of new shares will be Rs. 95. The dividend per share next year, DIV1, is Rs. 4.75 and it is
expected to grow at 6%.
Cost of internal equity:
= +
Cost of External equity:

Notes
Corporate Finance
b. Capital Asset Pricing Model (CAPM)

The CAPM provides a framework to determine the required rate of return on an asset and indicates
the relationship between return and risk of the asset. The risks, to which a security is exposed, can
be classified into two groups:
● Unsystematic Risk: also called company specific risk as the risk is related to the
company's performance.
● Systematic Risk: market specific risk under which a company operates e.g. inflation,
Government policy, interest rate etc.
Unsystematic Risk can be eliminated by an investor through diversification. As per CAPM method
business should be concerned solely with non-diversifiable risk. The non-diversifiable risks are
assessed in terms of beta coefficient.
Cost of capital under this approach can be calculated as:
= + −
Where:
• Rf = Risk free rate of return
• β = Beta coefficient
• Rm = Rate of return on market portfolio
Components of the formula:

● The risk-free rate (Rf): The yields on the government Treasury securities are used as the
risk-free rate.
● The market risk premium (Rm – Rf): measured as the difference between the long-term
market return and the risk-free rate.
● The beta of the firm’s share (β): Beta (β) is the systematic risk of an ordinary share in
relation to the market.
Required rate of return = Risk free rate + Risk premium
According to CAPM investors need to be compensated in two ways- time value of money and risk.
The second half of the formula represents risk and calculates the amount of compensation the
investor needs for taking on additional risk.
Illustration:
For a company, Risk-free rate is 7%, Market risk premium is 9% and Beta of share is 1.3.
Solution:
The cost of equity is:
= + −

Notes
ke = 0.07 + 0.09 × 1.3

= 0.187
= 18.7%
Dividend-growth Model vs. CAPM

The dividend-growth approach has limited application. First, it assumes that the dividend per
share will grow at a constant rate, g, forever. Second, the expected dividend growth rate, g, should
be less than the cost of equity, ke, to arrive at the simple growth formula. Dividend-growth
approach cannot be applied to those companies which are not paying any dividends or whose
dividend per share is growing at a rate higher than ke, or whose dividend policies changes
frequently.
Concept of WACC
Weighted average cost of capital is the expected average future cost of funds over the long run
found by weighting the cost of each specific type of capital by its proportion in the firm’s capital
structure.
Average v/s Weighted Average

Proportions of various sources of funds in the capital structure of a firm are different. The overall
cost of capital should take into account the relative proportions of different sources in order to be
representative.
7.6 Steps in the calculation of WACC

1. Assigning weights to specific costs.
2. Multiplying the cost of each of the sources by the appropriate weights.
3. Dividing the total weighted cost by the total weights.
1. Assignment of Weights
The aspects relevant to the selection of appropriate weights are: Historical weights versus Marginal
weights. Historical weights can be Book value weights or Market value weights.
The WACC (k0) can be calculated as:
Where:
● k0 = WACC
● kd (1 – T ) = After-tax cost of debt
● ke = Cost of debt equity
● D = Amount of debt
● E = Amount of equity
Marginal Cost

Notes
Corporate Finance
The marginal weights represent the percentage share of different financing sources the firm intends
to raise. The basis of assigning relative weights is, additional issue of funds and, hence, marginal
weights. What is commonly known as the WACC is in fact the weighted marginal cost of capital
Historical Cost
The use of the historical weights is based on the assumption that the firm’s existing capital structure
is optimal and, therefore, should be maintained in the future. The historical cost that was incurred
in the past in raising capital is not relevant in financial decision-making.
Book Value v/s Market Value Weights

● Market value weights: Use market values to measure the proportion of each type of
capital to calculate weighted average cost of capital.
● Book value weights: Use accounting (book) values to measure the proportion of each type
of capital to calculate the weighted average cost of capital.
There will be difference between the book value and market value weights, and hence, WACC will
be different. WACC will be understated if the market value of the share is higher than the book
value.
Advantages for the Book Value Weights

Managers prefer the book value weights for calculating WACC as besides the simplicity of the use,
managers claim following advantages for the book value weights:
● It can be easily derived from the published sources.
● The book value debt-equity ratios are analyzed by investors to evaluate the risk of the
firms.
Illustration: WACC
A firm’s after-tax cost of capital of the specific sources is as follows:
Cost of debt 10%
Cost of preference shares 15%
Cost of equity funds 16%
Debt Rs. 3,00,000
Preference capital Rs. 2,00,000
Equity capital Rs. 5,00,000
Total: Rs. 10,00,000
Calculate the weighted average cost of capital, k0, using book value weights.
Solution:
Source of funds Amount Proportion
Debt 3,00,000 0.3 (30)

Notes
Preference capital 2,00,000 0.2 (20)
Equity capital 5,00,000 0.5 (50)
10,00,000 1.00 (100)
Source of funds Cost Weighted Cost
Debt 0.10 0.03
Preference capital 0.15 0.03
Equity capital 0.16 0.08
0.14
Weighted average cost of capital = 14%
7.7 International Dimensions in Cost of Capital

The Risk premium and Beta used depends on the view that a company has regarding capital
markets. If capital markets are integrated the appropriate equity risk premium should reflect a
world benchmark (say, MSCI World Index),
(RM – Rf )W.
If markets are segmented (or if the shareholders hold domestic portfolios), then the appropriate
equity risk premium should be based on a domestic benchmark (RM – Rf )D.
Cost of capital does differ in different countries. In a segmented market the market portfolio (M) in
the CAPM formula would be the domestic portfolio instead of the world portfolio (W). Financial
integration or segmentation at the international level affects the cost of capital.
World CAPM:
Ri = Rf + βW (RM – Rf )W
Domestic CAPM:
Ri = Rf + βD (RM – Rf )D
The difference between these two models can be significant.
Illustration:
Compare the US$ cost of capital for IBM and Sony. US$ risk-free interest rate is 6%, global risk
premium 4%. IBM & Sony’s global equity betas in US$ estimated at 0.83 and 1.66 respectively.
Solution
US$ denominated cost of capital can be estimated using the following equation.
Ri = Rf + βiUS (RUS – Rf)
Where:
Ri == Expected Return from the capital market
Rf = Risk-free Return
βi = Systematic Risk

Notes
Corporate Finance
(RM – Rf) = Market Risk Premium
Given:
● Global Market Risk-premium: 4%
● Risk-free interest rate in US: 6%
Equity betas:
● For IBM: 0.83
● For Sony: 1.66
RIBM = 6% + 0.83 *4%

= 9.30%
RSony = 6% + 1.66 *4%
= 12.60%
Summary
● Cost of capital is the return required by the providers of capital to the business as a
compensation for their contribution to the total capital.
● Debt Issued at Par: The before-tax cost of debt (kd) is the rate of return required by debt
providers. Before-tax cost of debt issued and to be redeemed at par is equal to the
contractual rate of interest (i).
= =
● Debt Issued at Discount or Premium: Present Value method can be rewritten as follows to
compute the before-tax cost of debt
● Cost of Preference Shares is given by the following equation:
● Cost Redeemable Preference Share:
= +
1+ 1+
● Cost of Internal Equity: The Dividend-growth Model

The dividend valuation model for a firm assuming dividends are expected to grow at a
constant rate (g) and dividend payout ratio is constant:
= +
● Cost of External Equity: The minimum rate of return, which the equity shareholders
require on funds supplied by them, is the cost of external equity.
= +
● Capital Asset Pricing Model (CAPM)

Notes
= + −
● Weighted average cost of capital is the expected average future cost of funds over the long
run found by weighting the cost of each specific type of capital by its proportion in the
firm’s capital structure.
● International Dimensions in Cost of Capital: The Risk premium and Beta used depends on
the view that a company has regarding capital markets. If capital markets are integrated
the appropriate equity risk premium should reflect a world benchmark (say, MSCI World
Index)
(RM – Rf )W.
● If markets are segmented (or if the shareholders hold domestic portfolios), then the
appropriate equity risk premium should be based on a domestic benchmark (RM – Rf )D.
● Cost of capital does differ in different countries. In a segmented market the market
portfolio (M) in the CAPM formula would be the domestic portfolio instead of the world
portfolio (W).
Keywords
Cost of capital, cost of, cost of equity, cost of internal equity, WACC, CAPM
Self Assessment
1. From Firms perspective, cost of capital is the minimum _________ required to justify the use
of capital.
A. Investment
B. Amount
C. rate of return
D. none of the above
2. Cost of capital is also known as

A. Composite Cost of Capital
B. Weighted Average Cost of Capital
C. Combined Cost of Capital
D. All of the above
3. Cost of capital is highest in case of:

A. Debt
B. Equity
C. Loans
D. Bonds
4. Key advantages of financing through debentures and bonds are:

A. It reduces tax liability
B. It reduces WACC
C. It does not dilute control of owners
D. All of the above.
5. Which of the following statements are false?

A. Retained earnings do not involve any cost.
B. Composite cost refers to the sumof the cost of equity and cost of debt.

Notes
Corporate Finance
C. According to the traditional approach, cost of capital is affected by debt-equity mix.

D. All of the above
6. To compute the required rate of return for equity in a company using the CAPM, it is
necessary to know all of the following EXCEPT:
A. the risk-free rate
B. the beta for the firm.
C. the earnings for the next time period.
D. the market return expected for the time period.
7. The common stock of a company must provide a higher expected return than the debt of the
same company because
A. There is less demand for stock than for bonds.
B. There is greater demand for stock than for bonds.
C. There is more systematic risk involved for the common stock.
D. There is a market premium required for bonds.
8. Which of the following is true regarding the cost of equity calculation using the Dividend
Growth model?
A. Difficult to estimate the future or the expected dividends.

B. Difficult to estimate the growth of dividends.
C. Both a and b
9. The cost of equity using CAPM, if risk-free rate is 8%, market risk premium is 8%, beta of
share is 1.2:
A. 17.6 percent
B. 18.5 percent
C. 17.2 percent
D. 16.8 percent
10. What is/are the disadvantage/s of the dividend-growth model?

A. It assumes that the dividend per share will grow at a constant rate forever.
B. Expected dividend growth rate, g, should be less than the cost of equity, ke, to arrive at the
simple growth formula.
C. Dividend-growth approach cannot be applied to those companies which are not paying any
dividends.
D. All of the above
11. The company cost of capital for a firm with a 60/40 debt/equity split, 8% cost of debt, 15%
cost of equity, and a 35% tax rate would be:
A. 7.02%
B. 9.12%
C. 10.80%
D. 13.80%
12. How much is added to a firm's weighted average cost of capital for 45% debt financing with
a required rate of return of 10% and with a tax rate of 35%?
A. 1.29%

Notes
B. 2.93%
C. 3.50%
D. 4.50%
13. Which component is more likely to be biased if book values are used in the calculation of
WACC rather than market values?
A. Debt
B. Preferred stock
C. Common stock
D. All categories should be equally biased.
14. If a company's cost of capital is less than the required return on equity, then the firm:
A. is financed with more than 50% debt.
B. is perceived to be safe.
C. has debt in its capital structure.
D. cannot be using any debt.
15. A firm's overall cost of capital:

A. is unaffected by changes in the tax rate.
B. is another term for the firm's internal rate of return.
C. is the same as the firm's return on equity.
D. is the required return on the total assets of a firm.

1. C 2. D 3. B 4. D 5. D
6. C 7. C 8. C 9. A 10. D
11. B 12. B 13. C 14. C 15. D
Review Questions
1. Explain the difference between dividend growth model and CAPM model in calculating the
cost of equity.
2. What is the difference between the market value and book value?
3. Discuss the meaning of WACC. Illustrate it with an example.
4. Calculate the cost of equity capital of H Ltd., whose risk-free rate of return equals 10%. The
firm's beta equals 1.75 and the return on the market portfolio equals to 15%.
5. Cost of equity of a company is 10.41% while cost of retained earnings is 10%. There are 50,000
equity shares of Rs.10 each and retained earnings of Rs. 15,00,000. Market price per equity
share is Rs.50. Calculate WACC using market value weights if there are no other sources of
finance.
Further Readings
McGraw-Hill.

Notes
Corporate Finance
Publishing
(2017). Fundamentals of corporate finance. Melbourne, VIC: Pearson Australia
4. https://www.investopedia.com/terms/c/costofequity.asp
5. https://corporatefinanceinstitute.com/resources/knowledge/finance/cost-of-
debt/
6. https://www.investopedia.com/terms/w/wacc.asp

Notes
Dr. Atif Ghayas, Lovely Professional University Unit 08: Financing Decisions
Unit 08: Financing Decisions

CONTENTS
Objectives
Introduction
8.1 Capital Structure
8.2 Capital Structure Theories
8.3 Net Income Approach
8.4 Net Operating Income Approach
8.5 Traditional Position
8.6 Modigliani-Miller (MM) Approach
8.7 Checklist for Capital Structure Decisions
8.8 Costs of Financial Distress
Summary
Keywords
Self Assessment
Review Questions
Further Readings
Objectives
• explain the concept of capital structure
• understand the Net Income Approach
• understand the Net Operating Income Approach
• understand the Traditional Approach
• explain the MM approach
• understand the Arbitrage process
• analyze MM approach under corporate taxes
• list the factors affecting Capital Structure
• analyze the cost of financial distress
Introduction
In the preceding chapters, we discussed about the investment decisions which mainly deals with
the decisions related to the allocation of funds. Now, we will discuss about another important
function of the financial manager called as the financial decisions. Financial decision deals with the
decisions related to the sourcing of funds. As we already know, there are different sources of
finance available for a firm like equity shares, debentures, retained earnings etc. However, all these
difference sources of finance can be divided into two categories viz. Debt and Equity and firm’s
decision to opt for any of them depends on several factors. The combination of debt and equity
capital in the firm’s total capital is called as the capital structure. In this chapter, we will discuss
about the capital structure and about the different theories of capital structure.

Notes
Corporate Finance
8.1 Capital Structure

When a firm needs capital to finance its project, it has various capital sources which it can avail
such as equity shares, preference shares, debentures, bank loan, etc. A firm can use these
instruments in different proportions to meets its requirement. However, all the sources of finance
can be broadly classified into two major groups: Debt and equity. A firm can use 100% of equity
and no debt, 50% Equity and 50% debt or 10% equity and 90% debt and so on. Capital structure
refers to the proportion of debt and equity capital in a firm’s total capital.
Optimum Capital Structure

Optimum capital structure is that capital structure at which the Weighted Average Cost of Capital
(WACC) or the Overall cost of capital of the firm is minimum and hence, the value of firm is
maximum. Firms try to attain the optimum capital structure to maximize the value of the firm.
Capital structure and the Value of the Firm:

An important question that a firm face is about how much should be the proportions of equity and
debt in the capital structure of a firm? As we already know that the valuation and cost of capital are
inversely related i.e., that the value of the firm is maximum when the cost of capital is minimum.
So, given a certain level of earnings, the value of the firm is maximized only when the overall cost
of capital of the firm is minimized and vice versa.
8.2 Capital Structure Theories

In the finance literature, there are different views on the relationship between capital structure and
firm value. Mainly there are three different views, given as under:
1. There is no relationship between capital structure and firm value meaning that capital
structure is irrelevant for the value of the firm.
2. Financial leverage has a positive effect on firm value up to a point and negative effect
thereafter.
3. Greater debt in the capital structure, higher is the value of the firm.
Second and the third view proposes that capital structure is relevant for the value of the firm. Based
on these views, there are four important theories of capital structure.
Net Income Approach
Relevance
Traditional Approach
Capital Structure
Theories
Net OperatingIncome
Approach
Irrelevance
MM Proposition
8.3 Net Income Approach

According to Net Income Approach, capital structure decisionsare relevant to the valuation of the
firm.A change in the debt level will lead to a change in the overall cost of capital as well as the total
value of the firm. If the financial leverage is increased, the WACC or the overall cost of capital will
decline, while the value of the firm and the market price of shares will increase.

Notes
As the degree of leverage increases, the proportion of debt (cheaper source of funds) in the capital
structure increases.As a result, the weighted average cost of capital declines, leading to an increase
in the total value of the firm. The increased use of debt will increase the shareholder’s earnings and,
hence, the market value of the ordinary shares.With a proper mix of debt and equity, a firm can
evolve an optimum capital structure which will be the one at which value of the firm is the highest
and the overall cost of capital is the lowest. At that structure, the market price per share would be
maximum.
Assumptions:
The Net Income approach is based on certain assumption which are:
• There are no taxes.
• The cost of debt is less than the cost of equity.
• Use of debt does not change the risk perception of investors.
Example: A company’s expected annual net operating income (EBIT) is Rs 50,000. The
company has Rs. 2,00,000, 10% debentures. The equity capitalization rate (ke) of the company is
12.5%.
Increase in Value: Let us suppose that the firm has decided to raise the amount of debenture by Rs
1,00,000 and use the proceeds to retire the equity shares.
 The ki and ke would remain unaffected as per the assumptions of the NI Approach.
300000 160000
0 = .10 + 0.125 = 10.9%
460000 460000
The use of additional debt has caused the total value of the firm to increase and the overall cost of
capital to decrease.
Decrease in Value: If we decrease the amount of debentures the total value of the firm will
decrease and the overall cost of capital will increase.
Let us suppose that the amount of debt has been reduced by Rs 1,00,000 to Rs 1,00,000 and a fresh
issue of equity shares is made to retire the debentures.

Notes
Corporate Finance
100000 320000
0 = .10 + 0.125 = 11.9%
420000 460000
The decrease in leverage has increased the overall cost of capital and has reduced the value of firm.
Fig. 1: The effect of Debt on the cost of capital (NI)
As the degree of leverage increases, k0 decreases and approaches the cost of debt when leverage is
1.0, that is, (k0= ki). At this point, the firm’s overall cost of capital would be minimum. NI Approach
says that the firm can employ almost 100% debt to maximize its value.
8.4 Net Operating Income Approach

After NOI approach, lets discuss the Net operating income approach. This approach suggests that
the capital structure decision of a firm is irrelevant to its value i.e., a firm’s debt level will not affect
its firm value. Any change in leverage will not lead to any change in the total value of the firm.The
market price of shares as well as the overall cost of capital is independent of the degree of leverage.
The Net Operating approach is based on certain propositions:
a) Overall Cost of Capital is Constant: Overall capitalization rate of the firm remains
constant, for all degrees of leverage.
It means that the market evaluates the firm as a whole and the split of the capitalization
between debt and equity is not relevant.
b) Residual Value of Equity: Total market value of equity capital is S or (V – B). where total
value of the firm is V and Total value of debt is B.
c) Changes in Cost of Equity Capital: The cost of equity capital increases with the degree of
leverage. The increase in the proportion of debt in the capital structure would lead to an

Notes
increase in the risk to the shareholders. To compensate for the increased risk, the
shareholders would expect a higher rate of return on their investments.
d) Cost of Debt:The cost of debt (ki) has two parts: a) Explicit cost: which is represented by
the rate of interest. Irrespective of the degree of leverage, the firm is assumed to be able to
borrow at a given rate of interest and b) Implicit cost: Increase in the degree of leverage
causes an increase in the cost of equity capital. The benefit with the use of debt, in terms of
the explicit cost, is exactly neutralized by the implicit cost represented by the increase in ke.
As a result, the real cost of debt and the real cost of equity, according to the NOI
Approach, are the same and equal k0.
e) Optimum Capital Structure: Total value of the firm will remain constant irrespective of
the degree of leverage.The market price of shares will also not change with the change in
the debt-equity ratio. Optimum capital structure does not exist.
Illustration:
Operating income of firm is Rs 50,000; Cost of debt is 10%; and outstanding debt is Rs 2,00,000. If
the overall cost of capital is 12.5%, what would be the total value of the firm and the equity-
capitalization rate?
In order to examine the effect of leverage, let us assume that the firm increases the amount of debt
from Rs 2,00,000 to Rs 3,00,000.The value of the firm would remain unchanged at Rs 4,00,000, but
the equity-capitalization rate would go up to 20%.

Notes
Corporate Finance
Let us further suppose that the firm retires debt by Rs 1,00,000 by issuing fresh equity shares of the
same amount.The value of the firm would remain unchanged at Rs 4,00,000 and the equity
capitalization rate would come down to 13.33%.
ke, increases with the increase in the degree of leverage. kegone up from 15 per cent to 20 per cent
with the increase in leverage from 0.50 to 0.75. The equity capitalization rate decreases with the
decrease in the degree of leverage.It has come down from 15 per cent to 13.33% with the decrease in
leverage from 0.50 to 0.25.
Fig. 2: The effect of Debt on the cost of capital (NOI)
8.5 Traditional Position

After NI and NOI approach comes Tradition approach. Traditional approach comes under theories
of relevance. According to this theory, a judicious mix of debt and equity capital can increase the
value of the firm by reducing the WACC up to certain level of debt. WACC decreases only within
the range of financial leverage and after reaching the minimum level, it starts increasing with
financial leverage.
In simple terms, as the debt in the capital structure is increased gradually, the overall cost of capital
first decreases up to a point, but starts increasing after it. With regard to the optimum capital
structure, this theory states that a firm has an optimum capital structure that occurs when overall
cost of capital is minimum, and as a result, maximizing the value of the firm.
Example:Suppose a firm is expecting a net operating income of Rs. 150 crores on assets of Rs.
1,500 crores, which are entirely financed by equity. The firm’s the cost of equity is 10%. It is
considering substituting equity capital by issuing debentures of Rs. 300 crores at 6% interest rate.
The cost of equity is expected to increase to 10.56%. The firm is also considering the alternative of

Notes
raising debentures of Rs. 600 crore and replaces equity. The debt-holders will charge interest of 7%,
and the cost of equity will rise to 12.5% to compensate shareholders for higher financial risk.Notice
that at higher level of debt both the cost of equity and cost of debt increase.
No Debt 6% Debt 7% Debt
NOI 150 150 150
Cost of Debt (INT) 0 18 42
Net Income (NOI-INT) 150 132 108
Cost of Equity Ke 0.100 0.105 0.125
Market Value of Equity 1500 1250 864

(NOI-INT)/ke
Market value of Debt 0 300 600
Total value of firm V = E + D 1500 1550 1464
Equity to Total Value we = E/V 1.00 0.806 0.590
Debt to Total Value wd = D/V 0.00 0.194 0.410
WACC (Ke x we + kd x wd) 0.100 0.097 0.103
The value of the firm may first increase with moderate leverage, reach the maximum value and
then start declining with higher leverage. This is because WACC first decreases and after reaching
the minimum, it starts increasing with leverage.
Stages in the Traditional Theory

Traditional theory states that there are three stages in the firm as the degree of the debt is increased
in the total capital of the firm (Fig. 3):
i. First stage: Increasing value
In the first stage, as the debt is introduced in the capital structure of the firm, the cost of equity, ke
either remains constant or rises slightly with debt. The cost of debt, kd, remains constant as the
investorsconsiders the use of debt as a reasonable policy. The WACC in this stage decreases with
increasing leverage, and thus, the total value of the firm also increases.
ii. Second stage: Optimum value:
As the degree of leverage is gradually increased in the capital structure, the cost of equity starts
increasing. With the increasing level of debt, the degree of risk of the firm is also increased, and due
to this reason, equity shareholders start demanding higher returns as compensation. Upon reaching
a certain degree of leverage, any further increases in leverage have a negligible effect on WACC as
the increase in the cost of equity due to the added financial risk offsets the advantage of low-cost
debt. At the point, WACC will be minimum, and thus, the value of the firm will be maximum.
iii. Third stage: Declining value
In the third stage, there is higher level of debt in the capital structure which means that there is
higher level of risk in the firm. Due to this high risk, investors demand a higher return which
exceeds the benefits of cheaper debt. Hence, the overall cost of the capital increases. The value of
the firm decreases with leverage as WACC increases with leverage.

Notes
Corporate Finance
Fig. 3: The effect of Debt on the cost of capital (TA)
8.6 Modigliani-Miller (MM) Approach

This approach also falls under the irrelevant theory of the capital structure i.e., it also posits that the
capital structure of the firm doesn’t affect the value of the firm. The Modigliani-Miller approach is
similar to the Net Operating Income Approach. However, it provides behavioral justification for
constant WACC and the constant total value of the firm. This approach suggests that the WACC
does not change with a change in the capital structure. The approach is based on certain which are:
• The overall cost of capital (k0) and the value of the firm (V) are independent of its capital
structure.
• The k0 and V are constant for all degrees of leverage.
• The total value is given by capitalizing the expected stream of operating earnings at a discount
rate appropriate for its risk class.
Fig. 1: Leverage and Cost of Capital (MM Approach)
Assumptions of MM Approach
The MM approach is based on various assumptions which are discussed below:
1. The capital markets are perfect, which means:
a. Securities are infinitely divisible.
b. Investors are free to buy/sell securities.
c. Investors can borrow without restrictions.
d. There are no transaction costs.
e. Information is perfect.

Notes
f. Investors are rational.
2. All investors have the same expectation of firm’s net operating income.
3. Business risk is equal among all firms within similar operating environment.
4. The dividend payout ratio is 100 per cent.
5. There are no taxes. (Which was removed later)
Propositions under MM approach:

Under the MM approach, there are two propositions:
Proposition I
According to the first proposition, the total value of a firm must be constant irrespective of the
degree of leverage.The cost of capital (WACC) as well as the value of the firm must be the constant
regardless of the capital structure.The operational justification of the first proposition is the
‘Arbitrage process’. Arbitrage process refers to the purchasing of securities whose prices and lower
sellingthose securities whose prices are higher. The investors of the firm whose value is higher will
sell their shares and instead buy the shares of the firm whose value is lower. It proposes that total
value of the homogeneous firms which differ only in respect of leverage cannot be different.
In the arbitrage process, the behavior of the investors will have the effect of:
i. increasing the value of the firm whose shares are being purchased.
ii. lowering the value of the firm whose shares are being sold.
This will continue till the market prices of the two identical or homogeneous firms become
identical. This arbitrage process results in providing the investor same return, at lower investment
as he or she was getting by investing in the firm whose total value was higher and yet, his risk is
not increased.This is so because the investors would borrow in the proportion of the degree of
leverage present in the firm.
Illustration:
Assume there are two firms, L and U, which are identical in all respects except that firm L has 10%,
Rs 5,00,000 debentures. The EBIT of both the firms are equal Rs 1,00,000. The equity-capitalization
rate (ke) of firm L is higher (16%) than that of firm U (12.5%).
Solution:
The total market value of the firm L is more than firm U.This situation cannot continue as the
arbitrage process will operate and the values of the two firms will be brought to an identical level.
Arbitrage Process:

Notes
Corporate Finance
The logic behind arbitrage process is as follows: Suppose an investor, Mr. X, holds 10% of the
outstanding shares of the levered firm (L). His holdings amount to Rs 31,250 (i.e., 0.10 x Rs 3,12,500)
and his share in the earnings that belong to the equity shareholders would be Rs 5,000 (0.10 x Rs
50,000).He will sell his holdings in firm L and invest in the unlevered firm U. Since firm U has no
debt in its capital structure, the financial risk to Mr. X would be less than in firm L. To reach the
level of financial risk of firm L, he will borrow additional funds equal to his proportionate share in
the levered firm’s debt on his personal account.
Instead of the firm using debt, Mr. X will borrow money. The effect of this is that he is able to
introduce leverage in the capital structure of the unlevered firm by borrowing on his personal
account. Mr. X will borrow Rs 50,000 at 10% rate of interest. His proportionate holding (10%) in the
unlevered firm will amount to Rs 80,000 on which he will receive a dividend income of Rs
10,000.Out of the income of Rs 10,000 from the firm U, Mr. X will pay Rs 5,000 as interest on his
personal borrowings. He will be left with Rs 5,000 i.e., the same amount as he was getting from the
levered firm L. But his investment outlay in firm U is less Rs 30,000 as compared with that in firm L
(Rs. 31,250). At the same time, his risk is identical in both the situations.
(A) Mr. X’s position in firm L (levered) with 10 per cent equity-holding
(i) Investment outlay Rs 31,250
(ii) Dividend Income 5,000
(B) Mr. X’s position in firm U (unlevered) with 10% equity holding
(i) Total funds available (own funds, Rs 31,250 + borrowed funds, Rs 50,000) 81,250
(ii) Investment outlay (own funds, Rs 30,000 + borrowed funds, Rs 50,000) 80,000
(iii) Dividend Income: 5,000

Total Income (0.10 x Rs 1,00,000) Rs 10,000
Less: Interest payable on borrowed funds 5,000
(C) Mr. X’s position in firm U if he invests the total funds available
(i) Investment costs 81,250.00
(ii) Total income 10,156.25
(iii) Dividend income (net) 5,156.25

(Rs 10,156.25 – Rs 5,000)
It is clear that Mr. X will be in a better position by selling his securities in the levered firm and
buying the shares of the unlevered firm. With same risk level of the two firms, he gets the same
income with lower investment outlay in the unlevered firm. He will obviously prefer switching
from the levered to the unlevered firm.The resultant increased demand for the securities of the
unlevered firm will lead to an increase in the market price of its shares. The price of the shares of
the levered firm will decline. This will continue till it is possible to reduce the investment outlays
and get the same return.
Beyond this point, switching from firm L to firm U or arbitrage will not be identical. This is the
point of equilibrium. At this point, the total value of the two firms would be identical.The cost of
capital of the two firms would also be the same. Thus, it is unimportant what the capital structure
of firm L is. The weighted cost of capital (k0) after the investors exercises their ‘home-made’
leverage is constant because investors exactly offset the firm’s leverage with their own.
Proposition II
Second proposition says that due to the increased risk caused by the increased level of debt, the
investors will demand higher return as compensation. This will negate the benefit of using the
cheaper debt and as a result, the overall cost of capital will be constant.In an all-equity financed
firm the opportunity cost of capital is equal its cost of equity.

Notes
It provides justification for the levered firm’s opportunity cost of capital remaining constant with
financial leverage. The cost of equity, ke, will increase enough to offset the advantage of cheaper
cost of debt.A levered firm will have higher required return on equity to compensate for financial
risk. The ke for a levered firm should be higher than the opportunity cost of capital, ka; that is, the
levered firm’s ke > ka. It should be equal to constant ka, plus a financial risk premium. How is this
financial risk premium determined? We know that a levered firm’s opportunity cost of capital:
You can solve this equation to determine the levered firm’s cost of equity, ke :
For an unlevered firm, D is zero; therefore, the second part of the equation is zero and the
opportunity cost of capital, ka equals the cost of equity, ke . Second part is the financial risk
premium.The required return on equity is positively related to financial leverage, because the
financial risk of shareholders increases with financial leverage.
Fig. 2: Cost of Equity under MM Preposition II
Illustration:
Suppose ABC Limited is an all equity financed company. It has 10,000 shares outstanding. The
market value of these shares is Rs. 120,000. Expected operating income of the company is Rs.
18,000.
The expected EPS of the company is:
Rs. 18,000/10,000
= Rs. 1.80.
As ABC is an unlevered company, its opportunity cost of capital will be equal to its cost of equity:
ABC is considering borrowing Rs. 60,000 at 6% rate of interest and buying back 5,000 shares at the
market value of Rs. 60,000.Now ABC has Rs. 60,000 equity and Rs. 60,000 debt in its capital
structure. The debt-equity ratio is 1:1. The change in the company’s capital structure does not affect
its assets and expected net operating income.
However, EPS will change. The expected EPS is:

Notes
Corporate Finance
ABC’s expected EPS increases by 60% due to financial leverage. If ABC’s expected NOI fluctuates,
its EPS will show greater variability with leverage than as an unlevered firm. As the firm’s
operating risk does not change, its opportunity cost of capital will still remain 15%. The cost of
equity will increase to compensate for the financial risk:
Criticism of the MM Hypothesis

Although the MM hypothesis holds an important position in modern finance theory, however it a
lot of criticism mainly due to the unrealistic assumptions of this approach. The major criticism is
discussed below:
1. Discrepancy in the Lending and borrowing rates:

The assumption that firms and individuals can borrow at the same rate of interest is unrealistic
in nature. As the firms have a higher credit standing, they are able to borrow at lower rates of
interest than individuals.
2. Transaction costs:
The MM approach that there is no transaction cost. Transaction cost is the cost incurred in
buying and selling of the security. In practical world, transaction costs exists and it interferes
with the arbitrage process.
3. Institutional restrictions:
Individual investor may not be able to replace personal leverage with the corporate leverage
due to the institutional restrictions. Hence it will affect the working of the arbitrage and thus
the home-made leverage may not be possible.
4. Existence of Corporate Tax:

As we know that the interest charges in a firm are tax deductible, which means that the cost of
borrowing funds to the firm is less than the contractual rate of interest. The existence of interest
charges gives the firm a tax advantage.
The MM Hypothesis under Corporate Taxes

In their first hypothesis, Modigliani and Miller assumed that there exist no corporate taxes and
showed that the leverage doesn’t affect the value of the firm. However, due this assumption of no
corporate taxes, there approach was heavily criticized. Later on, they modified their position by
relaxing the assumption of the absence of corporate taxes in order to make their hypothesis more
realistic and proposed that the if corporate taxes are taken into the picture, then the capital
structure or the usage of leverage does affect the value of the firm.
Since interest on debt is tax-deductible, the effective cost of borrowing is less than the contractual
rate of interest.Therefore, a levered firm would have greater market value than an unlevered firm.
Value of the levered firm would exceed that of the unlevered firm by an amount equal to the
levered firm’s debt multiplied by the tax rate.
Vl= Vu+ Bt
Where:
• Vl = value of levered firm
• Vu = value of unlevered firm
• B = amount of debt

Notes
Example:The earnings before interest and taxes are Rs 10 lakh for companies L and U. They
are same in all respects except that Firm L uses 15% debt of Rs 20 lakh; Firm U does not use
debt.Given the tax rate of 35%, the stakeholders of the two firms will receive different amounts. The
EBIT are Rs 10 lakh for companies L and U.
The total income to both debt holders and equity holders of levered Company L is higher. The
reason is debt-holders receive interest without tax-deduction at the corporate level, equity holders
of company L have their incomes after tax-deduction. As a result, total income to both types of
investors increases by the interest payment times the rate, that is, Rs 3,00,000 x 0.35 = Rs 1,05,000.
MM in this approach proposes that the value of the firm is maximized when its capital structure
contains only debt. However, if the firm uses high level of debt will lead to high chances of default.
As the amount of debt in the capital structure increases, so does the probability of incurring these
costs.As a result, excessive use of debt may cause a rise in the cost of capital due to the increased
financial risk and may reduce the value of the firm.
8.7 Checklist for Capital Structure Decisions

As we have seen, the use of debt in capital structure or financial leverage has both benefits as well
as costs.While the main advantage of debt is the tax benefit, its cost is financial distress and reduced
financial profitability.A number of factors have a bearing on the determination of an optional
capital structure of a firm.Therefore, a financial manager should design an appropriate capital
structure, taking into consideration these factors.
The factors governing the capital structure decisions:

There are several factors which affect the capital structure decisions of the firm. Some of the
important factors are listed below and discussed:
1. Profitability aspect
2. Liquidity aspect
3. Control
4. Industry Debt levels
5. Nature of industry
6. Consultation with analysts
7. Commercial strategy
8. Timing
9. Company characteristics
10. Tax planning

Notes
Corporate Finance
Profitability
The objective of the firm is to maximize the wealth of the shareholders, profitability analysis
through EBIT-EPS analysis should be carried out.The EBIT-EPS analysis is an important tool to
analyze the impact of different financial plans on the shareholders’ income. The firm should check
the EPS of the firm under different financial plans. This analysis determines the optimum mix of
debt and equity in the capital structure and helps determine the alternative that gives the highest
value of EPS.
Coverage Ratio
Coverage ratio is the ratio of Earnings before interest and taxes relative to the interest payments.
This ratio is used to examine the ability of a firm to payback the interest payments from its
earnings.The ratio measures the size of interest payments relative to the EBIT.
Where:
 EBIT = Earnings Before Interest and taxes

 I = Interest Expenses
Higher coverage ratio signifies that would be in a position to meet its obligations of interest
payment.An interest coverage ratio below one indicates the company is not generating sufficient
revenues to satisfy its interest expenses.
Suppose that a company’s earnings are Rs. 625,000 and it has debts upon which it is liable for
payments of Rs. 90,000. The interest coverage ratio for the company is
Rs. 625,000 / Rs. 90,000
= 6.94.
Liquidity
It may be possible that the EBIT is adequate to cover interest payments but the firm may not have
sufficient cash to pay. Cash flow analysis yields a number of advantages. It focuses on the solvency
of the firm during adverse circumstances, takes into consideration cash flows that do not appear in
the profit and loss account.It gives an insight into the inventory of financial resources available in
the event of recession.
Cash Flow Analysis:

One measure is the ratio of fixed charges to net cash inflows. The greater the coverage ratio, the
greater is the amount of debt that a firm can use.Cash budget can also be prepared to determine
whether the expected cash flows are sufficient to cover the fixed obligations.
Control
If the dividends on preference shares have not been paid for a certain number of years,
shareholders are given the right to participate in the voting. If the main aim of the management is
to maintain control, they will go with debt and preference capital in case when additional capital is
required. If the company borrows more than what it can repay, the creditors may seize the assets of
the company.It might be better to sacrifice a measure of control by some additional equity rather
than run the risk of losing all control to creditors.
Leverage ratios in industry

One of the important factors to be considered is the average leverage ratio of the other companies in
the same industry. Comparison with the companies belonging to the same industry, having a
similar business risk is helpful. Comparison is helpful as it acts as a warning to the management
that there may be something wrong with the debt-equity ratio of the company.
Nature of Industry

Notes
Not all companies are same, hence their earnings and risk class also differ based on their industry
type. If an industry’s sales fluctuate widely, the firm should have a low degree of financial
leverage.Industries dealing with non-durable consumer goods and products which have an
inelastic demand are not likely to be subject to wide fluctuations in sales. Such industries can afford
to have higher debt proportions in capital structure.The stage of the life cycle also affects capital
structure decision. If the industry is in its infancy, more emphasis needs to be placed on equity
capital. In Maturity phase, the firm should assure that it obtains funds when needed. If business is
in decline phase the firm should build plan which allows for easy contraction in the sources of the
funds used.
Consultation with Investment Bankers and Lenders

Financial analysts have access to information regarding securities of a large number of companies
and know how the market evaluates them.The type of securities which they will prefer to buy is
significant information for the financial manager of the firm.The finance manager must think from
the point of view of the investors and consult with the investment bankers and the lenders while
making the leverage decisions.
Flexibility
Flexibility to change the capital structure based on the circumstances of the firm is an important
factor to be considered. The finance manager must keep himself in a situation where he can change
positions. While designing the capital structure, he should assess the impact of present financial
plan on the future. There should be room for flexibility not only in obtaining funds but also in
refunding them.
Timing of Issue
Timing of the of issue of capital is also important. Equity and debt capital should be made at a time
when the state of the economy as good as the capital market is ideal to provide the funds. Firm
should evaluate the alternative methods of financing in the light of general market conditions.For
example, it will be useful to postpone borrowings if decline in interest rates is expected in the
future.
Characteristics of the Company

Small firms must rely upon the owner’s funds for as its very difficult to obtain long-term debts.In
contrast, very large companies are forced to use different sources of funds as no single source can
fulfill their total requirements of funds.Firms with a high credit standing are in a better position to
get funds from the sources of their choice.
Tax Planning
Due to interest deductibility, debt reduces the tax liability. The tax advantage of debt means that
firms will employ more debt to reduce tax liabilities and increase value.In the absence of personal
taxes, the interest tax shields increase the value of the firm.
8.8 Costs of Financial Distress

Financial distress refers to a situation where a company is not generating sufficient revenues to pay
back its interest obligations. The financial distress caused a lot of issues for the firm and there are
costs associated with the financial distress which has to be incurred by the firm. There are two
types of costs: Direct cost and Indirect cost:
Direct costs of financial distress include costs of insolvency. Once the insolvency proceedings start,
the conditions of assetsmay decline over time. Insolvency also causes high legal and administrative
costs.Indirect costs relate to the actions of employees, managers, customers, suppliers and
shareholders. Let’s discuss the indirect cost of the financial distress:
 Employees:

Notes
Corporate Finance
The output and productivity of employees of a financially distressed firm declines as they become
demotivated.This affects the reputation of the firm, and it may lead to the decline in the sales of its
products.
 Customers:
Customers get concerned about the quality of product or service. Thus, the demand for the firm’s
products or services starts falling sharply.
 Suppliers:
Suppliers reduce or discontinue granting credit to the firm fearing liquidation and liquidity
problems of a financially distressed firm. They fear that they may not be able to get back their
money.
 Investors:
Investors become concerned. Either investors are not ready to supply capital to the firm or they
make funds available at high costs and rigid terms and conditions. Non-availability of funds on
acceptable terms could adversely affect the operating performance of the firm.
 Shareholders:
Shareholder of the firms start behaving differently. When a firm is under financial distress, but not
insolvent, shareholders may be wanting to undertake risky projects. If a risky project succeeds, their
gain can be substantial. If the project fails, the creditors will suffer the loss.
 Managers:
Managers have a tendency to expropriate the firm’s resources in the form of perquisites and avoid
risk. When the firm is under financial distress, they may have higher temptation to pocket the
firm’s resources.Managers also start making decisions keeping in mind short-term rather than the
long-term interests of the company.
Financial distress reduces the value of the firm. Thus, the value of a levered firm is given as follows:
Value of levered firm = Value of unlevered firm + PV of tax shield – PV of financial distress
= + –
Fig. 1: Value of levered firm under Corporate Taxes and Financial distress
In fig. 1, when a firm uses more and more debt, the costs of financial distress increases, and the tax
benefit shrinks.The optimum point is reached when the marginal present values of the tax benefit
and the financial distress cost are equal. This is the point where the value of the firm is maximum.
Summary
 All the sources of finance can be broadly classified into two major groups: Debt and
equity. A firm can use 100% of equity and no debt, 50% Equity and 50% debt or 10%

Notes
equity and 90% debt and so on. Capital structure refers to the proportion of debt and
equity capital in a firm’s total capital.
 Optimum capital structure is that capital structure at which the Weighted Average Cost of
Capital (WACC) or the Overall cost of capital of the firm is minimum and hence, the value
of firm is maximum. Firms try to attain the optimum capital structure to maximize the
value of the firm.
 According to Net Income Approach, capital structure decisionsare relevant to the
valuation of the firm.A change in the debt level will lead to a change in the overall cost of
capital as well as the total value of the firm. If the financial leverage is increased, the
WACC or the overall cost of capital will decline, while the value of the firm and the
market price of shares will increase.
 Net operating income approach suggests that the capital structure decision of a firm is
irrelevant to its value i.e., a firm’s debt level will not affect its firm value. Any change in
leverage will not lead to any change in the total value of the firm.The market price of
shares as well as the overall cost of capital is independent of the degree of leverage.
 Traditional approach comes under theories of relevance. According to this theory, a
judicious mix of debt and equity capital can increase the value of the firm by reducing the
WACC up to certain level of debt. WACC decreases only within the range of financial
leverage and after reaching the minimum level, it starts increasing with financial leverage.
 MM Approach falls under the irrelevant theory of the capital structure i.e., it also posits
that the capital structure of the firm doesn’t affect the value of the firm. The Modigliani-
Miller approach is similar to the Net Operating Income Approach. However, it provides
behavioral justification for constant WACC and the constant total value of the firm.
 In their first hypothesis, Modigliani and Miller assumed that there exist no corporate taxes
and showed that the leverage doesn’t affect the value of the firm. However, due this
assumption of no corporate taxes, there approach was heavily criticized. Later on, they
modified their position by relaxing the assumption of the absence of corporate taxes in
order to make their hypothesis more realistic and proposed that the if corporate taxes are
taken into the picture, then the capital structure or the usage of leverage does affect the
value of the firm.
 There are several factors which affect the capital structure decisions of the firm such as:
Profitability aspect, Liquidity aspect, Control, Industry Debt levels, Nature of industry,
Consultation with analysts, Commercial strategy, Timing, Company characteristics and
Tax planning
 Financial distress refers to a situation where a company is not generating sufficient
revenues to pay back its interest obligations. The financial distress caused a lot of issues
for the firm and there are costs associated with the financial distress which has to be
incurred by the firm. There are two types of costs: Direct cost and Indirect cost.
Keywords
Capital structure, NI approach, NOI approach, Traditional approach MM Approach, Financial
distress
Self Assessment
1. The term "capital structure" refers to:
A. long-term debt, preferred stock, and common stock equity.

B. current assets and current liabilities.

Notes
Corporate Finance
C. total assets minus liabilities.

D. shareholders' equity.
2. A critical assumption of the net operating income (NOI) approach to valuation is:
A. that debt and equity levels remain unchanged.
B. that dividends increase at a constant rate.
C. that ko remains constant regardless of changes in leverage.
D. that interest expense and taxes are included in the calculation.
3. According to the traditional approach:
A. The overall capitalization rate holds constant with changes in financial leverage.
B. There is an optimum capital structure.
C. Total risk is not altered by changes in the capital structure.
D. Markets are perfect.
4. Firm's optimal capital structure:
A. is the debt-equity ratio that results in the lowest possible weighted average cost of capital.
B. is generally a mix of 40 percent debt and 60 percent equity.
C. is found by locating the mix of debt and equity which causes the earnings per share to equal
exactly Re. 1.
D. exists when the debt-equity ratio is 1:1.
5. Which of the following is true for Net Income Approach?
A. Higher debt increases value of the firm

B. Higher Debt is better
C. Lower debt increases WACC
D. All of the above
6. In MM-Model, irrelevance of capital structure is based on:
A. Cost of Debt
B. Cost of equity
C. Arbitrage Process
7. If taxes are assumed to exist, the MM model is identical to:
A. NI Approach
B. NOI Approach
C. Traditional Approach
D. All of the above
8. MM approach is known as theory of irrelevance when it is assumed that there is:
A. Absence of taxes
B. Presence of taxes.

Notes
C. Investors act rationally.

9. The presence of which one of the following costs is not used as a major argument against the
M&M arbitrage process?
A. Bankruptcy costs.
B. Agency costs.
C. Transactions costs.
D. Insurance costs.
10. Which of the following is not correct about MM model?
A. MM model provides a behavioral justification of NOI approach.

B. In MM model, personal leverage and corporate leverage are considered as perfect
substitute.
C. In the basic MM model, leverage affects the value of the firm.
D. In the MM model, the value of the levered firm can be found by first finding out the value of
the unlevered firm.
11. The explicit and implicit costs associated with corporate default are referred to as the
____________ costs of a firm.
A. Flotation
B. direct bankruptcy
C. financial distress
D. indirect bankruptcy
12. Indirect costs of financial distress:
A. effectively limit the amount of equity a firm issue.

B. include costs such as legal and accounting fees
C. tend to increase as the debt-equity ratio decreases
D. include the costs incurred by a firm as it tries to avoid seeking bankruptcy protection
13. The legal proceeding for liquidating or reorganizing a firm operating in default is called:
A. tender offer
B. bankruptcy
C. merger
D. takeover
14. The value of a firm is maximized when the:
A. weighted average cost of capital is minimized

B. cost of equity is maximized
C. tax rate is zero
D. levered cost of capital is maximized

Notes
Corporate Finance
15. In a world with taxes and financial distress, when a firm is operating with the optimal capital
structure the:
A. debt-equity ratio will be less than optimal

B. increased benefit from additional debt is equal to the increased bankruptcy costs of thatdebt
C. firm will be all-equity financed
D. required return on assets will be at its maximum point

1. A 2. C 3. B 4. A 5. B
6. C 7. B 8. D 9. D 10. C
11. C 12. D 13. B 14. A 15. B
Review Questions
1. Define Capital structure of a firm. Discuss the benefits of leverage.
2. Explain the NI and NOI approach in the capital structure theories
3. Discuss the working of Arbitrage Process as given under the proposition I of MM irrelevance
proposition.
4. List the factors which affect the capital structure decision of firm.
5. Discuss the indirect cost of the financial distress incurred by the by the firm.
Further Readings
Hill.
Publishing
3. Berk, Jonathan. & DeMarzo, Peter. & Harford, Jarrad. & Ford, Guy. & Mollica, Vito.
4. https://www.cfainstitute.org/en/membership/professional-
development/refresher-readings/capital-structure
5. https://www.investopedia.com/ask/answers/031915/what-capital-structure-
theory.asp

Notes
Dr. Atif Ghayas, Lovely Professional University Unit 09: EBIT-EPS Analysis
Unit 09 - EBIT-EPS Analysis

CONTENTS
Objectives
Introduction
9.1 Leverage
9.2 Leverage in Finance
9.3 Operating Leverage
9.4 Degree of Operating Leverage (DOL)
9.5 Financial Leverage
9.6 Degree of Financial Leverage
9.7 EBIT-EPS Analysis
9.8 Indifference Point
9.9 Combined Leverage
9.10 Degree of Combined Leverage
Summary
Keywords
Self Assessment
Review Questions
Further Readings
Objectives
• understand the concept of Leverage
• explain the concept of Operating Leverage
• discuss Degree of Operating Leverage
• explain the concept of Financial Leverage
• discuss Degree of Financial Leverage
• understand EBIT-EPS Analysis
• understand the concept of indifference point
• explain Combined Leverage
• discuss Degree of Combined Leverage
Introduction
In this chapter, we will continue our discussion on the financing decisions of the firm. We will
discuss the concept of leverage in the context of finance. As we already know by now that a firm
can fulfill its financing requirement through equity source or the debt source. Unlike the debt
source of capital, the equity source doesn’t carry any fixed rate of return and it varies according to
the earnings of the firm. We can call the return on the equity capital as the variable return and the
return on the debt capital as the fixed return. The return given to the equity capital is affected by
the fixed return carrying debt capital. Hence, the use of the asset or the source of capital which

Notes
Corporate Finance
carries fixed cost or return is called Leverage. We will discuss the types of leverage, concept of
operating leverage, financial leverage and the combined leverage.
9.1 Leverage
Leverage refers to accomplishing certain things which are otherwise not possible i.e., lifting of
heavy objects with the help of lever. It is a tool which makes our task easier, which produces
greater output with lesser efforts.
9.2 Leverage in Finance

The concept of leverage in finance refers to employment of an asset or source of funds for which the
firm has to pay a fixed cost or fixed return. Leverage is a strategy that companies use to increase
assets, cash flows, and returns, though it can also magnify losses. There are mainly two main types
of leverage: Operating leverage and financial leverage. Operating Leverage is the relationship
between the firm’s sales revenues and its EBIT ad is based on the cost structure of the firm.
Whereas, the financial leverage is the relationship between the firm’s earnings available for
ordinary shareholders and its EBIT and is based on the capital structure of the firm. Although, there
can be a third kind of leverage that is the combination of operating and financial leverage is known
as the Combined Leverage.
Types of Leverage
Based on Cost Based on Capital

Structure: Structure:
Operating Leverage Financial Leverage
9.3 Operating Leverage

The operating leverage results from the use of fixed cost in the cost structure. It can be defined as
the ability of the firm to use its fixed expenses to generate better returns. As we know that no
product can be made without incurring some cost, there are several costs incurred by the firm in
making the product. Now the cost can be divided into two main categories. a) Fixed cost and b)
Variable cost. Fixed costs as the name suggests are the fixed costs, and they do not change with the
number of units produced. E.g., rent paid for the factory. Variable cost is the cost that varies with
the number of units produced. E.g., raw material consumed in the production of the finished
product. Then there can be a third type of cost that is semi fixed/variable cost that falls between the
two.
Operating leverage measures the company’s fixed costs as a percentage of its total costs. A
company with a higher fixed cost will have higher Leverage as compared to a company having a

Notes
Unit 09: EBIT-EPS Analysis
higher variable cost. The ratio gives information about how much the operating profit of the
company will increase with a specific percentage change in sales.
The operating costs of a firm falls into two categories:
i. Fixed costs: Which do not vary with sales volume.
ii. Variable costs: which vary directly with the sales volume.
High Fixed Cost = High Operating Leverage
Example of high operating leverage company can be any Airline company. In an airline company,
the fixed costs are the cost incurred in acquiring the aircrafts, paying rent for the hangars, and
paying insurance fee of the aircrafts etc. whereas, the variable cost for the company will be the cost
of jet fuel and the runway charges, these costs change with the change in the level of operations.
Example of low operating leverage company can be any consulting company. The fixed costs for
the consulting company are usually rent and utilities and the variable cost includes the salaries of
the staff.
Effect of operating leverage:

Effect of having high level of operating leverage in the firm is that a unit change in the volume of
sales results will result in a more than proportional change in operating profit. A company with
higher leverage generates bigger profits when sales go up because fixed costs remain the same as
revenues increase. However, higher operating leverage company will experience bigger losses too
when the sales drops. Hence, the operating leverage will affect the firm’s business risk also which is
the risk of the firm not being able to cover its fixed operating costs.
Illustration:
Firm ABC sells products for Rs 100 per unit. It has a variable operating cost of Rs 50 per unit and
fixed operating costs of Rs 50,000 per year. Calculate EBIT from the sale of:
i. 1,000 units
ii. 2,000 units
iii. 3,000 units.
Solution:
The following table shows the effect of change in sales on the EBIT of the firm.
Case 2 Base Case 1

(-50%) (+50%)
Sales (Units) 1,000 2,000 3,000
Sales Revenue 1,00,000 200,000 3,00,000
Less: Variable Operating Cost 50,000 1,00,000 150,000
Contribution 50,000 1,00,000 150,000
Less: Fixed operating cost 50,000 50,000 50,000
EBIT 0 50,000 1,00,000
-100% +100%
It can be seen that a unit change in the sales of high operating leverage firm will have a greater
effect on the EBIT of firm.

Notes
Corporate Finance
9.4 Degree of Operating Leverage (DOL)

The degree of operating leverage (DOL) is a ratio that measures how much the operating income of
a company will change due to a change in sales. Firms with a large proportion of fixed costs to
variable costs have higher levels of operating leverage.
ℎ
=
ℎ
Also,
Contribution = EBIT + Fixed Cost
Illustration:
Firm X’s Sales is 200 units; Variable costs are Rs. 40 and Fixed Costs are Rs. 80. Calculate the Degree
of Operating Leverage if the Sales:
i. Increases by 20% in year two.

ii. Decreases by 20% in year two.
Increases by 20% in year 2
Year 1 Year 2 Change %
Sales 200 240 20%
Variable Cost 40 48 20%
Contribution 160 192 20%
Fixed Cost 80 80 0%
EBIT 80 112 40%
ℎ
=
ℎ
40%
=
20%
DOL = 2
ii. Decreases by 20% in year 2
Year 1 Year 2 Change

%
Sales 200 160 -20%
Variable Cost 40 32 -20%
Contribution 160 128 -20%
Fixed Cost 80 80 0%
EBIT 80 48 -40%

Notes
ℎ
=
ℎ
−40%
=
−20%
DOL = 2
The degree of operating leverage helps the management in evaluating how sensitive the operating
income of a firm is with respect to a change in Sales. The financial analyst should fully understand
a company’s cost structure i.e., combination of fixed costs and variable costs as it can have a
significant impact on the operating income. Hence, we can say that the leverage is a two-edged
sword. On one hand it magnifies the profit of the firm, while on the other hand, can also increase
the potential for loss.
9.5 Financial Leverage

The firms’ total capital is made up primarily of debt and equity source of capital. The equity capital
carries variable return i.e., dividend, and the debt capital which carries fixed return in the form of
interest. The term financial leverage refers to the use of the fixed-charges sources of funds in the
capital structure i.e., debt capital along with the owners’ equity.
Financial leverage signifies the presence of fixed financial charges in the firm’s income stream. It is
defined as the ability of a firm to use fixed financial charges to magnify the effects of changes in
EBIT on the earnings per share.
For e.g., a company borrows Rs. 100 at 8% interest and invests it to earn 12% return, the balance of
4% after payment of interest will constitutes the profit from financial leverage. If the company
could earn only a return of 6 % on Rs 100, the loss to the shareholders would be Rs 2 per annum.
Measures of Financial leverage

There are several ratios to measure the financial leverage in a firm.
1. Debt ratio: The ratio of Debt to Total Capital
2. Debt–equity ratio: Debt-Equity ratio
3. Interest coverage: EBIT/Interest

Notes
Corporate Finance
Advantage:
The main benefit of using debt in the capital structure is that it is used as a means of increasing the
return to common shareholders. If a firm earn a return that is higher than the return to be paid to
the debt holders, then the additional return will go to the equity holders.
Disadvantage:
The main limitation of using debt in the capital structure is that an excessive amount of financial
leverage i.e., use of debt in the total capital, will increase the risk of failure, as it becomes more
difficult to repay debt.
Illustration:
For a company ABC, Earnings before Interest and Taxes (EBIT) in the current year is Rs 10,000. The
firm has 5% debentures of Rs 40,000, and 10% preference shares of Rs 20,000. The tax rate applicable
is 35%. Moreover, the outstanding ordinary shares are 1,000. How would the EPS be affected if the
EBIT is:
i. Rs 6,000, and
ii. Rs 14,000
Solution:
Case 2 Base Case 1

(-40%) (+40)
EBIT 6,000 10,000 14,000
Less: Interest on bonds 2,000 2,000 2,000
Earnings before taxes (EBT) 4,000 8,000 12000
Less: Taxes (35%) 1,400 2,800 4,200
Earnings after taxes (EAT) 2,600 5,200 7,800
Less: Preference dividend 2,000 2,000 2,000
Earnings available for ordinary 600 3,200 5,800

shareholders
Earnings per share (EPS) 0.6 3.2 5.8
-81.25 +81.25%
Illustration:
A company has Rs 1,00,000, 10% debentures and 5,000 equity share outstanding. The tax rate
applicable is 35%. Calculate the change in EPS at three levels of EBIT:
i. Rs 50,000,
ii. Rs 30,000, and
iii. Rs 70,000
Solution:
Case 2 Base Case 1

(-40%) (+40)
EBIT 30,000 50,000 70,000

Notes
Less: Interest 10,000 10,000 10,000
Earnings before taxes (EBT) 20,000 40,000 60,000
Less: Taxes 7,000 14,000 21,000
Earnings after taxes (EAT) 13,000 26,000 39,000
Earnings per share (EPS) 2.6 5.2 7.8
-50% +50%
As we can see in the above illustrations, presence of fixed-interest sources of funds results in a more
than proportionate change in EPS as a result of change in EBIT level. The greater the amount of
fixed-interest sources of funds ,the higher is the financial leverage in the firm.
9.6 Degree of Financial Leverage

The degree of financial leverage (DFL) is the ratio that measures the sensitivity of a company’s
earnings per share to fluctuations in its operating income, as a result of changes in its capital
structure. This ratio indicates that the higher the degree of financial leverage, the more volatile
earnings will be. It shows the percentage change in a firm’s earnings per share (EPS) resulting from
a percent change in the operating profit.
% ℎ
= >1
% ℎ
Or,
Illustration:
Consider the following data for a company ABC. Calculate the Degree of financial Leverage.
Year 1 Year 2
Operating Income (EBIT) 4435,869 4810,445
EPS 4.87 6.58

Solution:
The formula of Degree of Financial leverage is:
% ℎ
= >1
% ℎ
%Change in EPS (Year 2)
= (6.58 – 4.87)/4.87 =35.2%
%Change in EBIT (Year 2)
= (4,810,445 – 4,435,869)/4,435,869 =8.4%

Notes
Corporate Finance
Degree of Financial Leverage (Year 2)
= 35.2% / 8.4% = 4.12x
Importance of DFL
● It indicates the relationship between the capital structure of a company and its operating
income.
● A low ratio is indicative of the low percentage of debt in capital structure.
● On the other hand, a high ratio indicates a higher percentage of debt in capital structure
and these companies are vulnerable.
Financial Risk
The financial risk refers to the risk of the firm not being able to cover its fixed financial costs. When
a firm uses high level of debt in the capital structure, it also has to pay a significant amount in the
form of interest payment also out of its profits. With the increase in financial charges, the firm is
also required to raise the level of EBIT necessary to meet financial charges.
9.7 EBIT-EPS Analysis

The EBIT-EPS analysis is a method to study the effect of leverage on the earnings of the firm. It
involves the comparison of alternative methods of financing under various assumptions of EBIT. It
analyzes the effect of financing alternatives on Earnings per Share. A firm has the choice to raise
funds from different sources like debt and equity in different proportions. The choice of the mix of
debt and capital would be the one, which would result into the largest EPS for the firm.
Illustration:
A firm has a capital structure exclusively comprising of ordinary shares of Rs 10,00,000. The firm
now wishes to raise additional Rs 10,00,000 for expansion.
a) Entire amount through equity.

b) 50% equity capital and 50% as 5% debentures.
c) Entire amount as 6% debentures.
d) 50% as equity capital and 50% as 5% preference capital.
Assume that:
● Existing EBIT is Rs. 1,20,000

● The tax rate is 35%,
● Outstanding ordinary shares are 10,000.
● Market price per share is Rs 100.
Which financing plan should the firm select?
A B C D
EBIT 120,000 120,000 120,000 120,000
Less: Interest - 25,000 60,000 -
Earnings before taxes (EBT) 120,000 95,000 60,000 120,000
Less: Taxes (35%) 42,000 33,250 21,000 42,000
Earnings after taxes (EAT) 78,000 61,750 39,000 78,000
Less: Preference dividend - - - 25,000

Notes
Earnings available for ordinary 78,000 61,750 39,000 53,000

shareholders
No. of Shares 20,000 15,000 10,000 15,000
Earnings per share (EPS) 3.9 4.1 3.9 3.5

The above table shows that the financing alternative B is the most favorable combination as the EPS
is highest at this combination. Although the proportion of ordinary shares in the total capital under
the plan D is equal to plan B, however, the EPS is lowest in plan D. This is because interest on debt
is tax-deductible while the dividend on preference shares is not.
Before-tax costs of the financing plans are:
A. Financing Plan B 25,000

B. Financing Plan C 60,000
C. Financing Plan D (Rs 25000/1 – 0.35) = 38,462
Equal amount of EBIT is necessary to cover the fixed financial charges. EPS would be 0 for plans B,
C and D for the EBIT level of Rs 25,000, Rs 60,000 and Rs 38,462 respectively.
This level of EBIT may be termed as financial break even (BEP) level of EBIT because it represents
the level of EBIT necessary for the firm to break even on its fixed financial charge. EBIT less than
this level will result in negative EPS.
= +
1−
Where:
● = ℎ
● = ,
● =
As fixed financial charges are added, the break-even point for zero EPS is increased by the amount
of the additional fixed cost. Beyond the financial break-even point, increase in EPS is more than the
proportionate increase in EBIT.
Illustration:
EBIT-EPS relationship under the various EBIT assumptions:
i. 80,000 (4% ROA)

ii. 1,00,000 (5% ROA)
iii. 1,30,000 (6.5% ROA)
iv. 1,60,000 (8% ROA)
v. 2,00,000 (10% ROA)
i. EBIT = Rs 80,000 (4% Return on Investment)
A B C D
EBIT 80,000 80,000 80,000 80,000
Less: Interest - 25,000 60,000 -
Less: Taxes (35%) 28,000 19,250 7,000 28,000

Notes
Corporate Finance
EAT for equity- holders 52,000 35,750 13,000 27,000
ii. EBIT = Rs 100,000 (5% Return on Investment)
A B C D
EBIT 100,000 100,000 100,000 100,000
Less: Interest - 25,000 60,000 -
Less: Taxes (35%) 35,000 26,250 14,000 35,000
EAT for equity-holders 65,000 48,750 26,000 40,000
iii. EBIT = Rs 130,000 (6.5% Return on Investment)
A B C D
EBIT 130,000 130,000 130,000 130,000
Less: Interest - 25,000 60,000 -
Less: Taxes (35%) 45,500 36,750 24,500 45,500
EAT for equity-holders 84,000 68,250 45,500 59,500
iv. EBIT = Rs 160,000 (8% Return on Investment)
A B C D
EBIT 160,000 160,000 160,000 160,000
Less: Interest - 25,000 60,000 -
Less: Taxes (35%) 56,000 47,250 35,000 56,000
Earnings after taxes (EAT) 1,04,000 87,750 65,000 1,04,000

Notes
EAT for equity-holders 1,04,000 87,750 65,000 79,000
v. EBIT = Rs 200,000 (10% Return on Investment)
A B C D
EBIT 2,00,000 2,00,000 2,00,000 2,00,000
Less: Interest - 25,000 60,000 -
Earnings before taxes (EBT) 200,000 1,75,000 1,40,000 2,00,000
Less: Taxes (35%) 70,000 61,250 49,000 70,000
Earnings after taxes (EAT) 1,30,000 1,13,750 91,000 1,30,000
EAT for equity-holders 1,30,000 1,13,750 91,000 1,05,000
Earnings per share (EPS) 6.5 7.6 9.1 7
When the EBIT level exceeds the financial break-even level (Rs 25,000, Rs 60,000 and Rs 38,462 for
financing alternatives, B, C and D respectively) EPS increases. The % increase in EPS is the greatest
when EBIT is nearest the break-even point. In Plan C, an increase of 25% in EBIT (from Rs 80,000 to
Rs 1,00,000) results in a 100% increase in EPS (from Re 1.3 to Rs 2.6). The % increase in EPS is only
40 % (from Rs 6.5 to Rs 9.1) as a result of the change in EBIT at higher levels from Rs 1,60,000 to Rs
2,00,000 (i.e., 25 per cent increase). Between preference share (D) and ordinary share (A)
alternatives, the EPS is equal (Rs 5.2) at Rs 1,60,000 EBIT level.
Above this level, alternative D will give better EPS; while below it, alternative A would provide
higher EPS. The EPS in alternatives A and B are the same at EBIT level of Rs 1,00,000. Above this, B
plan would lead to higher EPS; at levels lower than this, financing plan A would provide higher
EPS. The debt alternative (B) gives higher EPS for all levels of EBIT as compared to the preference
share alternative (D)
9.8 Indifference Point

The indifference point is the EBIT level at which the EPS is the same for two alternative financial
plans. If the expected level of EBIT exceeds the indifference level, the use of debt would be
advantageous from the viewpoint of EPS. If the expected level is less than the indifference point,
the advantage of EPS would be available from the use of equity capital.
Fig. 1: Indifference Point Formula

Notes
Corporate Finance
For a New Company:

The indifference point can be determined by:
i. Equity shares versus Debentures:
(1 − ) ( − )(1 − )
=
Where:
● X = EBIT at the indifference point

● N1 = No. of equity shares outstanding if only equity shares are issued.
● N2 = No. of equity shares outstanding if both debentures and equity shares are issued.
● I = the amount of interest on debentures
● t = corporate income tax rate
a) Equity shares versus Preference shares:
(1 − ) (1 − ) −
=
b) Equity shares versus Preference shares with tax on Preference dividend
(1 − ) (1 − ) − (1 + )
=
Where:
● N3 = No. of equity shares outstanding if both preference and equity shares are issued.
● DP = Amount of dividend on preference shares.
● Dt = Tax on Preference dividend.
(iii) Equity shares versus Preference shares and Debentures:
(1 − ) ( − )(1 − ) −
=
N4 = number of equities shares outstanding if both preference shares and debentures are issued.
For an Existing Company:

If the debentures are already outstanding, assume
I1 = interest paid on existing debt, and
I2 = interest payable on additional debt, then the indifference point would be determined as:
Illustration:
The manager of a firm has formulated various financial plans to finance Rs 30,00,000:
i. Either equity capital of Rs 30,00,000 or Rs 15,00,000 10% debentures and Rs 15,00,000

equity.

Notes
ii. Either equity capital of Rs 30,00,000 or 13% preference shares of Rs 10,00,000 and Rs
20,00,000 equity;
iii. Either equity capital of Rs 30,00,000 or 13% preference capital of Rs 10,00,000, (subject to
dividend tax of 10 per cent), Rs 10,00,000 10% debentures and Rs 10,00,000 equity; and
iv. Either equity share capital of Rs 20,00,000 and 10% debentures of Rs 10,00,000 or 13%
preference capital of Rs 10,00,000, 10% debentures of Rs 8,00,000 and Rs 12,00,000 equity.
Determine the indifference point for each financial plan, assuming 35% corporate tax rate and the
face value of equity shares as Rs 100.
(1 − ) ( − )(1 − )
=
(1 − 0.35) ( − 1,50,000)(1 − 0.35)

=
30,000 15,000
0.65 0.65 − 97,500
=
30,000 15000
0.65 = 1.3 − 1,95,000
−0.65 = −1,95,000
1,95,000
= = 3,00,000
0.65
Particulars Equity Equity + Debt
EBIT 3,00,000 3,00,000
Less: Interest - 1,50,000
Earnings before taxes 3,00,000 1,50,000
Less: Taxes 1,05,000 52,500
Earnings for equity-holders 1,95,000 97,500
No. of Equity shares 30,000 15,000
EPS 6.5 6.5
(1 − ) (1 − ) −
=
(1 − 0.35) ( − 0.35) − 1,30,000)

=
30,000 20,000
0.65 0.65 − 1,30,000
=
30,000 20000
= . 6,00,000
(1 − ) ( − )(1 − ) − (1 + )
=
(1 − 0.35) ( − 1,00,000)(1 − 0.35) − 1,30,000(1 + 0.1)

=
30,000 10,000
0.65 0.65 − 65,000 − 1,43,000
=
30,000 10,000
= . 4,80,000
( − )(1 − ) ( − )(1 − ) −
=
( − 1,00,000)(1 − 0.35) ( − 80,000)(1 − 0.35) − 1,30,000)

=
20,000 12,000

Notes
Corporate Finance
= . 5,50,000
Graphic Approach
Graphic representation of financial plans (i) and (ii) of previous example. The EPS for EBIT values
of Rs 2,00,000 and Rs 6,00,000 are plotted on the graph under each financial plan in case of Figure 1.
100% equity financing plan starts from origin (O) because EPS would be 0 if EBIT is 0.
EBIT required to have the value of the EPS as 0 is Rs 1,50,000 (Interest charges payable on 10%
debentures of Rs 15,00,000). So, the starting point of 50% equity financing plan starts from Rs 1.5
lakh. The point at which the two lines intersect is the indifference point (IP). In 33% preference
share financial plan (Fig. 2), EPS would not be 0 if the firm’s EBIT is Rs 1,30,000, because dividend
payable on preference share is not tax-deductible. The required amount is Rs 2,00,000 [Rs 1,30,000)
(1 – 0.35)]. Thus, the starting point of preference share financial plan would be Rs 2 lakh.
The EBIT-EPS chart gives a bird’s eye view of EPS at various levels of EBIT. The EPS value at the
estimated level of EBIT can be quickly ascertained. The IP can be compared with the most likely
level of EBIT. If the likely level of EBIT is more than the IP, the use of fixed cost financing plan may
be recommended, otherwise equity plan would be more suitable. Conversely, the lower the likely
level of EBIT in relation to the indifference point, the more useful the unlevered financial plan
would be from the view point of EPS.

Notes
Indifference Point
The indifference point may be computed in another way using market value as the basis. As the
objective of financial management is the maximization of share prices, the market price of shares of
a firm with two different financial plans should be identical.
So, on the basis of level of EBIT which ensures identical market price for alternative financial plans:
(1 − ) ( − )(1 − ) −
/ = /
Where:
• P/E1= P/E ratio of unlevered plan.

• P/E2= P/E ratio of levered plan.
Illustration:
Determine the indifference point at which market price of equity shares of a corporate firm will be
the same from the following data:
Funds required = Rs 50,000.
Existing number of equities shares outstanding, 5,000 @ Rs 10 per share.
Existing 10% debt of Rs 20,000
Funds required can be raised either by:
(a) issue of 2,000 equity shares, netting Rs 25 per share or
(b) New 15% debt.
The P/E ratio will be 7 times in equity alternative and 6 times in debt alternative.
Corporate tax rate: 35%
Solution:
Confirmation Table:
Particulars 15% Debt Equity
EBIT 47,000 47,000
Less: Interest 9,500 2,000
Earnings before taxes 37,500 45,000

Notes
Corporate Finance
Less: Taxes 13,125 15,750
Earnings after taxes 24,375 29,250
No. of Equity shares 5,000 7,000
EPS 4.875 4.18
P/E ratio (times) 6 7
Market Price of the share 29.25 29.25
9.9 Combined Leverage

Combined leverage is the product of operating leverage and the financial leverage. Both leverages
are concerned with ascertaining the ability to cover fixed charges. If they are combined, the result is
total leverage and the risk associated with combined leverage is known as Total risk.
Formula
DCL = DOL x DFL
% ℎ % ℎ % ℎ
= × =
% ℎ % ℎ % ℎ
= × =
− −
9.10 Degree of Combined Leverage

The degree of combined leverage measures the percentage change in a firm’s EPS resulting from a 1
percentage change in the sales. It measures the total risk associated with the firm. It studies the
impact of change in sales on EPS. It is the sum of business plus financial risk.
Illustration:
ABC Limited, which currently has revenues of ₹500,000. (₹500 units are sold at ₹1,000 per unit).
Its variable costs are ₹ 500 per unit and fixed operating costs are ₹ 200,000. Its fixed interest
expenses are ₹ 30,000 and the Tax rate is 50%. Moreover, it has 10,000 shares outstanding. The
financial profile of the company at two levels of sales viz. 500 units (the current level) and 600 (a
level 20% higher than the current level).
Solution:
Particulars Case A Case B
Sales 500 units 600 units
Revenues 500,000 6,00,000
Variable Costs 250,000 300,000
Fixed operating interest 200,000 200,000
Profit before interest and taxes 50,000 100,000
Interest 30,000 30,000

Notes
Profit after tax 20,000 70,000
Tax 10,000 35,000
Profit after tax 10,000 35,000
EPS 1 3.5
In the example, a 20% increase in revenues leads to a 250% increase in EPS, due to the existence of
fixed operating costs and interest expenses. Fixed costs magnify the impact of changes in revenues.
The magnification of revenues works in the reverse direction as well. For example, in the above
case a 20% decline in unit sales (from 500 units to 400 units) leads to a 250 percent fall in profit
before tax from ₹20,000 to – ₹30,000.
To illustrate the calculation of Degree of combined leverage, consider the data for ABC Limited:
● P = ₹1,000
● V = ₹500
● F = ₹200,000
● I = ₹30,000
Degree of combined leverage may be computed for Q = 500 units and Q = 600 units.
= × =
− −
500(1,000 − 500)
( = 500) =
500(1,000 − 500) − 200,000 − 30,000
250,000
= = 12.5
20,000
600(1,000 − 500)
( = 500) =
600(1,000 − 500) − 200,000 − 30,000
300,000
= = 4.29
70,000
Effect of Combined Leverage

Operating and financial leverages together cause wide fluctuation in EPS for a given change in
sales. If a company employs a high level of operating and financial leverage, even a small change in
the level of sales will have dramatic effect on EPS. This combination can prove risky for the
company. If sales decline, the adverse effect on EPS will be very severe. Public utilities companies
can combine high operating leverage with high financial leverage as they have stable or rising sales.
A company whose sales fluctuate widely should avoid use of high leverage since it will be exposed
to a very high degree of risk.
Summary
● The use of the asset or the source of capital which carries fixed cost or return is called
Leverage. We will discuss the types of leverage, concept of operating leverage, financial
leverage and the combined leverage.
● The concept of leverage in finance refers to employment of an asset or source of funds for
which the firm has to pay a fixed cost or fixed return. Leverage is a strategy that
companies use to increase assets, cash flows, and returns, though it can also magnify
losses. There are mainly two main types of leverage: Operating leverage and financial
leverage.

Notes
Corporate Finance
● The operating leverage results from the use of fixed cost in the cost structure. It can be
defined as the ability of the firm to use its fixed expenses to generate better returns.
● A company with higher leverage generates bigger profits when sales go up because fixed
costs remain the same as revenues increase. However, higher operating leverage company
will experience bigger losses too when the sales drops. Hence, the operating leverage will
affect the firm’s business risk.
● The degree of operating leverage (DOL) is a ratio that measures how much the operating
income of a company will change due to a change in sales.
● The term financial leverage refers to the use of the fixed-charges sources of funds in the
capital structure i.e., debt capital along with the owners’ equity.
● The degree of financial leverage (DFL) is the ratio that measures the sensitivity of a
company’s earnings per share to fluctuations in its operating income, as a result of
changes in its capital structure.
● The EBIT-EPS analysis is a method to study the effect of leverage on the earnings of the
firm. It involves the comparison of alternative methods of financing under various
assumptions of EBIT. It analyzes the effect of financing alternatives on Earnings per Share.
● The indifference point is the EBIT level at which the EPS is the same for two alternative
financial plans. If the expected level of EBIT exceeds the indifference level, the use of debt
would be advantageous from the viewpoint of EPS. If the expected level is less than the
indifference point, the advantage of EPS would be available from the use of equity capital.
● Combined leverage is the product of operating leverage and the financial leverage. Both
leverages are concerned with ascertaining the ability to cover fixed charges. If they are
combined, the result is total leverage and the risk associated with combined leverage is
known as Total risk.
DCL = DOL x DFL
● The degree of combined leverage measures the percentage change in a firm’s EPS resulting
from a 1 percentage change in the sales. It measures the total risk associated with the firm.
It studies the impact of change in sales on EPS. It is the sum of business plus financial risk.
Keywords
Corporate finance, EBIT-EPS analysis, Operating Leverage, Financial Leverage, Combined leverage,
Indifference Point,
Self Assessment
1. Higher operating leverage is related to the use of additional __________.
A. fixed costs
B. variable costs
C. debt financing
D. common equity financing
2. Operating leverage is equal to:

A. Contribution x Earnings before interest and tax
B. Contribution / Earnings before interest and tax
C. Earnings before interest and tax / Contribution
D. Earnings before interest and tax + Contribution
3. Which of the following is studied with the help of operating leverage?

A. Analysis of Business Risk

Notes
B. Analysis of Financial Risk

C. Analysis of Production Risk
D. Analysis of Credit Risk
4. The extent to which an organization uses fixed cost on its cost structure is called:
A. Overall leverage
B. Financial leverage
C. Fixed Leverage
D. Operating leverage
5. Degree of operating leverage of 1.5 means:

A. If sales increase by 1.5%, the EBIT will increase by 1%
B. If EBIT increase by 1%, the EPS will increase by 1 %
C. If sales rise by 1%, EBIT will rise by 1.5%
D. If sales rise by 1%, EBIT will remain unaffected
6. Financial leverage is equal to:

A. Earnings before interest and tax / (Earnings before tax)
B. Earnings before interest and tax / (Earnings before interest and tax + Interest)
C. (Earnings before interest and tax – Interest) / Earnings before interest and tax
D. (Earnings before interest and tax + Interest) / Earnings before interest and tax
7. Financial leverage:
A. reflects the firm's commitment to fixed, financial assets
B. has no impact on the earning of the firm
C. reflects the amount of debt used in the capital structure of the firm
D. primarily affects the left side of the balance sheet
8. A higher degree of financial leverage may be desirable for:

A. a stable firm, with positive growth, under favorable economic conditions
B. an unstable firm operating in an uncertain environment
C. a stable firm operating in an uncertain environment
D. neither the stable nor unstable firm under any circumstances
9. Lower financial leverage is related to the use of additional __________.

A. fixed costs
B. variable costs
C. debt financing
D. common equity financing
10. An EBIT-EPS indifference analysis chart is used for

A. evaluating the effects of business risk on EPS.

Notes
Corporate Finance
B. examining EPS results for alternative financing plans at varying EBIT levels.
C. determining the impact of a change in sales on EBIT.
D. showing the changes in EPS quality over time.
11. Combined Leverage gives us the relation between

A. EBIT and Contribution
B. Sales and EBIT
C. EBIT and EBT
D. Contribution and EBT
12. Composite leverage (CL) will be calculated as:

A. CL = OL + FL
B. CL = OL x FL
C. CL = OL/FL
13. The indifference point identifies:

A. equality of impact on EPS between two financing plans
B. equality of impact on EBIT between two financing plans
C. equality of impact on revenue between two financing plans
D. equality of impact on number of shares between two financing plans
14. Degree of combined leverage:

A. should be minimized by the financial manager
B. affects only balance sheet items
C. decreases the firm's operating profit
D. shows the impact of sales or volume changes on bottom line EPS.
15. If Combined Leverage is 2, Sales Increases by 20% then EPS will

A. Increase by 40%
B. Decrease by 40%
C. Will not changed
D. Will increase by 10%

1. A 2. B 3. A 4. D 5. C
6. A 7. C 8. A 9. D 10. B
11. D 12. B 13. B 14. D 15. A

Notes
Review Questions
1. Define the concept of leverage. Explain the different types of leverage
2. Explain the relation between Leverage and risk
3. Explain in detail the EBIT-EPS analysis
4. What is an indifference point in the EBIT-EPS analysis?
5. Does financial leverage always increase the earnings per share? Illustrate your answer.
Further Readings
Hill.
Publishing
4. https://www.investopedia.com/ask/answers/030915/how-do-you-find-level-ebit-
where-eps-doesnt-change.asp
5. https://www.investopedia.com/terms/l/leverage.asp
6. https://www.investopedia.com/articles/stocks/06/opleverage.asp

Notes
Dr. Atif Ghayas, Lovely Professional University Unit 10: Dividend Decisions
Unit 10: Dividend Decisions

CONTENTS
Objectives
Introduction
10.1 Meaning of Dividend
10.2 Concept of Dividend decision
10.3 Factors determining Dividend Decisions
10.4 Forms of Dividend
10.5 Theories of Dividend
10.6 Walter’s Model
10.7 Gordon’s Model
10.8 MM Argument
Summary
Keywords
Self Assessment
Review Questions
Further Readings
Objectives
 understand dividend decisions.

 list the factors determining dividend decisions.
 discuss Forms of dividends.
 discuss Relevance theories.
 understand Walter’s Model.
 understand Gordon’s Model.
 discuss the logic behind irrelevance theory.
 understand MM argument.
 explain the proof of MM argument.
Introduction
In this course, till now we have discussed Financing decisions and the investments decisions. Now
we will discuss another important decision under financial decision which is known as Dividend
decisions. As we already know that the financing decisions are related with the acquisition of the
capital and the investment decision are related with the application of those funds. Shareholders
are the owners of the firms and they get the profits left after the payment of taxes and payment of
interest to the debenture holders. But a firm may distribute the entire profits to the shareholders or
keep a part of it and keep the rest as the retained earnings.Dividend decisions are the decisions
which deal with the distribution of firms’ profits among its shareholders.

Notes
Corporate Finance
Financial Decisions
Investment
Financing decision Dividend decision
decision
Fig.1 Financial Decisions
10.1 Meaning of Dividend

Dividend refers to that part of the part after tax which is distributed to the shareholders of the
company. The profit earned by a company after paying taxes can be used for:
a) Distribution of dividend or,

b) Can be retained as surplus for future growth
The part of the profits that is distributed to the shareholders is known as the dividend.
10.2 Concept of Dividend decision

Dividend decisions are the decision regarding whether the firm should distribute all profits, or
retain them, or distribute a portion and retain the balance. The proportion of profits distributed as
dividends is called the dividend-payout ratio and the retained portion of profits is known as the
retention ratio. A firm tries to select that dividend policy which maximizes the market value of the
firm’s shares and is known as the optimum dividend policy.
Objectives of Dividend Policy

The dividend policy is designed by keeping following objectives in considerations:
a) Shareholders’ Need for Income:

Many shareholders prefer current earnings in the form of dividend. The payment of dividends may
significantly affect the market price of a share. If the firm does not pay the dividend, its market
price may go down. In order to maximize wealth under uncertainty, the firm must pay enough
dividends to satisfy the investors.
b) Firm’s Need for Funds:

However, firms also need funds for various purposes which can be sources through issuing equity
or debt or using retained earnings. The retained earnings are a cheap source of capital available to
the firms. These earnings of the firm may be considered as a source of long-term funds. With this
approach, dividends will be paid only when the firm does not have profitable investment
opportunities. Retained earnings are preferred because, unlike external equity, they do not involve
any flotation costs.
10.3 Factors determining Dividend Decisions

The decisions related to the dividends are determined by various factors which are discusses
below:
i. Dividend Payout Ratio:

Notes
The dividend payout ratio is the ratio of dividend to total earnings. As we know that the
dividend policy of the firm affects both the shareholders’ wealth and the long-term growth
of the firm. Hence, the optimum dividend policy should maintain a balance between
current dividends for shareholders and future growth of the firm which maximizes the
price of the firm’s shares.
ii. Stability of dividends:

The term dividend stability refers to the consistency in the stream of dividends. It means
that a certain minimum amount of dividend is paid out by the firm regularly to its
shareholders. Three forms of such stability may be distinguished:
a) Constant Dividend Per Share:

Under this form of stable dividend policy, a company follows a policy of paying a certain
fixed amount per share as dividend. For e.g., on a share of face value of Rs 100, a firm
may pay a fixed amount of Rs 10 as dividend. This amount would be paid year after year,
irrespective of the level of earnings. The dividends per share are increased over the years
when the earnings of the firm increase.
Fig. 2:
b) Constant Payout Ratio:

In this policy, firm pays a constant percentage of net earnings as dividend to the
shareholders. Dividends would fluctuate proportionately with earnings. If a company
adopts a 30 per cent payout ratio, then 30 per cent of every rupee of net earnings will be
paid out as the dividend.
c) Stable Rupee Dividend plus extra Dividend:

Under this policy, firm usually pays a fixed dividend to the shareholders and in years of
prosperity i.e., when firm earns abnormal profits. Extra dividend is paid over and above
the regular dividend.
Merits of Stability of Dividends:

The stable dividends are preferred due to the following benefits:
a) Resolution of investors’ uncertainty.

Notes
Corporate Finance
b) Investors’ desire for current income.
c) Institutional investors’ requirements.
d) Raising additional finances.
iii. Legal Constraints
The dividend decision is also affected by certain legal, contractual, and internal requirements and
constraints. The legal factors relate to certain statutory requirements. The contractual restrictions
arise from certain loan conditions. The internal constraints are the result of the firm’s liquidity
position. Legal factors specify the conditions under which dividends must be paid. Such conditions
relate to:
Capital Impairment:
Rules Legal enactments limit the amount of cash dividends that a firm may pay. A firm cannot pay
dividends out of its paid-up capital. Otherwise, there would be a reduction in the capital adversely
affecting the security of its lenders.
Net Profits:
A firm cannot pay cash dividends greater than the amount of current profits plus the accumulated
balance of retained earnings. For e.g., section 205 of the Indian Companies Act says that dividends
shall be paid only out of the current profits or past profits after providing for depreciation.
Insolvency:
If the firm is currently insolvent, it is prohibited from paying dividends. Similarly, a firm would not
pay dividends if such a payment leads to insolvency. The reason behind the rule is to protect the
creditors by prohibiting the liquidation of near-bankrupt firms through cash dividend payments to
the equity owners.
Contractual Requirements:
Certain restrictions on the payment of dividend may be accepted by a company when acquiring
external capital. Such restrictions may cause the firm to restrict the payment of cash dividends until
a certain level of earnings has been achieved.
Internal Constraints:
a) Liquid assets: Whether the firm has sufficient cash funds to pay cash dividends.
b) Growth prospects: Availability of external funds and its cost.
c) Financial requirements: If a firm has abundant investment opportunities, it should prefer a
low payout ratio.
d) Availability of funds: The dividend policy is also restricted by the availability of funds and
the need for additional investment.
e) Earnings stability: The more stable the income stream, the higher is the dividend payout
ratio.
f) Control: Management employs dividend policy as an effective instrument to maintain its
position of command and control.
iv. Owner’s Considerations
The dividend policy is also affected by:
a) Tax Status: If a firm has a large no. of owners who are in high tax brackets, its dividend policy
should follow high retention policy. On the other hand, if majority of the shareholders are in a
lower tax bracket, they would probably favor a higher payout of earnings because of the need
for current income.
b) Opportunities: Firm should evaluate the rate of return available from external investments. If
owners have better opportunities outside, the firm should opt for a higher D/P ratio and vice-
versa.
c) Dilution of Ownership: Low retentions may result in the issue of new equity shares in the
future. By retaining a high percentage of its earnings, the firm can minimize the possibility of
dilution of earnings.

Notes
v. Clientele Effect
Companies with high dividend payouts would attract investors who needs current dividends and
low dividend payout companies would attract those who need capital gains. When a company
chooses to pursue a particular dividend policy, it has chosen a policy to attract a particular clientele.
vi. Capital Market Considerations
If a firm has easy access to the capital market it can follow a liberal dividend policy. Firms which
depend heavily on financial institutions for procuring funds, declare a minimum dividend so that
they can remain on the ‘eligible’ list of these institutions. It is because most financial institutions are
prohibited by their charter from buying shares in companies which pay no dividends.
vii. Inflation
With rising prices, funds generated from depreciation may be inadequate to replace obsolete
equipment. These firms have to depend upon retained earnings as a source of funds to make up the
shortfall. Consequently, their dividend payout tends to be low during periods of inflation.
10.4 Forms of Dividend

Dividends are usually paid to shareholders in the form of cash. However, there are other options
also such as payment of the bonus shares and buyback of shares. Additionally, the share split is not
a form of dividend, but it’s effects are similar to the effects of the bonus shares.
1.Cash
1.Forms of Dividend
1.Bonus shares
1.Shares buyback
1.Share Split
2.(Not a form of dividend, but its
effects are similar to bonus shares)
a) Cash Dividends
The most popular way for paying the dividend is through cash. But in order to pay cash dividends,
a company should have enough cash in its bank account when cash dividends are declared. When
cash dividend is distributed, both the total assets and the net worth of the company are reduced.
The market price of the share drops generally by the amount of the cash dividend distributed.
b) Bonus Shares
Another mode of paying dividend is through the issuance of bonus shares. An issue of bonus
shares is the distribution of shares free of cost to the existing shareholders. The effect of issuing
bonus shares is that the number of outstanding shares of the company are increased. Moreover, the

Notes
Corporate Finance
declaration of the bonus shares will increase the paid-up share capital and reduce the reserves and
surplus (retained earnings) of the company.
Example:
Rs. Crore
Paid-up share capital (1 crore Shares, Rs 10 par) 10
Share Premium 15
Reserves and Surplus 8
Total net Worth 33
Company X pays bonus shares in 1:10 ratio. At the time of the issue of bonus shares, the market
price per share is Rs 30. The bonus shares are issued at the market price—a premium of Rs 20 over
the face value of Rs 10 each share.
Rs. Crore
Paid-up share capital (1.10 crore Shares, Rs 10 par) 11
Share Premium 17
Total net Worth 33
The amount is be transferred from the reserves and surplus account to the paid-up share capital
account and the share premium account.
c) Share Split
A share split is a method to increase the number of outstanding shares through a proportional
reduction in the par value of the share. A share split affects only the par value and the number of
outstanding shares; the shareholders’ total funds remain unaltered.
Example: Consider the capital structure of Company X:
Rs. Crore
Paid-up share capital (1 crore Shares, Rs 10 par) 10
Share Premium 15
Total net Worth 33
Company X split their shares two-for-one. The capitalization of the company after the split is as
follows:
Rs. Crore
Paid-up share capital (2 crore Rs 5 par) 10
Share Premium 15

Notes
Total net Worth 33
Reasons for Share Split

A firm splits the share for the following reasons:
• To make trading in shares attractive.

• To signal the possibility of higher profits in the future.
• To give higher dividends to shareholders.
d) Buyback of Shares
The buyback of shares refers to the act of repurchasing of its own shares by a company. In India the
following conditions apply in case of the buyback shares:
• A company buying back its shares will not issue fresh capital, except bonus issue, for
the next 12 months.
• The company will state the amount to be used for the buyback of shares and seek
prior approval of shareholders.
• The buyback of shares can be affected only by utilizing the free reserves.
• The company will not borrow funds to buy back shares.
• The shares bought under the buyback schemes will be extinguished and they cannot
be reissued.
Methods of Shares Buyback

There are two methods of the share buyback in India. First, a company can buy its shares through
authorized brokers on the open market. Second, the company can make a tender offer, which will
specify the purchase price, the total amount and the period within which shares will be bought
back.
10.5 Theories of Dividend

With regard to the dividend-firm value relationship, there are multiple views of the experts. Some
suggests that dividend policy affects the value of the firm, whereas other suggests that there is not
relationship between dividend policy and the firm value. These views or approaches can be
classified into two broad categories, relevance theories and irrelevance theories.
Dividend
Theories
Relevance Irrelevance
Theories Theories
Modigliani Miller
Walter’s Model Gordon’s Model
Approach
Relevance Theories
According to the relevance approaches, the dividend decisions affect the value of the firm. In other
words, If the choice of the dividend policy affects the value of a firm, it is considered as relevant. If

Notes
Corporate Finance
the dividend is relevant, there must be an optimum payout ratio. Optimum payout ratio is that
ratio which gives highest market value per share.
10.6 Walter’s Model

Walter’s model was proposed by Professor James E. Walter. The model shows the importance of
the relationship between the firm’s rate of return, r, and its cost of capitalk, in determining the
dividend policy that will maximize the wealth of shareholders.
The assumptions of the Walter’s model are:

 There is only Internal financing
 Constant return and cost of capital
 100% payout or retention of earnings
 Constant EPS and DIV
 Time periods is Infinite
Formula of Walter’s Model:
Or,
Where:
P = market price per share
DIV = dividend per share
EPS = earnings per share
r = firm’s rate of return (average)
k = firm’s cost of capital or capitalization rate
The above formula shows that the market price per share is the sum of the present value of two
sources of income:
a) Present value of the infinite stream of constant dividends, DIV/k, plus

b) Present value of the infinite stream of capital gains, [r (EPS – DIV)/k]/k.
Example: Consider the following information for a) Growth firm, b) Normal firm and c)
Declining firm. In the growth firm, rate of return (r) is greater than the cost of capital (k). In the
Normal firm, rate of return (r) is equal to the cost of capital (k) and in the declining firm, rate of
return (r) is less than the cost of capital (k). Let’s consider the effect of different dividend policies on
the EPS of the firm in the three cases.
a. Growth Firm, r > k

r = 0.15, k = 0.10, EPS = Rs 10
 Payout Ratio 0%

Notes
DIV = Rs 0
P = 0 + (0.15/0.10) (10 – 0)/0.10
= Rs 150
 Payout Ratio 40%
DIV = Rs 4
P = 4 + (0.15/0.10) (10 – 4)/0.10
= Rs 130
DIV = Rs 8
P = 8 + (0.15/0.10) (10 – 8)/0.10
= Rs 110
DIV = Rs 10
P = 4 + (0.15/0.10) (10 – 10)/0.10
= Rs 100
b. Normal Firm, r = k
r = 0.10, k = 0.10, EPS = Rs 10
 Payout Ratio 0%
DIV = Rs 0
P = 0 + (0.10/0.10) (10 – 0)/0.10
= Rs 100
DIV = Rs 4
P = 4 + (0.10/0.10) (10 – 4)/0.10
= Rs 100
DIV = Rs 8
P = 8 + (0.10/0.10) (10 – 8)/0.10
= Rs 100
DIV = Rs 10

Notes
Corporate Finance
P = 4 + (0.10/0.10) (10 – 10)/0.10
= Rs 100
c. Declining Firm, r < k

r = 0.8, k = 0.10, EPS = Rs 10
 Payout Ratio 0%
DIV = Rs 0
P = 0 + (0.8/0.10) (10 – 0)/0.10
= Rs 80
DIV = Rs 4
P = 4 + (0.8/0.10) (10 – 4)/0.10
= Rs 88
DIV = Rs 8
P = 8 + (0.8/0.10) (10 – 8)/0.10
= Rs 96
DIV = Rs 10
P = 4 + (0.8/0.10) (10 – 10)/0.10
= Rs 100
In the Walter’s model, the dividend policy of the firm depends on the availability of investment
opportunities and the relationship between the firm’s internal rate of return, r and its cost of capital,
k. Hence,
• Retain all earnings when r > k
• Distribute all earnings when r < k
• Dividend policy has no effect when r = k.
Illustration:The following information is available for the firm ABC:
• Earning per share: Rs. 4
• Return on investment or internal earning: 18%
• Return required by shareholder: 15%
• Price per share as per the Walter model if the payout ratio is: a) 40%, b) 50% and c) 60%

Notes
Solution
According to the Walter’s Model:
Pay-out Ratio Price per Share P
40% 1.60 + 0.18(2.40)/0.15 Rs. 29.87

0.15
50% 2 + 0.18(2)/0.15 Rs. 29.33
0.15
60% 2.40 + 0.18(1.60)/0.15 Rs. 28.80
0.15
Criticisms of Walter’s Model:

There are various criticisms of the Walter’s model:
• No External Financing: firm’s investment or its dividend policy will be sub-optimum.
• Constant return: Firm’s internal rate of return does not always remain constant.
• Constant opportunity cost of capital: A firm’s cost of capital or discount rate, k.
10.7 Gordon’s Model

Another model in relevance theory is Gordon’s Model. According to Prof. Gordon, Dividend Policy
almost always affects the value of the firm. The main proposition of the model is that the value of a
share reflects the value of the future dividends accruing to that share. Hence, the dividend payment
and its growth are relevant in valuation of shares. The model holds that the share’s market price is
equal to the sum of share’s discounted future dividend payment.
Assumptions
This model is based on various assumptions which are given below:
a) All equity firm
b) No external financing
c) Constant Returns
d) Constant Cost of Capital
e) Perpetual Earnings
f) No taxes
g) Constant Retention
h) Cost of Capital is greater than growth rate
Formula of Gordan’s Model:

Notes
Corporate Finance
Dividend per share is expected to grow when earnings are retained. The dividend per share is
equal to the payout ratio, (1 – b) times earnings per share, EPS; that is,
DIVt = (1 – b) EPSt.
It is assumed that the retained earnings are reinvested within the all-equity firm at the firm’s
internal rate of return, r. This allows earnings to grow at g = br per period.
Or,
Where:
P = Price
E = Earnings per Share
b = Retention Ratio
k = Cost of Capital
br = g = Growth Rate
Example:Consider the following information for a) Growth firm, b) Normal firm and c)
Declining firm. In the growth firm, rate of return (r) is greater than the cost of capital (k). In the
Normal firm, rate of return (r) is equal to the cost of capital (k) and in the declining firm, rate of
return (r) is less than the cost of capital (k). Let’s consider the effect of different dividend policies on
the EPS of the firm in the three cases according to the Gordon’s Model.
a) Growth Firm, r > k

r = 0.15, k = 0.10, EPS = Rs 10
g = br= 0.6 × 0.15
= 0.09
P = 10(1 - 0.6)
0.10 - 0.09
= 4/0.09
= 400
g = br= 0.4 × 0.15
= 0.06
P = 10(1 - 0.4)
0.10 - 0.09
= 6/0.04

Notes
= 150
g = br= 0.10 × 0.15
= 0.015
P = 10(1 - 0.1)
0.10 - 0.015
= 4/0.09
= 106
b) Normal Firm, r = k
r = 0.10, k = 0.10, EPS = Rs 10
g = br= 0.6 × 0.10
= 0.06
P = 10(1 - 0.6)
0.10 - 0.06
= 4/0.04
= 100
g = br= 0.4 × 0.10
= 0.04
P = 10(1 - 0.4)
0.10 - 0.04
= 6/0.06
= 100
g = br= 0.10 × 0.10
= 0.01
P = 10(1 - 0.1)
0.10 - 0.01
= 9/0.09
= 100
c. Declining Firm, r < k

Notes
Corporate Finance
r = 0.08, k = 0.10, EPS = Rs 10
g = br= 0.6 × 0.08
= 0.048
P = 10(1 - 0.6)
0.10 - 0.048
= 4/0.052
= 77
g = br= 0.4 × 0.08
= 0.032
P = 10(1 - 0.4)
0.10 - 0.032
= 6/0.068
= 88
g = br= 0.10 × 0.08
= 0.008
P = 10(1 - 0.1)
0.10 - 0.008
= 9/0.092
= 98
Illustration:The following information is available for Firm ABC:
 Earnings per share(EPS): Rs. 5

 Return required by shareholder: 16%
What rate of return should be earned on investment to ensure that the market price is Rs.50 when
the dividend payout is 40%?
Solution:
Dividend payout = 40% = 0.4, b = 100-40 = 60% = 0.6
(1 − )
=
−
5(1 − 0.6)
50 =
0.16 − 0.6
30r = 6
r = 0.20

Notes
= 20%
Gordon’s model suffers from the same limitations as the Walter’s Model.
Irrelevance Theory
According to the irrelevance approaches, the dividend decisions doesn’t affect the value of the firm.
According to this theory, the dividend policy of the firm is a residual decision and dividends are a
passive residual.Dividend policy of a firm will depend upon the available investment
opportunities.When a firm has sufficient investment opportunities, it will retain the earnings to
finance them. On the other hand, if acceptable investment opportunities are inadequate, earnings
would be distributed.
10.8 MM Argument
This approach was developed by Franco Modigliani and Merton Miller in 1961.They claimed that
neither the price of firm's stock nor its cost of capital is affected by its dividend policy.The value of
the firm depends on the firm’s earnings that result from its investment policy. Thus, when
investment decision of the firm is given, dividend decision is of no significance in determining the
value of the firm.
Value of the Investment

Firm’s Earnings
Firm Policy
A firm may face one of the following three situations regarding the payment of dividends:
i. The firm has sufficient cash to pay dividends.
ii. The firm does not have sufficient cash to pay dividends, and therefore, it issues new
shares to finance the payment of dividends.
iii. The firm does not pay dividends, but shareholders need cash.
In the first situation, when the firm pays dividends, shareholders get cash in their hands, but the
firm’s assets reduce (its cash balance declines). What shareholders gain in the form of cash
dividends, they lose in the form of their claims on the assets. There is no net gain or loss. The
wealth of shareholders will remain unaffected.
In the second situation, when the firm issues new shares to finance the payment of dividends, two
transactions take place. First, the existing shareholders get cash in the form of dividends, but they
suffer an equal amount of capital loss since the value of their claim on assets reduces. Thus, the
wealth of shareholders does not change. Second, the new shareholders part with their cash to the
company in exchange for new shares at a fair price per share. The fair price per share is the share
price before the payment of dividends less dividend per share to the existing shareholders. The
existing shareholders transfer a part of their claim to the new shareholders in exchange for cash.
The value of the firm will remain unaltered.
In the third situation, if the firm does not pay any dividend a shareholder can create a home-made
dividend by selling a part of his shares.The shareholder will have a smaller number of shares. He or
she has exchanged a part of the claim on the firm to a new shareholder for cash. The value of the
firm remains the same.

Notes
Corporate Finance
Illustration:The Company XYZ currently has 2 crore outstanding shares selling at a market price of
Rs 100 per share. The firm has no debt. It has internal funds available to make a capital expenditure
of Rs 30 crore.The expenditure is expected to generate a positive NPV of Rs 20 crore. The firm
wants to pay a dividend per share of Rs 15.
Given the firm’s expenditure plan and its policy of no borrowing, the firm will have to issue new
shares to finance payment of dividends to its shareholders.
How will the firm’s value be affected?
a) if it does not pay any dividend;

b) if it pays dividend per share Rs 15?
Solution:
The firm’s current value is:
2 × Rs 100 = Rs 200 crore.
After the Capital expenditure, the value will increase to:
Rs 200 + Rs 20 = Rs 220 crore.
 If the firm does not pay dividends, the value per share will be:
Rs 220/2 = Rs 110.
 If the firm pays a dividend of Rs 15 per share.
It will use its internal funds (15 × 2 = Rs 30 crore), and it will have to raise Rs 30 crore by issuing
new shares.The value of a share after paying dividend will be:
Rs 110 – Rs. 15 = Rs 95.
Thus, the existing shareholders get a cash of Rs 15 per share in the form of dividends, but suffers a
capital loss of Rs 15 in the form of reduced share value.
The firm will have to issue:
Rs 30 crore/ Rs 95 = Rs 31,57,895 (about 31.6 lakh) shares to raise Rs 30 crore.
The firm now has 2.316 crore shares at Rs 95 each share.
Thus, the value of the firm remains as:
2.316 × 95 = Rs 220 crore
Home-made dividend
MM dividend hypothesis suggests that shareholders do not necessarily depend on dividends for
obtaining cash. In a perfect market, they can get cash by creating “home-made dividend” without
any reduction in their wealth. Therefore, firms paying high dividends need not command higher
prices for their shares.
Assumptions
The MM approach is based on the following assumptions:

Notes
• The firm operates in perfect capital markets where investors behave rationally,
information is freely available to all, and transactions and flotation costs do not exist.
• Taxes do not exist; or there are no differences in the tax rates applicable to capital gains
and dividends.
• The firm has a fixed investment policy.
• Risk of uncertainty does not exist. That is, investors are able to forecast future prices and
dividends with certainty.
Proof of the Model:

Step 1: The market price of a share in the beginning of the period:
Where:
P0 = Current market price of a share,
ke = Cost of equity capital,
D1 = Dividend to be received at the end of period 1, and
P1 = Market price of a share at the end of period 1.
Step 2: Assuming no external financing, the total capitalized value of the firm would be:
Step 3: If the firm’s internal sources of financing its investment opportunities fall short of the funds
required, Eq. 2 can be written as:
Where, Δn is the number of new shares issued at the end of year 1 at price of P 1
Step 4: The total amount raised through new shares:
• ΔnP1 = Amount obtained from the sale of new shares.

• I = Total amount/requirement of capital budget.
• E = Earnings of the firm during the period.
• nD1 = Total dividends paid.
Step 5: If we substitute Eq. 4 into Eq. 3, we derive Eq. 5.

Notes
Corporate Finance
Cancelling positive nD1 and negative nD1.

Step 6: Conclusion:
As dividends (D) are not found in Eq. 6, Modigliani and Miller argued that dividends do not count
and that dividend policy has no effect on the share price.
Illustration:Firm XYZ Ltd. has 1 lakh outstanding shares selling at Rs 100 each. The firm has net
profits of Rs 10 lakh and intends to make new investments of Rs 20 lakh during the period. The
firm is also considering declaring a dividend of Rs 5 per share at the end of the current fiscal year.
The firm’s opportunity cost of capital is 10%.
What will be the price of the share at the end of the year if?
i. Dividend is not declared.

ii. Dividend is declared.
iii. How many new shares must be issued?
Solution:
The price of the share at the end of the current fiscal year is determined as follows:
i. The value of P1 when dividend is not paid is: P1 = Rs 100(1.10) – 0 = Rs 110

ii. The value of P1 when dividend is paid is: P1 = Rs 100(1.10) – Rs 5 = Rs 105
iii. The number of new shares to be issued by the company to finance its investments:
• Δn 105 = 20,00,000 – (10,00,000 - 5,00,000)

• Δn 105 = 15,00,000
• Δn = 15,00,000/105 = 14,285 Shares
Criticism of MM Model
The MM models is criticized for the following reasons:
• Capital markets are not perfect in reality.
• There may exist issue costs.
• Dividends may be taxed differently than capital gains.
• Investors may face difficulties in selling their shares.
Hence, due to the unrealistic nature of the assumptions, MM’s hypothesis lacks practical relevance.
Dividend policy of the firm may affect the perception of shareholders.

Notes
Relevance of Dividend Policy Under Market Imperfections

In practical world, investors like cash dividends. Thus, there is a clientele for high-payout
shares.Except tax-exempt investors, there does not seem to be a strong reason for investors to prefer
high-payout shares. In practical world, capital gains are taxed at a low rate, investors in high-tax
brackets would prefer low-payout shares.Managers have more information about the prospects of a
firm than shareholders. This is called information asymmetry and it leads to agency problems. The
high payout is considered as a device to reduce agency costs. Dividends have information value as
they convey signals about a company’s future earnings and growth prospects.Thus, there does not
seem to be a consensus on whether dividends matter or not. In practice, a number of factors will
have to be considered before deciding about the appropriate dividend policy of the firm.
Summary
 Dividend refers to that part of the part after tax which is distributed to the shareholders of
the company. The profit earned by a company after paying taxes can be used for
distribution of dividend or, can be retained as surplus for future growth. The part of the
profits that is distributed to the shareholders is known as the dividend.
 Dividend decisions are the decision regarding whether the firm should distribute all
profits, or retain them, or distribute a portion and retain the balance. The proportion of
profits distributed as dividends is called the dividend-payout ratio and the retained
portion of profits is known as the retention ratio. A firm tries to select that dividend policy
which maximizes the market value of the firm’s shares and is known as the optimum
dividend policy.
 The decisions related to the dividends are determined by various factors:
• Dividend Payout Ratio:
• Stability of dividends:
• Legal Constraints
• Owner’s Considerations
• Clientele Effect
• Capital Market Considerations
• Inflation
 According to the relevance approaches, the dividend decisions affect the value of the firm.
In other words, If the choice of the dividend policy affects the value of a firm, it is
considered as relevant. If the dividend is relevant, there must be an optimum payout ratio.
Optimum payout ratio is that ratio which gives highest market value per share.
 Walter’s model was proposed by Professor James E. Walter. The model shows the
importance of the relationship between the firm’s rate of return, r, and its cost of capitalk,
in determining the dividend policy that will maximize the wealth of shareholders.
 Formula of Walter’s Model:
 In the Walter’s model, the dividend policy of the firm depends on the availability of
investment opportunities and the relationship between the firm’s internal rate of return, r
and its cost of capital, k. Hence,
• Retain all earnings when r > k
• Distribute all earnings when r < k
• Dividend policy has no effect when r = k.
 Another model in relevance theory is Gordon’s Model. The main proposition of the model
is that the value of a share reflects the value of the future dividends accruing to that share.
Hence, the dividend payment and its growth are relevant in valuation of shares. The
model holds that the share’s market price is equal to the sum of share’s discounted future
dividend payment.
 Formula of Gordan’s Model:

Notes
Corporate Finance
 According to the irrelevance approaches, the dividend decisions doesn’t affect the value of
the firm. The dividend policy of the firm is a residual decision and dividends are a passive
residual.Dividend policy of a firm will depend upon the available investment
opportunities.When a firm has sufficient investment opportunities, it will retain the
earnings to finance them. On the other hand, if acceptable investment opportunities are
inadequate, earnings would be distributed.
 MM approach states that neither the price of firm's stock nor its cost of capital is affected
by its dividend policy.The value of the firm depends on the firm’s earnings that result
from its investment policy. Thus, when investment decision of the firm is given, dividend
decision is of no significance in determining the value of the firm.
 Relevance of Dividend Policy under Market Imperfections: In practical world, there does
not seem to be a consensus on whether dividends matter or not.
Keywords
Dividend Decisions, Walter’s Model, Gordon’s Model, MM Approach, Bonus Shares, Share Split,
Buyback of Shares.
Self Assessment
1. The factors involved in setting a dividend policy include all of the following EXCEPT:
A. restrictive covenants in a bond indenture.

B. growth prospects.
C. the legal prohibition on paying dividends which exceed current earnings.
D. capital impairment restrictions
2. The dividend policy must be formulated considering two basic objectives, namely
A. delaying the tax liability of the stockholder and information content.

B. maximizing shareholder wealth and delaying the tax liability of the stockholder.
C. maximizing shareholder wealth and providing for sufficient financing.
D. maintaining liquidity and minimizing the weighted average cost of capital.
3. The problem with a constant-payout-ratio dividend policy from the shareholder’s

perspectiveis that
A. it bores the shareholders.

B. if the firm’s earnings drop, so does the dividend payment.
C. even when earnings are low, the company must pay a fixed dividend.
D. there is no informational content.
4. The purpose of a stock split is to
A. affect the firm’s capital structure.

B. decrease the dividend.
C. enhance the trading activity of the stock by lowering the market price.
D. increase the market price of the stock.

Notes
5. The purpose of a reverse stock split is to

A. issue additional shares
B. increase the dividend.
C. increase the price of stock.
D. reduce trading activity.
6. Which is/are the relevance theory/theories of dividend policy

A. Walter’s Model
B. Gordon’s Model
C. Modigliani Miller Approach
D. Both a and b
7. Gordon’s “bird in hand” argument suggests that
A. dividends are irrelevant.

B. firms should have a 100 percent payout policy.
C. shareholders are generally risk averse and attach less risk to current dividends.
D. the market value of the firm is unaffected by dividend policy.
8. Which of the following is an argument for the relevance of dividends?

A. Informational content.
B. Reduction of uncertainty.
C. Some investor’s preferences for current income.
9. Dividend policy determines___________

A. What portion of earnings will be paid out to stockholders.
B. What portion will be retained in the business to finance long-term growth.
C. Both (A) and (B)
10. Which one of the following is not an assumption of the Walter's relevance theory model?
A. The firm has a very long life.

B. Earnings and dividends do not change while determining the value.
C. The internal rate of return (r) and cost of capital (k) of the firm are constant.
D. The firms are financed through external sources.
11. Which of the following theory is known as irrelevance theory of dividend?

A. Walter’s Model
B. Gordon’s Model
C. Modigliani and Miller Proposition
D. Both a and b

Notes
Corporate Finance
12. MM Theory in perfect market suggests that dividend payment:
A. Has a positive impact on the value of firm.

B. Has no impact on the value of a firm.
C. Has a negative impact on the value of firm.
D. Has negligible impact on the firm.
13. Which one of the following is not an assumption of the Modigliani-Miller (MM) model?
A. There are perfect capital markets.

B. Investors do not behave rationally.
C. There are not flotation and transactions costs.
D. No investors are large enough to affect the market price of shares.
14. Which one of the following is not an assumption of the Modigliani-Miller (MM) model?
A. There is no risk or uncertainty in regard to the future of the firm.
B. Information about the company is available without any cost.
C. The firm has rigid investment policy.
D. Dividend policy has no impact on the market price of the shares.
15. Modigliani and Miller argue that the dividend decision:
A. Is irrelevant as the value of the firm is based on the earning power of its assets.
B. Is relevant as the value of the firm is not based just on the earning power of its assets.
C. Is irrelevant as dividends represent cash leaving the firm to shareholders, who own the firm
anyway.
D. Is relevant as cash outflow always influences other firm decisions

1. C 2. C 3. B 4. C 5. D
6. D 7. C 8. D 9. C 10. D
11. C 12. B 13. B 14. A 15. A
Review Questions
1. Explain the concept of Dividend policy.
2. List the factors affecting the Dividend policy of the firm.
3. Discuss the various forms of dividend.
4. Illustrate the Walter’s model of Dividend under Growth, Normal and Declining firm.
5. Explain the Modigliani and Millers argument.
Further Readings

Notes
Hill.
Publishing
4. https://efinancemanagement.com/dividend-decisions
5. https://www.investopedia.com/terms/d/dividendpolicy.asp

Notes
Dr. Atif Ghayas, Lovely Professional University Unit 11: Forms of Dividend
Unit 11: Forms of Dividend

CONTENTS
Objectives
Introduction
11.1 Cash Dividends
11.2 Bonus Shares
11.3 Share Split
11.4 Buyback of Shares
11.5 Dividend Policies in Practice
Summary
Keywords
Self Assessment
Review Questions
Further Readings
Objectives
● discuss the concept behind Bonus Shares.
● explain the concept of Share Split.
● list the advantage and disadvantages of Bonus Share and Share Split.
● explain Stock Repurchase,
● discuss Dividend Policies in practice.
Introduction
In the previous chapter we discussed about the dividend decisions and the dividend policy in a
firm. In this chapter we will discuss about different forms in which a firm can distribute the
dividends to the shareholders. Usually, firms pay the dividends in the form of cash, however firms
can issue bonus shares also. Similarly, firms can split the shares or buyback their own shares also.
We will discuss each of the dividend form in detail and will also discuss their advantages,
disadvantage and the impact of different forms of dividends on the firm.
Forms of Dividend
Dividend is the potion of firm’s earnings that is distributed among the shareholders. The dividends
are usually paid in terms of cash. Other options are payment of the bonus shares and shares
buyback. The share split is not a form of dividend; but the effect is similar to the effects of the bonus
shares.
11.1 Cash Dividends

In order to pay the dividend in the form of cash, a company should have enough cash in its bank
account. Cash dividends can affect the liquidity position of the firm; thus, a firm should properly
manage its cash position if it pays the dividends in cash. When the company follows a stable
dividend policy, it should prepare a cash budget for the coming period to indicate the necessary

Notes
Corporate Finance
funds. In practice, the total assets and the net worth of the company are reduced when the cash
dividend is distributed to the shareholders. Usually, the market price of the share drops by the
amount of the cash dividend distributed.
11.2 Bonus Shares

Sometimes, instead of paying dividends in cash, firms issue extra shares to the shareholders. Bonus
shares issue means distribution of shares free of cost to the existing shareholders. The effect of such
issuance is that the it increases the number of outstanding shares of the company. It involves
issuing new shares on a pro rata basis to the current shareholders. Usually, the declaration of the
bonus shares will increase the paid-up share capital and reduce the reserves and surplus of the
company. For e.g., if a shareholder owns 50 shares at the time when a 1:10 bonus issue is made, the
shareholder will receive 5 additional shares. Bonus shares will increase the paid-up share capital
and reduce the reserves and surplus.
Example: Company X pays bonus shares in 1:10 ratio. The market price per share is Rs 30.
(Premium: Rs 20, face value: Rs 10 each share). The bonus shares are issued at the market price.
Rs. Crore
Paid-up share capital 10

(1 Crore shares of Rs. 10 par)
Share Premium 15
Reserve and Surpluses 8
Total Net worth 33
After issuing the bonus shares:
Rs. Crore

(1.10 Crore shares of Rs. 10 par)
Share Premium 17
Total Net worth 33
In the above example, the amount is transferred from reserves and surplus account to the paid-up
share capital account and the share premium account. The total net worth of the company does not
change by the bonus shares; only the balance of the paid-up share capital is readjusted.
Bonus shares and shareholders wealth

In practice, the issue of bonus shares does not affect the wealth of shareholders. The Earning per
Share (EPS) and market price per share falls in the same proportion to the bonus issue. For e.g.,
Suppose, as a result of increasing the number of shares by 1:10, the EPS of Company X will decrease
by 10%, the market price per share will also fall by 10%.
Suppose, the net earnings of the company are Rs. 2.20 crore, the EPS before the declaration of the
bonus issue is Rs. 2.20 (Rs. 2.20 crore/1.00 crore). After the bonus shares, the EPS will be Rs. 2 (Rs.
2.20 crore/1.10 crore).

Notes

The earnings of shareholders will remain same. Total earnings of a shareholder holding 100 shares:
Before the bonus shares is Rs. 220 (Rs. 2.20 × 100)
After the bonus issue: Rs. 220 (Rs. 2.00 × 110)
Market price per share will also drop by Rs. 2.73; i.e., Rs. 30 (1 – 1.00/1.10).
The total market value of the shareholder’s holdings after the bonus shares is Rs. 3,000 (Rs. 27.27 ×
110), which is same as the total value before the bonus shares. The bonus shares have no impact on
the wealth of shareholders. In practice, immediately after the announcement of bonus issue, the
market price of a company’s share changes depending on the investor’s expectations. Sharp decline
in the share price may be observed if the bonus issue falls short of the investors’ expectation.
Advantages to the Shareholders:

There are many benefits of bonus shares for the firm as well as the shareholders as discussed below:
● Tax benefit:
Receipt of bonus shares by the shareholder is not taxable as income.
● Indication of higher future profits:
Issue of bonus shares is interpreted as an indication of higher profitability.
● Future dividends may increase:
If a fixed DPS paying company continues to pay same dividend after bonus issue, the total cash
dividends of the shareholders will increase.
● Psychological value:
The receipt of bonus shares gives a chance to make capital gains. They also associate it with the
prosperity of the company
● Conservation of cash:
It allows the company to declare a dividend without using up cash.
● Only means to pay dividend under financial difficulty and contractual restrictions
● It leads to more attractive share price
Conditions for the Issue of Bonus Shares:

There are several conditions for the issue of the bonus shares:
● A company is not allowed to declare bonus shares unless partly paid-up shares have been
converted into fully paid-up shares.
● Bonus shares are made out of share premium and free reserve, which includes investment
allowance reserve but excludes capital reserve on account of assets revaluation.
● In no time the amount of bonus issue should exceed the paid-up capital.
● A company can declare bonus shares once in a year.
● The company’s shareholders should pass a resolution approving the proposal of the bonus
issue, clearly indicating that the rate of dividend is payable on the increased capital.
● A company intending to issue bonus shares should not be in default of payments of statutory
dues to employees and term loans to financial institutions.

Notes
Corporate Finance
● The maximum bonus shares ratio is 1:1; that is, one bonus share for one fully paid-up share
held by the existing shareholders.
● However, two criteria are required to be satisfied within the limit of the maximum ratio. They
are:
● Residual reserve criterion: It requires that the reserve remaining after the amount capitalized
for bonus issue should be at least equal to 40 per cent of the increased paid-up capital.
● Redemption reserve and capital reserve on account of assets revaluation are excluded while
investment allowance reserve is included in computing the minimum residual reserve
● Profitability criterion: It requires that 30 per cent of the previous three years’ average pre-tax
profit (PBT) should be at least equal to 10 per cent of the increased paid-up capital.
11.3 Share Split

Another form of payment of dividend is through share splitting. In share split, a share is split or
divided into multiple parts. The effect of share split is that it increases the number of outstanding
shares through a proportional reduction in the par value of the share. A share split affects only the
par value and the number of outstanding shares whereas, the shareholders’ total funds remain
unaltered.
For example, consider this case:
● Capital structure of Company X:
Rs. Crore

(1 crore shares of Rs. 10 par)
Share Premium 15
Total Net worth 33
• Company X split their shares two-for-one.
The capitalization of the company after the split is as follows:
Rs. Crore

(2 crore shares of Rs. 5 par)
Share Premium 15
Total Net worth 33
In the above case, the only effect of share split is that the number of paid-up shares capital have
been increased and the thus the price per share has been reduced.

Notes
Reasons for Share Split

Firms split shares for the following reasons:
i. To make trading in shares attractive:
After splitting of the share, the price of the share reduces and thus the share of the company is
placed in a more popular trading range. Thus, It helps in increasing the marketability and
liquidity of a company’s shares
ii. To signal the possibility of higher profits in the future:
The share splits are also used by the management to signal the investors that the company is
expected to earn higher profits in future.
iii. To give higher dividends to shareholders:
When the share is split, usually the dividend does not reduce and thus the DPS increases
proportionately.
 Reverse Stock Split

Reverse stock split refers to the act of merging the shares. Firms sometime merge the shares and
thus reduces the number of total outstanding shares. There is no impact of reverse stock split on the
earnings and shareholders’ wealth. The price of share can be increased with a reverse split. The
reverse split of 1:4 implies that for each four shares, one share would be given in exchange.
For example, a company has 20 lakh outstanding shares of Rs. 5 par value per share. Suppose it
declares a reverse split of one-for-four. After the split, it will have 5 lakh shares of Rs. 20 par value
per share. The reverse split is generally an indication of financial difficulty.
Advantages
There are several benefits of reverse share split for the firm:
● It brings the market price of shares within popular range.
● It is perceived as favorable news by the investors.
● Reverse share split announcements improve the prospect of raising additional funds
Rationale for issuing Bonus Shares and Share Split:

Several hypotheses have been proposed in support of bonus share which are discussed below:
i. Signaling hypothesis:
Announcement of bonus shares signals about the optimistic future of the issuing firm to
the market as there is information asymmetry between managers and investors.
ii. Trading range hypothesis:
The issue of bonus shares and share splits would have the effect of bringing the market
price of shares within a more popular range. Enable more investors to trade in the share.
iii. Liquidity hypothesis:
The issue of bonus shares and stock splits brings the share price in an optimum trading
range. It makes the stock more attractive to small investors which enhances liquidity by
increasing the volume of shares traded.
iv. Tax-timing hypothesis:
For the investors, the tax is deferred till such time the shareholders sell their shares.
v. Cash substitution hypothesis:
The issue of bonus shares enables the conservation of corporate cash i.e.; the firm can save
its cash by issuing the bonus shares.
vi. Attention hypothesis:

Notes
Corporate Finance
Managers use bonus shares to attract attention from the analysts to revalue their future
cash flows.
11.4 Buyback of Shares

Share repurchase implies that a company buys back its own shares. It is an alternative method to
pay cash dividends. Share repurchases reduce the number of equity shares outstanding in the
market. Share repurchase would result in higher (i) EPS and (ii) market price of a share
In India the following conditions apply in case of the buyback shares:
● A company buying back its shares will not issue fresh capital for the next 12 months.
● The company will state the amount to be used for the buyback of shares and seek prior
approval of shareholders.
● The buyback of shares can be affected only by utilizing the free reserves.
● The company will not borrow funds to buy back shares.
● The shares bought under the buyback schemes will be extinguished and they cannot be
reissued.
Example
The earnings available to the equity holders of the company ABC is Rs 50 lakh. Company wants to
utilize Rs 40 lakh of these earnings either to pay cash dividends or to repurchase shares. There are
20 lakh shares (of face value of Rs 10) outstanding and the current market price is Rs 20 per share.
The company can pay cash dividend of Rs 2 per share or can repurchase shares at Rs 22 per share
through a tender offer. Show the impact of repurchase on the EPS and MPS of the remaining shares
assuming no change in total earnings and price-earnings ratio.
Solution:
● Current EPS = Rs 50 lakh ÷ 20 lakh shares = Rs 2.5

● Current P/E ratio [Rs 20, MPS ÷ Rs 2.5, EPS] = 8 times
● No. of shares repurchased [Rs 40 lakh ÷ Rs 22] = 1,81,818 shares
● EPS after repurchasing 1,81,818 shares = [Rs 50 lakh ÷ the shares left (20 lakh — 1,81,818 =
18,18,182)] = Rs 2.75
● Expected MPS after repurchase (EPS x P/E ratio) [Rs 2.75 x 8 times] = Rs 22
● Expected receipts per share to equity shareholder:
(a) When cash dividends are paid
= MPS remains unchanged at Rs 20 + Rs 2,
Cash dividend = Rs 22
(b) When shares are repurchased
= MPS rises to Rs 22 + 0
Dividend = Rs 22
Methods of Shares Buyback

Notes

a) A company can buy its shares through authorized brokers on the open market. For e.g.,
Reliance Industries announced buyback of shares in the year 2000 at a price of Rs. 303 per
share.
Reason: Company wanted to signal to the shareholders that it would reward its shareholders by
returning surplus cash to them.
b) The company can make a tender offer, which will specify the purchase price. For e.g., Kirloskar
Oil Engines Limited made a tender offer to buy back 40 lakh shares at Rs. 75 for Rs. 30 crore or
Rs. 300 million).
Reason: To return surplus cash to shareholders.
Advantages of Share Repurchase:

There are several benefits of Share repurchase for the firm.
● Return of surplus cash to shareholders:
The buying shareholders will benefit since the company generally offers a price higher than the
current market price of the share.
● Increase in the share value:
When the company distributes the surplus cash, its operating efficiency and P/E ratio remains
intact. With reduced number of shares, EPS increases and share price also increases.
● Increase in the temporarily undervalued share price:
The share price of a number of companies may be undervalued. Companies may buy back
shares at higher prices to move up the current share prices.
● Achieving the target capital structure:
If a company has high proportion of equity in its capital structure, it can reduce equity capital
by buying back its shares.
● Consolidating control:
The promoters of the company benefit by consolidating their ownership and control over
companies through the buyback arrangement. They do not sell their shares to the company but
make the buyback attractive for others. Their proportionate ownership increases.
● Tax savings by companies:
Dividend payments are taxable in the hands of companies. They will avoid paying dividend
taxes if they compensate shareholders through the share buyback.
● Protection against hostile takeovers:
In a hostile takeover, a company may buy back its shares to reduce the availability of shares
and make takeover difficult.
Disadvantage of Shares Repurchase

However, there are few disadvantages of share repurchases for the firm.
● Not an effective defense against takeover:
Useful defense mechanism against hostile takeover only in case of the cash rich companies. In
India, companies are not allowed to borrow to buy back their shares. Therefore, the buyback is not
effective in protecting those companies that do not have cash.

Notes
Corporate Finance
● Shareholders do not like the buyback:
Shareholders may not like the buyback of shares; they might prefer increasing dividends over the
years. They consider dividends more dependable than the share buyback.
● Loss to the remaining shareholders:
The remaining shareholders may lose if the company pays excessive price for the shares under the
buyback scheme.
● Signal of low growth opportunities:
The buyback of shares utilizes the firm’s cash. It may signal to investors that the company does not
have long-term growth opportunities to utilize the cash.
11.5 Dividend Policies in Practice

i. Regular dividend policy
ii. Stable Dividend Policy
iii. Irregular Dividend Policy
iv. No Dividend Policy
Regular dividend policy:

Under the regular dividend policy, the company pays out dividends to its shareholders every year.
If the company makes abnormal profits (very high profits), the excess profits will not be distributed
to the shareholders but are withheld by the company as retained earnings. If the company makes a
loss, the shareholders will still be paid a dividend under the policy. The regular dividend policy is
used by companies with a steady cash flow and stable earnings. Companies that pay out dividends
this way are considered low-risk investments because while the dividend payments are regular,
they may not be very high.
Stable dividend policy

Under the stable dividend policy, the percentage of profits paid out as dividends is fixed. For
example, if a company sets the payout rate at 6%, it is the percentage of profits that will be paid out
regardless of the amount of profits earned for the financial year. Whether a company makes Rs. 10
Lack or Rs. 1 Lack, a fixed dividend will be paid out. Investing in a company that follows such a
policy is risky for investors as the amount of dividends fluctuates with the level of profits.
Shareholders face a lot of uncertainty as they are not sure of the exact dividend they will receive.
Irregular dividend policy

Under this policy, the company is under no obligation to pay its shareholders. If they a make an
abnormal profit in a certain year, they can decide to distribute it to the shareholders or not pay out
any dividends at all and instead keep the profits for business expansion and future projects. The
irregular dividend policy is used by companies that do not enjoy a steady cash flow or lack
liquidity. Investors who invest in a company that follows the policy face very high risks as there is a
possibility of not receiving any dividends during the financial year.
No dividend policy
Under the no dividend policy, the company doesn’t distribute dividends to shareholders. It is
because any profits earned is retained and reinvested into the business for future growth.

Notes

Companies that don’t give out dividends are constantly growing and expanding, and shareholders
invest in them because the value of the company stock appreciates. For the investor, the share price
appreciation is more valuable than a dividend payout.
Summary
● Forms of Dividend: Dividend is the potion of firm’s earnings that is distributed among the
shareholders. The dividends are usually paid in terms of cash. Other options are payment of
the bonus shares and shares buyback. The share split is not a form of dividend; but the effect
is similar to the effects of the bonus shares.
● Cash Dividends: In order to pay the dividend in the form of cash, a company should have
enough cash in its bank account. Cash dividends can affect the liquidity position of the firm;
thus, a firm should properly manage its cash position if it pays the dividends in cash.
● Bonus Shares: Sometimes, instead of paying dividends in cash, firms issue extra shares to
the shareholders. Bonus shares issue means distribution of shares free of cost to the existing
shareholders. The effect of such issuance is that the it increases the number of outstanding
shares of the company.
● In practice, the issue of bonus shares does not affect the wealth of shareholders. The Earning
per Share (EPS) and market price per share falls in the same proportion to the bonus issue.
● Share Split: Another form of payment of dividend is through share splitting. In share split, a
share is split or divided into multiple parts. The effect of share split is that it increases the
number of outstanding shares through a proportional reduction in the par value of the
share.
● Reverse Stock Split: Reverse stock split refers to the act of merging the shares. Firms
sometime merge the shares and thus reduces the number of total outstanding shares. There
is no impact of reverse stock split on the earnings and shareholders’ wealth. The price of
share can be increased with a reverse split.
● Buyback of Shares: Share repurchase implies that a company buys back its own shares. It is
an alternative method to pay cash dividends. Share repurchases reduce the number of
equity shares outstanding in the market. Share repurchase would result in higher (i) EPS
and (ii) market price of a share
● There are various dividend policies in practice such as:
● Regular dividend policy: Under the regular dividend policy, the company pays out
dividends to its shareholders every year.
● Stable dividend policy: Under the stable dividend policy, the percentage of profits paid out
as dividends is fixed.
● Irregular dividend policy: Under this policy, the company is under no obligation to pay its
shareholders. If they a make an abnormal profit in a certain year, they can decide to
distribute it to the shareholders or not pay out any dividends at all.
● No dividend policy: Under the no dividend policy, the company doesn’t distribute
dividends to shareholders. It is because any profits earned is retained and reinvested into
the business for future growth.
Keywords
Dividend, Bonus Shares, Share Split, Reverse share split, Share Buyback, Dividend policy

Notes
Corporate Finance
Self Assessment
1. Bonus shares are issued to:
A. Debenture holders
B. Preference shareholders
C. Public
D. Existing shareholders
2. Bonus issue must be authorized

A. By the board of directors
B. Article of association of the company
C. Shareholders by ordinary resolution
D. All of the above
3. If a company makes bonus issue at 2:3 then it means

A. For every two shares three bonus shares will be allotted
B. For every three shares two bonus shares will be allotted
C. For every Eve shares three bonus shares will be allotted
D. For every five shares two bonus shares will be allotted
4. Which of the following statement is false?

A. Bonus issue is made out of free revenue or securities premium collected in cash only
B. Bonus share can be issued out from revaluation Profit
C. No bonus issue can be made within twelve months of any issue
D. Company can issue Bonus shares in any ratio
5. Which statement/s is/are true regarding share split:

A. It increases the number of outstanding shares through a proportional reduction in the par
value of the share.
B. A share split affects only the par value and the number of outstanding shares.
C. The shareholders’ total funds remain unaltered.
D. All of the above
6. Which is/are the advantage/s of the stock buyback:
A. Enables return of surplus cash to shareholders

B. Results in increase in the share value
C. Helps in achieving the target capital structure
D. All of the above
7. Due to share repurchases, the number of equity shares outstanding in the market_________.
A. Increases
B. Decreases
C. Remains constant

Notes

8. In India, a company buying back its shares will not issue fresh capital for the next __
months.
A. 12 months
B. 6 months
C. 18 months
D. 9 months
9. Which is/are true regarding repurchase of shares by a company:
A. The buyback of shares can be affected only by utilizing the free reserves.
B. The company will not borrow funds to buy back shares.
C. The shares bought under the buyback schemes will be extinguished and they cannot be
reissued.
D. All of the above
10. The problem with the regular dividend policy from the firm’s perspective is that
A. it bores the shareholders.

B. if the firm’s earnings drop, so does the dividend payment.
C. Even when earnings are low, the company must pay a fixed dividend.
D. it increases the shareholders’ uncertainty.
11. All of the following are true of stock splits except:
A. Market price per share is reduced after the split.

B. The number of outstanding shares has increased.
C. Retained earnings are changed.
D. Proportional ownership is unchanged.
12. The repurchase of stock is considered …………. decision rather than ……….. decision.
A. an investment; a financing
B. financing; an investment
C. an investment; a dividend
D. a dividend; a financing
13. A stock split will cause a change in the total amounts shown in which of the following
balance sheet accounts?
A. Cash
B. Common stock
C. Paid-in capital
14. A …………… occurs when there is an increase in the number of shares out-standing by
reducing the par value of stock.
A. Stock split
B. Stock dividend
C. Extra dividend
D. Regular dividend
15. A ……………. is the expected cash dividend that is normally paid to shareholders.
A. Stock split

Notes
Corporate Finance
B. Stock dividend
C. Extra dividend
D. Regular dividend

1. D 2. D 3. B 4. B 5. D
6. D 7. B 8. D 9. D 10. C
11. C 12. B 13. D 14. A 15. D
Review Questions
1. Discuss the disadvantages of issuing cash dividends.
2. Discuss the impact of bonus share on the paid-up capital and the reserve of the firm.
3. Explain the advantages of the Bonus shares for the firm
4. Analyze the difference between share split and the reverse split.
5. Explain briefly the different types of dividend policy in practice.
Further Readings
McGraw-Hill.
Publishing
4. https://www.accountingtools.com/articles/2017/5/16/types-of-dividends
5. https://corporatefinanceinstitute.com/resources/knowledge/finance/dividend/

Notes
Dr. Atif Ghayas, Lovely Professional University Unit 12: Working Capital Management
Unit 12: Working Capital Management

CONTENTS
Objectives
Introduction
12.1 Working capital Management
12.2 Operating Cycle
12.3 Gross operating Cycle
12.4 Net Operating Cycle or Cash Conversion Cycle
12.5 Determinants of Working Capital
12.6 Cash Management
12.7 Cash Planning
12.8 Managing Cash Collections and Disbursements
12.9 Determining the Optimum Cash Balance
12.10 Investing Surplus Cash in Marketable Securities
12.11 Receivables Management
Summary
Keywords
Self Assessment
Review Questions
Further Readings
Objectives
 understand the concept of working capital management,
 discuss working capital policies,
 explain the risk-return tradeoff.
 explain the reasons for holding cash
 underline the need for cash management
 discuss the techniques of preparing cash budget
 discuss Receivables management.
 understand Credit policies.
 explain Credit terms.
 explain Collection policies.
Introduction
In this book, till now we have discussed all the long-term financial decisions in a firm. Now we will
move to the short-term decisions of a firm. Short-term decisions are mainly related to the working
capital decisions of firm and include the decisions related to the management of Cash, inventory
and receivables. Thus, in this chapter we will discuss the working capital management in detail.

Notes
Corporate Finance
12.1 Working capital Management
Meaning
Working capital management is concerned with the management of current assets in a firm.
Management of working capital is an integral part of financial management.One aspect of working
capital management is the trade-off between profitability and risk (liquidity).There is a conflict
between profitability and liquidity. If a firm focus more on Profitability, then its liquidity will be
adversely affected, and on the other hand, if it focuses more on liquidity, its profitability will be
affected. Hence, the firm has to strike a balance between the profitability and the liquidity.
There are two concepts of working capital:
a) Gross Working Capital
b) Net Working Capital
a) Gross working capital
Gross working capital refers to the firm’s investment in current assets.Current assets are the assets
which can be converted into cash within an accounting year.E.g., cash, short-term securities,
debtors, bills receivable, stock (inventory). The focus of Gross working capital is on:
• How to optimize investment in current assets?
• How should current assets be financed?
b) Net working capital
Net working capital refers to the difference between current assets and current liabilities. Current
liabilities are those claims of outsiders which are expected to mature for payment within an
accounting year. It can be positive or negative. The focus of Net working capital in on:
• Liquidity management.
• The net working capital concept also covers the question of judicious mix of long-term and
short-term funds for financing the current assets.
12.2 Operating Cycle

The concept of operating cycle related to the time duration required to convert raw material into
inventories into sales and finally into cash.
Acquisition of Manufacture of the

Sale of the product
resources product
A firm needs to maintain liquidity to purchase raw materials and pay expenses. Similarly, stocks of
raw material and work-in-process are kept to ensure smooth production. Also, stock of finished
goods is required to meet the demands of customers.Debtors are created because goods are sold on
credit for marketing and competitive reasons.
Length of the operating cycle:

The length of the operating cycle is the sum of:
i. Inventory conversion period (ICP)
ii. Debtors (receivables) conversion period (DCP)

Notes
Unit 11:
12: Working Capital Management
Debtors’ conversion period is the time required to collect the outstanding amount from the
customers.
Firm also purchases raw materials on credit from the supplier. Payables, which the firm can defer,
are spontaneous sources of capital to finance investment in current assets. The Creditors (payables)
deferral period (CDP)is the length of time the firm is able to defer payments on various resource
purchases.
12.3 Gross operating Cycle

Gross operating cycle is the total of inventory conversion period and debtors’ conversion period
whereas the difference between Gross operating cycle and payables deferral period is net operating
cycle (NOC).
GOC is given as follows:
Gross operating cycle = Inventory conversion period + Debtor’s conversion period.
Where: The inventory conversion (ICP) is the sum of:
a) Raw material conversion period (RMCP)
b) Work-in-process conversion period (WIPCP) and
c) Finished goods conversion period (FGCP)
a) Raw material conversion period (RMCP) is the average time period taken to convert material
in to work-in-process.
b) Work-in-process conversion period (WIPCP) is the average time taken to complete the semi-
finished work or work-in-process.
c) Finished goods conversion period (FGCP) is the average time taken to sell the finished goods.
 Debtor conversion period (DCP) is the average time taken to convert debtors into cash.

Notes
Corporate Finance
 Creditor deferral period (CDP) is the average time taken by the firm in paying its
creditors.
12.4 Net Operating Cycle or Cash Conversion Cycle

Net Operating Cycle is the difference between gross operating cycle and payables deferral period.
NOC = GOC – CDP
Net operating cycle is also referred to as cash conversion cycle.
Types of Working Capital

a) Permanent or Fixed working Capital
b) Fluctuating or variable working capital
a) Permanent or Fixed working Capital

A firm needs some level of current assets which are continuously required by a firm throughout the
year.It is permanent in the same way as the firm’s fixed assets are. This minimum level of current
assets is known as permanent working capital. Working capital requirement above this level will
fluctuate and will depends upon the changes in production and sales, the need for working capital.
b) Fluctuating or variable working capital

Extra working capital needed to support the changing production and sales activities of the firm.
Firm creates a temporary working capital to meet liquidity requirements that will last only
temporarily. Permanent working capital is stable over time, whereas temporary working capital is
fluctuating.
Fig. Normal Firm Fig: Growing Firm
Both excessive as well as inadequate working capital positions are dangerous from the firm’s point
of view. Excessive working capital means holding costs and idle funds which earn no profits for the
firm. Inadequate working capital results in production interruptions and inefficiencies and sales
disruptions.
Dangers of excessive working capital

Notes
 Results in unnecessary accumulation of inventories.

 Chances of inventory mishandling, waste, theft and losses increase.
 It is an indication of defective credit policy and slack in collection period.
 Results into managerial inefficiency.
 May make dividend policy liberal and difficult to cope with in future.
Dangers of Inadequate working capital

 Becomes difficult for the firm to undertake profitable projects.
 It becomes difficult to implement operating plans and achieve the firm’s profit target.
 Results in Operating inefficiencies.
 Fixed assets are not efficiently utilized.
 Firm may face tight credit terms.
12.5 Determinants of Working Capital

There are various factors which affects the working capital requirement in the firm:
a) Nature of Business
Nature of the business and the product manufactured by the firm affects the level of working
capital requirement in the firm. For e.g., retail stores must carry large stocks of a variety of goods.
Whereas, Public utilities may have limited need for working capital and have to invest abundantly
in fixed assets.
b) Market and Demand Conditions

Growing firms may need to invest funds in fixed assets. This will increase investment in current
assets to support enlarged scale of operations. When there is an upward swing in the economy,
sales will increase; correspondingly, the firm’s investment in inventories and debtors will also
increase.
c) Technology and Manufacturing Policy

Longer the manufacturing cycle, larger will be the firm’s working capital requirements.On the other
hand, the manufacturing cycle of products such as detergent powder, soaps, chocolate, etc., may be
a few hours. An extended manufacturing time span means a larger tie-up of funds in inventories.
d) Credit Policy
The credit terms to be granted to customers may depend upon the norms of the industry to which
the firm belongs.A liberal credit policy will be detrimental to the firm and will create a problem of
collection later on.A high collection period will mean tie-up of large funds in debtors. Slack
collection procedures can increase the chance of bad debts.
e) Availability of Credit from Suppliers

A firm will need less working capital if liberal credit terms are available to it from the
suppliers.Suppliers’ credit finances the firm’s inventories and reduces the cash conversion cycle.In
the absence of suppliers’ credit, the firm will have to borrow funds from a bank.
f) Operating Efficiency
The efficiency in controlling operating costs and utilizing fixed and current assets leads to
operating efficiency. The use of working capital is improved and pace of cash conversion cycle is
accelerated with operating efficiency. Better utilization of resources improves firm’s profitability.
g) Price Level Changes

Rising price levels will require a firm to maintain higher amount of working capital. Those
companies that can immediately revise their product prices with rising price levels will not face a
severe working capital problem.

Notes
Corporate Finance
Importance of Working Capital Management
There are many reasons which makes the working capital management decision very important for
the firm:
a) Time: Working capital management requires much of the financial manager’s time.
b) Investment: Working capital represents a large portion of the total investment in assets.
c) Criticality: Working capital management has great significance for all firms but it is very
critical for small firms.
d) Growth: The need for working capital is directly related to the firm’s growth
Liquidity vs. Profitability:Risk–Return Trade-off

The two important aims of the working capital management are: Profitability and Solvency.
Solvency refers to the firm’s continuous ability to meet maturing obligations. To ensure solvency,
the firm should be very liquid, which means larger current assets holdings. If the firm maintains a
relatively large investment in current assets, it will have no difficulty in paying claims of creditors
when they become due. However, there is a cost associated with maintaining a sound liquidity
position. A considerable amount of the firm’s funds will be tied up in current assets. Lets
understand this through this example.
Suppose, a firm has the following data:
Sales (100,000 units @ Rs. 15) 15,00,000
EBIT 1,50,000
Fixed Assets 5,00,000
The three possible current assets holdings of the firm are: Rs 5,00,000, Rs 4,00,000 and Rs 3,00,000. It
is assumed that fixed assets level is constant and profits do not vary with current assets levels.
The effect of the three alternative current assets policies:
Working Capital Policy Conservative Moderate Aggressive

A B C
Sales 15,00,000 15,00,000 15,00,000
EBIT 150,000 150,000 150,000
Current Assets 5,00,000 4,00,000 3,00,000
Fixed Assets 5,00,000 5,00,000 5,00,000
Total Assets 10,00,000 9,00,000 8,00,000
ROA (EBIT/Total Assets) 15% 16.67% 18.75%
CA/FA 1.00 0.80 0.60
Findings
 A (conservative policy) provides greatest liquidity (solvency) to the firm, but also the
lowest return on total assets.
 C (aggressive policy) provides highest return but provides lowest liquidity.

Notes
Unit
Unit12:
11:Working
WorkingCapital
CapitalManagement
Management
 B demonstrates a moderate policy and generates a return higher than alternative A but
lower than alternative C.
Policies for Financing Current Assets

Three types of financing may be distinguished as:
a) Long-term financing
b) Short-term financing
c) Spontaneous financing
Approaches to finance working capital:

Depending on the mix of short and long-term financing, the approach followed by a company may
be referred to as:
a) Matching Approach
b) Conservative Approach
c) Aggressive Approach
a) Matching (Hedging) Approach

Long-term financing will be used to finance fixed assets and permanent current assets and short-
term financing to finance temporary or variable current assets. E.g., a ten-year loan may be raised to
finance a plant with an expected life of ten years; stock of goods to be sold in thirty days may be
financed with a thirty-day commercial paper or a bank loan.
As the level of firm’s fixed assets and permanent current assets increases, the long-term financing
level also increases. The temporary or variable current assets are financed with short-term funds
and as their level increases, the level of short-term financing also increases. Under this plan, no
short-term financing will be used if the firm has a fixed current asset need only.
b) Conservative Approach
Under this plan, the firm finances its permanent assets and also a part of temporary current assets
with long-term financing. In the periods when the firm has no need for temporary current assets,
the idle long-term funds can be invested.Under this approach the firm has less risk of facing the
problem of shortage of funds.

Notes
Corporate Finance
c) Aggressive Approach
Under an aggressive policy, the firm finances a part of its permanent current assets with short-term
financing. Some extremely aggressive firms may even finance a part of their fixed assets with short-
term financing. The relatively large use of short-term financing makes the firm riskier.
Hence, a balanced approach is to finance permanent current assets by long-term sources and
‘temporary’ current assets by short-term sources of finance. Theoretically, short-term debt is
considered to be risky and costly to finance permanent current assets.
12.6 Cash Management

Introduction
Cash is the basic input needed to keep the business running on a continuous basis. It is also the
final output expected to be realized by selling the service or product manufactured by the firm. The
firm should keep sufficient cash, neither more nor less.Cash management is concerned with the
managing of:
i. Cash flows into and out of the firm,
ii. Cash flows within the firm, and
iii. Cash balances held by the firm at a point of time by financing deficit or investing surplus
cash.
Meaning of Cash
Cash is the money which a firm can disburse immediately without any restriction. The term ‘cash’
with reference to cash management is used in two senses. In a narrow sense, it is used broadly to
cover currency and generally accepted equivalents of cash, such as cheques, drafts and demand
deposits in banks. The broad view of cash also includes near-cash assets, such as marketable
securities and time deposits in banks

Notes
Importance of Cash Management

 It is the most significant and the least productive asset that a firm holds. It is used to pay
the firm’s obligations.
 The aim of cash management is to maintain adequate control over cash position.
 It is also important because it is difficult to predict cash flows accurately
 Inflows and outflows of cash do not occur at the same time.
Dimensions of cash management

There are various aspects of cash management, which are discussed below:
 Cash planning: Cash inflows and outflows should be planned to project cash surplus or
deficit for each period of the planning period.
 Managing the cash flows: The cash inflows should be accelerated while, as far as possible,
the cash outflows should be decelerated
 Optimum cash level: The cost of excess cash and danger of cash deficiency should be
matched to determine the optimum level of cash balances.
 Investing surplus cash: The surplus cash balances should be properly invested to earn
profits.
Motives of Holding Cash

A firm may hold cash due to the following reasons:
a) The Transactions motive
b) The Precautionary motive
c) The Speculative motive
a) Transaction Motive
To conduct its business in the ordinary course. The inflows (receipts), and outflows
(disbursements) do not perfectly coincide or synchronize. At times, receipts exceed outflows
while, at other times, payments exceed inflows. To ensure that the firm can meet its obligations
when payments become due it must have an adequate cash balance.
b) Precautionary Motive
The precautionary motive is the need to hold cash to meet contingencies in the future. The
unexpected cash needs at short notice may be the result of: Floods, strikes, Bills may be
presented for settlement earlier than expected, unexpected slowdown in collection of accounts
receivables.Cancellation of some order for goods; and Sharp increase in cost of raw materials.
c) Speculative Motive
It refers to the desire of a firm to take advantage of opportunities which present themselves at
unexpected moments. While the precautionary motive is defensive in nature, Speculative
motive represents a positive and aggressive approach.Firms aim to exploit profitable
opportunities and keep cash in reserve to do so.

Notes
Corporate Finance
12.7 Cash Planning
Cash planning is a technique to plan and control the use of cash. It helps to anticipate the future
cash flows and needs of the firm and reduces the possibility of idle cash balances.Cash planning
protects the financial condition of the firm by developing a projected cash statement, from a
forecast of expected cash inflows and outflows, for a given period. Cash plans are very crucial in
developing the overall operating plans of the firm. It may be done on daily, weekly or monthly
basis. The period and frequency of cash planning generally depends upon the size of the firm and
philosophy of the management. Large firms prepare daily and weekly forecasts. Medium-size firms
usually prepare weekly and monthly forecasts. Small firms may not prepare formal cash forecasts
because of the non-availability of information
Cash Forecasting and Budgeting

Cash budget is a device to plan for and control cash receipts and payments.A cash budget is a
summary statement of the firm’s expected cash inflows and outflows over a projected time period.It
gives information on the timing and magnitude of expected cash flows and cash balances over the
projected period. This information helps the financial manager to determine the future cash needs
of the firm. Generally, forecasts covering periods of one year or less are considered short-
term.Those extending beyond one year are considered long-term.
a) Short-term Cash Forecasts

The aims of preparing short-term cash forecasts are:
 To determine operating cash requirements

 To anticipate short-term financing.
 To manage investment of surplus cash.
Approaching for preparing cash forecasts:

For making forecasts of cash receipts and payments, two approaches are used in practice:
(i) The receipts and disbursements method

(ii) The adjusted net income method
The receipts and disbursements method are generally employed to forecast for limited periods,
such as a week or a month. The adjusted net income method, on the other hand, is preferred for
longer durations ranging from a few months to a year. Both methods have their pros and cons
i. Receipts and disbursements method

This approach is employed to forecast for shorter periods and in it, the individual items of receipts
and payments are identified and analyzed.Cash outflows could be categorized as:
(i) operating outflows: cash purchases, payments of payables, advances to suppliers, wages
and salaries and other operating expenses,
(ii) capital expenditures,
(iii) contractual payments: repayment of loan, interest and tax payments; and
(iv) Discretionary payments: ordinary and preference dividend.
Such categorization helps in determining avoidable expenditures. Once the forecasts for cash
receipts and payments have been developed, they can be combined to obtain the net cash inflow or
outflow for each month. The net balance for each month would indicate whether the firm has
excess cash or deficit. The peak cash requirements would also be indicated. If the firm has a policy

Notes
of maintaining some minimum cash balance, arrangements must be made to maintain this
minimum balance in periods of deficit.
ii. Adjusted net income method

This method of cash forecasting involves the tracing of working capital flows. Two objectives of the
adjusted net income approach are: (i) to project the company’s need for cash at a future date and (ii)
to show whether the company can generate the required funds internally, and if not, how much
will have to be borrowed or raised in the capital market.The adjusted net income method uses
profit and loss statement and balance sheet to work out cash flows. As cash flows are difficult to
predict, a financial manager does not base his forecasts only on one set of assumptions.He
considers possible scenarios and performs a sensitivity analysis.
b) Long-term Cash Forecasting

Prepared to give an idea of the company’s financial requirements in the distant future. Not as
detailed as the short-term forecasts are. Once a company has developed a long-term cash forecast, it
can be used to evaluate the impact of new product developments or plant acquisitions on the firm’s
financial condition, for three, five, or more years in the future.
The main uses of the long-term cash forecasts are:
 It indicates the company’s future financial needs, especially its working capital
requirements.
 It helps to evaluate proposed capital projects. It pinpoints the cash required to finance
these projects as well as the cash to be generated by the company to support them.
 It helps to improve corporate planning. Long-term cash forecasts compel each division to
plan for the future and to formulate projects carefully.
 Long-term cash forecasts may be made for two, three or five years.
 Long-term cash forecasting reflects the impact of growth, expansion or acquisitions; it also
indicates financing problems arising from these developments.
12.8 Managing Cash Collections and Disbursements

Financial manager should ensure that there does not exist a significant deviation between projected
cash flows and actual cash flows. To achieve this, cash management efficiency will have to be
improved through a proper control of cash collection and disbursement.
Accelerating Cash Collections

Cash collections can be accelerated by reducing the lag or gap between the time a customer pays
bill and the time the cheque is collected and funds become available for the firm’s use.The amount
of cheques sent by customer which are not yet collected is called collection or deposit float.
Decentralized Collections:
A large firm can speed up its collections by following a decentralized collection procedure. It is a
system of operating through a number of collection centers, instead of a single collection center
centralized at the firm’s head office.Decentralized collection system saves mailing and processing
time which reduces the deposit float and the financing requirements.
Suppose a company has credit sales of Rs 146 crore per year. Its collections will average Rs 40 lakh
per day (146 crore ÷ 365). If the company could reduce its mailing and processing time from five
days to three days and deposit cheques into the bank two days earlier, outstanding balance would
be reduced by Rs 80 lakh. If the annual borrowing rate was 18%, the company has saved an

Notes
Corporate Finance
opportunity cost of Rs 14.40 lakh on annual basis. Decentralized collection system results in
potential savings which should be compared with the cost of maintaining the system.
Lock-box System:
This system helps the firm to eliminate the time between the receipt of cheques and their deposit in
the bank. The firm establishes a number of collection centers, considering customer locations and
volume of remittances.At each center, the firm hires a post office box and instructs its customers to
mail their remittances to the box. The firm’s local bank is given the authority to pick up the
remittances directly from the local-box. The bank picks up the mail several times a day and
deposits the cheques in the firm’s account. For the internal accounting purposes of the firm, the
bank prepares detailed records of the cheques picked up.
Controlling Disbursements
The firm should make payments using credit terms to the fullest extent.There is no advantage in
paying sooner than agreed. By delaying payments as much as possible, the firm makes maximum
use of trade credit as a source of funds. Suppose a company purchased raw materials worth Rs 730
million in 2020 and followed the policy of paying within credit terms offered by the supplier. If the
company paid one day earlier, creditors’ balance would decline by one day’s purchase. Trade credit
would decrease by Rs 2 million (Rs 730 million/ 365).If the interest rate is 18%, the company’s
interest costs will increase by Rs 3,60,000 on an annual basis.
Delaying disbursement results in maximum availability of funds. However, the firms that delay in
making payments may endanger its credit standing. This can put the firm in difficulties in
obtaining enough trade credit. Also, the suppliers may build implicit costs in the prices of goods
supplied, and may also reduce the quality. On the other hand, paying early may not result in any
substantial advantage to the firm unless cash discounts are offered. Thus, keeping in view the
norms of the industry, the firm should pay within the terms offered by the suppliers.
Disbursement or Payment Float:

When the firm’s actual bank balance is greater than the balance shown in the firm’s books, the
difference is called disbursement or payment float. The difference between the total amount of
cheques drawn on a bank account and the balance shown on the bank’s books is caused by transit
and processing delays. If the financial manager can accurately estimate when the cheques issued
will be deposited and collected, he or she can invest the ‘float’ during the float period to earn a
return.
12.9 Determining the Optimum Cash Balance

A firm maintains the operating cash balance for transaction purposes. The amount of cash balance
depends on the risk-return trade-off.The firm should maintain optimum cash balance, neither too
high nor too low.
Baumol’s Model
The Baumol model of cash management provides a formal approach for determining a firm’s
optimum cash balance under certainty.It is a model that provides for cost-efficient transactional
balances and assumes that the demand for cash can be predicted with certainty and determines the
optimal conversion size.
Firm sells securities and starts with a cash balance of C rupees. As the firm spends cash, its cash
balance decreases steadily and reaches to zero. The firm replenishes its cash balance to C rupees by
selling marketable securities. This pattern continues over time. As the cash balance decreases
steadily, the average cash balance will be: C/2.

Notes
Unit 11:
The firm incurs a holding cost for keeping the cash balance.It is an opportunity cost; i.e. the return
foregone on the marketable securities. If the opportunity cost is k, then the firm’s holding cost for
maintaining an average cash balance is:
Holding cost = k(C/2) (1)
The firm incurs a transaction cost whenever it converts its marketable securities to cash. Total
number of transactions during the year will be total funds requirement, T, divided by the cash
balance, C, i.e., T/C.
If per transaction cost is c, then the total transaction cost will be:
Transaction cost = c(T/C) (2)
The total annual cost of the demand for cash will be:
Total cost = k(C/2) + c(T/C) (3)
The holding cost increases as demand for cash, C, increases. However, the transaction cost reduces
because with increasing C, the number of transactions will decline. Thus, there is a trade-off
between the holding cost and the transaction cost.
Assumptions of Baumol’s model:
 The firm is able to forecast its cash needs with certainty.

 The firm’s cash payments occur uniformly over a period of time.
 The opportunity cost of holding cash is known and it does not change over time.
 The firm will incur the same transaction cost whenever it converts securities to cash.
Formula for the optimum cash balance

The optimum cash balance, C is obtained when the total cost is minimum:
Where:
C is the optimum cash balance

Notes
Corporate Finance
c is the cost per transaction
T is the total cash needed during the year
k is the opportunity cost of holding cash balance
Example: Company ABC estimates its total cash requirement as Rs 2 crore next year.
Opportunity cost of funds is 15% per annum. The company will have to incur Rs 150 per
transaction when it converts its short-term securities to cash. Determine the optimum cash balance.
How much is the total annual cost of the demand for the optimum cash balance?
The Annual cost will be:

Total cost = 150(20,000,000/200,000) +0.15(200,000/2)
= 150(100) + 0.15(100,000)
= 15,000 + 15,000
= Rs 30,000
The Miller-Orr Model

In practice, firms do not use their cash balance uniformly nor are they able to predict daily cash
inflows and outflows. The Miller-Orr (MO) model overcomes this shortcoming and allows for daily
cash flow variation.MO model provides for upper control limit and the lower control limit as well
as a return point.
If the firm’s cash flows fluctuate randomly and hit the upper limit, then it buys sufficient
marketable securities to come back to the return point. When the firm’s cash flows hit the lower
limit, it sells sufficient marketable securities to bring the cash balance back to the return point.The
firm sets the lower control limit as per its requirement of maintaining minimum cash balance.The
difference between the upper limit and the lower limit depends on the following factors:
• The Transaction Cost (c)
• The Interest Rate (i)
• The Standard Deviation (σ) of Net Cash Flows.
The formula for determining the distance between upper and lower control limits (called Z) is:

Notes
The upper and lower limits will be far off from each other (i.e., Z will be larger) if transaction cost is
higher or cash flows show greater fluctuations. The limits will come closer as the interest increases.
Z is inversely related to the interest rate. It is noticeable that the upper control limit is three times
above the lower control limit and the return point lies between the upper and the lower limits.
Thus, Upper Limit = Lower Limit + 3Z
Return Point = Lower Limit + Z
The net effect is that the firms hold the average cash balance equal to:
Average Cash Balance = Lower Limit + 4/3 Z
The MO Model isan attempt to make the Baumol Model more realistic as regards the pattern of
cash flows. As against the assumption of uniform and certain levels of cash balances in the Baumol
Model, the MO Model assumes that cash balances randomly fluctuate between an upper bound (h)
and a lower bound (O). When the cash balances hit the upper bound, the firm has too much cash
and should buy enough marketable securities to bring the cash balances back to the optimal bound
(z). When the cash balances hit zero, the financial manager must return them to the optimum
bound (z) by selling/ converting securities into cash
12.10 Investing Surplus Cash in Marketable Securities

The excess amount of cash held by the firm to meet its variable cash requirements and future
contingencies should be temporarily invested in marketable securities, which can be regarded as
near moneys. A number of marketable securities may be available in the market.
Selecting Investment Opportunities

In choosing among alternative investments, the firm should examine three basic features of
security:
 Safety:
The firm would invest in very safe securities. Firm would tend to invest in the highest yielding
marketable securities.Higher the default risks, higher the return from security. Low risk securities
will earn low return.
 Maturity:
Maturity refers to the time period over which interest and principal are to be made. For safety
reasons the firms for the purpose of investing excess cash prefer short-term securities.
 Marketability:
Marketability refers to convenience and speed with which a security or an investment can be
converted into cash. As the funds invested in marketable securities will be needed by the firm in
near future, it would invest in the securities that are readily marketable.
Types of Short-term Investment Opportunities
 Treasury bills
Treasury bills (TBs) are short-term government securities. The difference between the issue price
and the redemption price, is return on treasury bills.
 Commercial papers

Notes
Corporate Finance
Commercial papers (CPs) are short-term, unsecured securities issued by highly creditworthy large
companies. They are issued with a maturity of three months to one year.
 Certificates of deposits
Certificates of deposits (CDs) are papers issued by banks acknowledging fixed deposits for a
specified period of time. CPs are negotiable instruments that make them marketable securities
 Bank deposits
A firm can deposit its temporary cash in a bank for a fixed period of time. The interest rate depends
on the maturity period.
 Inter-corporate deposits
Inter-corporate lending/borrowing or deposits (ICDs) is a popular short-term investment
alternative for companies in India. Generally, a cash surplus company will deposit (lend) its funds
in a sister or associate company or with outside companies with high credit standing.
 Money market mutual funds

Money market mutual funds (MMMFs) focus on short-term marketable securities such as TBs, CPs,
CDs or call money. They have a minimum lock-in period of 30 days, and after this period, an
investor can withdraw his or her money any time at a short notice or even across the counter in
some cases.
12.11 Receivables Management

Introduction
A firm may sell its goods and services either on cash or on credit. Trade credit happens when a firm
sells its products or services on credit. This trade credit creates account receivables.A credit sale has
three characteristics:
 Involve element of Risk.

 It is based on economic value.
 It implies futurity.
Debtors constitute a substantial portion of current assets of several firms. Granting credit and
creating debtors amount to blocking of the firm’s funds. The interval between the date of sale and
the date of payment has to be financed out of working capital.
Objectives
 Firms sell goods on credit to push their sales. Thus, receivables are treated as a marketing
tool.
 However, credit sales involve risk and cost also.
 Management should weigh the benefits as well as cost to determine the goal of receivables
management.
Costs related to Receivables

There are several costs associated with the receivable such as:
a) Collection cost
b) Capital cost
c) Delinquency cost
d) Default cost

Notes
a) Collection cost: These are the administrative costs incurred in collecting the receivables
from the customers and includes:
i. additional expenses on the creation and maintenance of a credit department.
ii. expenses involved in acquiring credit information.
a) Capital Cost:The increased level of accounts receivable is an investment in assets. They

have to be financed involving a cost.
b) Delinquency Cost: This cost arises out of the failure of the customers to meet their
obligations when payments on credit sales become due.
i. blocking-up of funds for an extended period,
ii. cost associated with steps that have to be initiated to collect the overdues.
c) Default Cost: Firm may not be able to recover the overdues because of the inability of the
customers. Such debts are treated as bad debts and have to be written off as they cannot be
realized.
The main benefit of credit sales is increase in sales.Firm may grant trade credit either to increase
sales to existing customers or attract new customers. Firm may extend credit to protect its current
sales against emerging competition.
Optimum level of Receivables

The decision to commit funds to receivables will be based on a comparison of the benefits and costs
involved, while determining the optimum level of receivables.
Dimensions of Receivables management

a) Credit policies
b) Credit terms
c) Collection policies
a) Credit Policies
The credit policy of a firm provides the framework to determine:whether or not to extend credit to
a customer and how much credit to extend. The credit policy decision of a firm has two broad
dimensions:
 Credit standards
 Credit analysis.
Credit Standards:
The term ‘credit standards’ represents the basic criteria for the extension of credit to customers.The
quantitative basis of establishing credit standards are factors such as credit ratings, credit
references, average payments period and certain financial ratios.Credit Standards may be:
i. Tight or restrictive
ii. Liberal or non-restrictive
The factors to be considered while deciding whether to relax credit standards or not are

Notes
Corporate Finance
 Collection cost
 Average collection period/cost of investment in accounts receivable
 Level of bad debt losses
a) Level of sales
Collection Costs:
The implications of relaxed credit standards are:
i. More credit
ii. A large credit department to service accounts receivable and related matters
iii. Increase in collection costs
Average Collection Period:
• A relaxation in credit standards, would lead to higher average accounts receivable.
• credit is extended liberally to even less creditworthy customers.
• It would result in a higher level of accounts receivable.
In contrast, a tightening of credit standards would signify
i. a decrease in sales and lower average accounts receivable, and
ii. an extension of credit limited to more creditworthy customers who can promptly pay their
bills and, thus, a lower average level of accounts receivable.
Bad Debt Expenses:
Can be expected to increase with relaxation in credit standards and decrease if credit standards
become more restrictive.
Sales Volume:
• As standards are relaxed, sales are expected to increase.
• A tightening is expected to cause a decline in sales.
Effect of Relaxation of Standards:
Example: A firm is currently selling a product @ Rs 10 per unit. The most recent annual sales
(all credit) were 30,000 units.The variable cost per unit is Rs. 6 and the average cost per unit, given a
sales volume of 30,000 units, is Rs 8. The total fixed cost is Rs 60,000. The average collection period
may be assumed to be 30 days.

Notes
Unit 11:
The firm is contemplating a relaxation of credit standards that is expected to result in a 15%
increase in units’ sales.The average collection period would increase to 45 days with no change in
bad debt expenses. It is also expected that increased sales will result in additional net working
capital to the extent of Rs 10,000. The increase in collection expenses may be assumed to be
negligible. The required return on investment is 15%. Should the firm relax the credit standard?The
decision to put the proposed relaxation in the credit standards into effect should be based on a
comparison of
a) additional profits on sales

b) cost of the incremental investments in receivables.
a) Profit on Incremental Sales:
b) Cost of Marginal Investment in Receivables:
This cost can be computed by finding the difference between the cost of carrying receivables before
and after the proposed relaxation in credit standards.
Turnover of accounts receivable:
Total cost of sales:
Present plan
= Number of units x cost per unit = 30,000 x Rs 8 = Rs 2,40,000
Proposed plan
= (30,000 x Rs 8) + (4,500 x Rs 6) = Rs 2,67,000
Average investment in accounts receivable:
Present plan
= Rs 2,40,000/12 = Rs 20,000
Proposed plan

Notes
Corporate Finance
= Rs 2,67,000/8 = Rs 33,375
The cost of marginal investments in accounts receivable:
This is the difference between the average investments in accounts receivable under
• the proposed plan and

• under the present plan
Average investments with proposed plan
Rs 33,375
Less average investment with present plan
Rs. 20,000
Marginal investments
Rs. 13,375
Given 15% as required return on the investments, the cost =
Rs 13,375 x 15100
Rs 2,006.25
This is an opportunity cost in that the firm would earn this amount from alternative uses if the
funds are not tied up in additional accounts receivable.
Cost of working capital:
Rs 10,000 x 0.15 = Rs 1,500.
Additional profits on increased sales as a result of relaxed credit standards is Rs 18,000. Cost of
incremental investments in accounts receivable is Rs 2,006.25 and working capital is Rs 1,500. The
firm should relax the standards such an action would lead to an overall increase in the profits of the
firm by Rs 14,493.75
Credit Analysis
A firm should develop procedures for evaluating credit applicants. Two steps involved in the credit
investigation process:
 obtaining credit information
 analysis of credit information
 Obtaining Credit Information
Internal Sources:

Notes

Unit 11:
Customers are asked to give details of financial operations.They are also required to furnish trade
references.This type of information is obtained from internal sources of credit information.
External Sources:
The availability of information from external sources depends upon the development of
institutional facilities.In India, the external sources of credit information are not as developed.
i. Financial Statements
ii. Bank References
iii. Trade References
iv. Credit Bureau Reports
 Analysis of Credit Information
Although there are no established procedures to analyze the information, the firm should devise
one to suit its needs.
The analysis should cover two aspects:
• Quantitative: Preparing an Aging Schedule of the accounts payable of the applicant as

well as calculate the average age of the accounts payable. Ratio analysis of the liquidity,
profitability and debt capacity of the applicant. Trend analysis over a period of time.
• Qualitative: The subjective judgement would cover aspects relating to the quality of
management. Here, the references from other suppliers, bank references and specialist
bureau reports would form the basis for the conclusions to be drawn.
b. Credit Terms
Credit terms specify the repayment terms of receivables.A firm should determine the credit terms
on the basis of cost-benefit trade-off.Credit terms have three components:
i. Credit period
ii. Cash discount
iii. Cash discount period
For e.g., ‘2/10 net 30’. 2 signifies the rate of cash discount (2%), which will be available to the
customers if they pay the overdue within the stipulated time.10 represents the time duration (10
days) within which a customer must pay to be entitled to the discount. 30 means the maximum
period for which credit is available and the amount must be paid in any case before the expiry of 30
days.
The cash discount has implications for the sales volume, average collection period/average
investment in receivables, bad debt expenses and profit per unit.In taking a decision regarding the
grant of cash discount, the management has to see what happens to these factors if it initiates
increase, or decrease in the discount rate.
Example:Effects of Increase in Cash Discounts

Notes
Corporate Finance
Example: In our previous example, suppose the firm is planning to allow 2% discount for
payment within 10 days after a credit purchase. Sales will increase by 15% and the average
collection period will drop to 15 days after the discount. Return on investment expected by the firm
is 15%, and 60% of the total sales will be on discount. Should the firm implement the proposal?
i. Profit on sales:
The profit on sale = sale of additional units multiplied by the difference between the sales price and
the variable cost per unit
= 4,500 (Rs 10 – Rs 6) = 4,500 x Rs 4 = Rs 18,000
ii. Saving on average collection period:
This saving is what would have been earned on the reduced investments in accounts receivable
as a result of the cash discount.
• Average investment in accounts receivable
= Cost of sales/Receivables turnover.
Present plan (without discount)
Proposed plan (with discount)
= Rs 11,125
Thus, if cash discount is allowed, the average investments in receivables will decline by Rs 8,875
(i.e., Rs 20,000 – Rs 11,125). Given a 15% rate of return, the firm could earn Rs 1,331.25 on Rs 8,875.
Thus, the saving resulting from a drop in the average collection period is Rs 1,331.25.The total
benefits associated with the cash discount:
Cash discount: The cost involved in the cash discount on credit sales, that is, 2% of credit sales:
= 0.02 x Rs 2,07,000 (i.e. 0.60 Rs 3,45,000)
= Rs 4,140
Against a cost of Rs 4,140, the benefit from initiating cash discount is Rs 19,331.25;
i.e. net gain of Rs 15,191.25 (Rs 19,331.25 – Rs 4,140).
The firm should adopt the proposal to allow 2% cash discount for payment within 10 days of the
credit purchase by the customers.

Notes
Unit 11:
Credit Period
Effect of Increase in Credit Period
Illustration:Suppose, a firm is planning to increase the credit period from 30 to 60 days. The
average collection period which is at present 45 days is expected to increase to 75 days. It is also
likely that the bad debt expenses will increase from the current level of 1% to 3% of sales.Total
credit sales are expected to increase from the level of 30,000 units to 34,500 units. The present
average cost per unit is Rs 8, the variable cost and sales per unit is Rs 6 and Rs 10 per unit
respectively. Assume the firm expects a rate of return of 15%. Should the firm extend the credit
period?
Solution:
(i) Profit on additional sales:
= (Rs 4 x 4,500) = Rs 18,000
(ii) Cost of additional investments in receivables:
= Average investments with the proposed credit period less average investments in receivables
with the present credit period:
Proposed plan:
= Cost of sales/Turnover of receivables
Present plan:
Additional investment in accounts receivable:
= Rs 55,625 – Rs 30,000
= Rs 25,625
Cost of additional investment at 15%:
= 0.15 x Rs 25,625
= Rs 3,843.75.
(iii) Additional bad debt expenses:
Bad debt with proposed credit period
= 0.03 x Rs 3,45,000 = Rs 10,350
Bad debt with present credit period

Notes
Corporate Finance
= 0.01 x Rs 3,00,000 = Rs 3,000
Additional bad debt expense
= (Rs 10,350 - Rs 3,000) = Rs 7,350
The incremental cost associated with the extension of the credit period is Rs 11,193.75 (Rs 3,843.75 +
Rs 7,350).
As against this, the benefits are Rs 18,000. There is, therefore, a net gain of Rs 6,806.25, that is, (Rs
18,000 – Rs 11,193.75). The firm should extend the credit period from 30 to 60 days.
c) Collection Policies
It refer to the procedures followed to collect accounts receivable when, after the expiry of the credit
period, they become due.
These policies cover two aspects:
 degree of effort to collect the overdues.
 type of collection efforts.
Degree of Collection Effort
To illustrate the effect of the collection effort, the credit policies of a firm may be categorized into
a) Strict
b) Lenient
The management has to consider a trade-off between liberal and tight policy.
The effect of tightening the collection:In the first place, the bad debt expenses would
decline.Moreover, the average collection period will be reduced. As a result of these two effects, the
firm will benefit and its profits will increase. But there would be a negative effect also.
• Increased collection costs.
• Decline in the volume of sales.
This may be because some customers may not like the pressure and intense efforts initiated by the
firm, and may switch to other firms.
Trade-off from Tight Collected Effort
Example:A firm is considering stricter collection policies. At present, the firm is selling 36,000
units on credit at a price of Rs 32 each. the variable cost per unit is Rs 25 while the average cost per
unit is Rs 29. average collection period is 58 days; and collection expenses amount to Rs 10,000. bad

Notes
Unit 11:
debts are 3%.If the collection procedures are tightened, additional collection charges amounting to
Rs 20,000 would be required, bad debts will be 1%;the collection period will be 40 days; sales
volume is likely to decline by 500 units. Assuming a 20% rate of return on investments. Should the
firm implement the decision?
Solution
(i) Bad debt expenses:
• Present plan:
(0.03 x Rs 11,52,000) = Rs 34,560
• Proposed plan:
(0.01 x Rs 11,36,000) = Rs. 11,360
• Savings in bad debt expenses:
= 23,200
(ii) Average collection period/average investment in receivables:
Savings in average investments (a – b) = 53,589
At 20% return, the firm would earn Rs 10,718 on this saving.
(iii) Sales volume: Since the sales volume will decline by 500 units, there would be a loss of Rs 3,500
(500 x Rs 7)
(iv) Additional collection charges = Rs 20,000.
• Thus, the total benefits from a tightening of the collection policy will be Rs 33,918 (Rs
23,200 + Rs 10,718) and the total cost will be Rs 23,500 (Rs 3,500 + Rs 20,000).
• Therefore, there would be a net gain of Rs 10,418 (Rs 33,918 – Rs 23,500).
• The firm should adopt the proposed strategy.
Type of Collection Efforts
After the credit period is over and payment remains due, the firm should initiate measures to
collect them. The effort should in the beginning be polite, but, with the passage of time, it should
gradually become strict.
The steps usually taken are:
i. letters and reminders to expedite payment
ii. telephone calls for personal contact
iii. personal visits
iv. help of collection agencies; and finally
v. legal action

Notes
Corporate Finance
vi. The firm should take stringent actions, like legal action, only after all other avenues have
been fully exhausted.
vii. They not only involve a cost but also affect the relationship with the customers.
viii. The aim should be to collect as early as possible; genuine difficulties of the customers
should be given due consideration.
Summary
 Working capital management is concerned with the management of current assets in
a firm. Management of working capital is an integral part of financial management. If
a firm focus more on Profitability, then its liquidity will be adversely affected, and on
the other hand, if it focuses more on liquidity, its profitability will be affected. Hence,
the firm has to strike a balance between the profitability and the liquidity.
 Gross working capital refers to the firm’s investment in current assets. Current assets
are the assets which can be converted into cash within an accounting year. E.g., cash,
short-term securities, debtors, bills receivable, stock (inventory). Net working capital
refers to the difference between current assets and current liabilities. Current
liabilities are those claims of outsiders which are expected to mature for payment
within an accounting year.
 The concept of operating cycle related to the time duration required to convert raw
material into inventories into sales and finally into cash. A firm needs to maintain
liquidity to purchase raw materials and pay expenses. Similarly, stocks of raw
material and work-in-process are kept to ensure smooth production. Also, stock of
finished goods is required to meet the demands of customers. Debtors are created
because goods are sold on credit for marketing and competitive reasons.
 Net Operating Cycle is the difference between gross operating cycle and payables
deferral period.
 There are various factors which affects the working capital requirement in the firm
such as Nature of Business, Market and Demand Conditions, Technology and
Manufacturing Policy, Credit Policy, Availability of Credit from Suppliers, Operating
Efficiency, Price Level Changes
 Depending on the mix of short and long-term financing, the approach followed by a
company may be referred to as Matching Approach, Conservative Approach and
Aggressive Approach
 Cash Management: The firm should keep sufficient cash, neither more nor less. Cash
management is concerned with the managing of: Cash flows into and out of the firm,
Cash flows within the firm, and Cash balances held by the firm at a point of time by
financing deficit or investing surplus cash.
 A firm may hold cash due to the following reasons: The Transactions motive, The
Precautionary motive and The Speculative motive
 Cash planning is a technique to plan and control the use of cash. It helps to anticipate
the future cash flows and needs of the firm and reduces the possibility of idle cash
balances. Cash planning protects the financial condition of the firm by developing a
projected cash statement, from a forecast of expected cash inflows and outflows, for a
given period. Cash plans are very crucial in developing the overall operating plans of
the firm.
 For making forecasts of cash receipts and payments, two approaches are used in
practice: The receipts and disbursements method and the adjusted net income method
 Financial manager should ensure that there does not exist a significant deviation
between projected cash flows and actual cash flows. To achieve this, cash
management efficiency will have to be improved through a proper control of cash
collection and disbursement.

Notes
Unit
Unit 12:
11: Working
Working Capital
Capital Management
Management
 The Baumol model of cash management provides a formal approach for determining
a firm’s optimum cash balance under certainty. It is a model that provides for cost-
efficient transactional balances and assumes that the demand for cash can be
predicted with certainty and determines the optimal conversion size.
 The optimum cash balance, C is obtained when the total cost is minimum:
 In practice, firms do not use their cash balance uniformly nor are they able to predict
daily cash inflows and outflows. The Miller-Orr (MO) model overcomes this
shortcoming and allows for daily cash flow variation. MO model provides for upper
control limit and the lower control limit as well as a return point.
 The net effect is that the firms hold the average cash balance equal to:
Average Cash Balance = Lower Limit + 4/3 Z
 The excess amount of cash held by the firm to meet its variable cash requirements and
future contingencies should be temporarily invested in marketable securities, which
can be regarded as near moneys. A number of marketable securities may be available
in the market such as Treasury bills, Commercial papers, Certificates of deposits,
Bank deposits, Inter-corporate deposits, Money market mutual funds.
 Receivables Management: A firm may sell its goods and services either on cash or on
credit. Trade credit happens when a firm sells its products or services on credit. This
trade credit creates account receivables. A credit sale has three characteristics: Involve
element of Risk, it is based on economic value, It implies futurity.
 There are several costs associated with the receivable such as: Collection cost, Capital
cost, Delinquency cost and Default cost.
 Dimensions of Receivables management are Credit policies, Credit terms and
Collection policies
Keywords
Working capital Management, Current Assets, Operating Cycle, Cash management, Receivables
Management, Credit Policy
Self Assessment
1. The average collection period for a firm measures the number of days
A. After a typical credit sale is made until the firm receives the payment
B. For a typical check to "clear" through the banking system
C. Beyond the end of the credit period before a typical customer payment is received
D. Before a typical account becomes delinquent
2. Which of the following does not result from liberalizing credit standards?
A. It leads to higher bad debt loss

B. It causes an increase in sales
C. It reduces the cost of collection
D. It increases the investment in receivables
3. Which of the following statements is true about the terms of trade credit 2/10, net 30?

Notes
Corporate Finance
A. 10% cash discount is offered for payment before 30 days
B. 2% cash discount is awarded for payment on the 30th day after purchase
C. 10% cash discount can be taken if paid by the second day after invoicing
D. No cash discount is offered from the eleventh day onwards after the date of purchase
4. Which of the following would NOT be a reasonable approach to reducing delinquencies?

A. send reminder letters
B. offer a trade discount
C. only accept cash
D. factor out all receivables
5. Which one of the following represents the correct order of the collections cycle?
A. send reminder letters, make telephone calls, sue the customer, hire a collection agency
B. send reminder letters, make telephone calls, hire a collection agency, sue the customer
C. make telephone calls, hire a collection agency, sue the customer, send reminder letters
D. sue the customer, make telephone calls, hire a collection agency, send reminder letters
6. Speculative motive of holding cash refers to
A. Holding the cash to utilize it in internal projects

B. Holding the cash for any future loss the company is expecting
C. Holding the cash to avail any future investment opportunity
D. Holding the cash to utilize it for international project
7. Marketable securities are primarily
A. short-term debt instruments.

B. short-term equity securities.
C. long-term debt instruments.
D. long-term equity securities.
8. Collection float is the __________.
A. total time between the mailing of the check by the customer and the availability of cash to
the receiving firm
B. time consumed in clearing the check through the banking system
C. time the check is in the mail
D. time during which the check received by the firm remains uncollected
9. Deposit float is the __________.
A. total time between the mailing of the check by the customer and the availability of cash to
the receiving firm
B. time consumed in clearing the check through the banking system
C. time the check is in the mail
D. time during which the check received by the firm remains uncollected

Notes
10. Concentration banking occurs when the firm __________.
A. moves cash from regional lockboxes to a centralized cash pool at a single institution
B. replaces their lockbox system with a system that involves the direct payment to the firm
C. reduces the control over the inflow and outflow of corporate cash
D. increases the quantity of cash balances that are "idle" (not earning a return)
11. The major current assets are _____________
A. cash and marketable securities

B. accounts receivable (debtors)
C. inventory (stock)
D. All of the above
12. Which of the following is an example of current liability:
A. accounts payable
B. bank overdraft
C. outstanding expenses.
D. All of the above
13. Net working capital refers to
A. total assets minus fixed assets.

B. current assets minus current liabilities.
C. current assets minus inventories.
D. current assets.
14. Which of the following would be consistent with a more aggressive approach to financing
working capital?
A. Financing short-term needs with short-term funds.

B. Financing permanent inventory buildup with long-term debt.
C. Financing seasonal needs with short-term funds.
D. Financing some long-term needs with short-term funds.
15. Permanent working capital:
A. varies with seasonal needs.

B. includes fixed assets.
C. is the amount of current assets required to meet a firm's long-term minimum needs?
D. includes accounts payable.

1. A 2. C 3. D 4. C 5. B
6. C 7. A 8. A 9. D 10. A

Notes
Corporate Finance
11. D 12. D 13. B 14. D 15. C
Review Questions
1. Explain the components of operating cycle.
2. Discuss the approaches to finance working capital
3. Analyze the Baumol’s model and Miller-Orr model of determining optimum cash balance
4. List the various dimensions of receivables management.
5. Discuss the various options available for Investing surplus cash.
Further Readings
Hill.
Publishing
4. https://www.investopedia.com/terms/w/workingcapitalmanagement.asp
5. https://www.accaglobal.com/an/en/student/exam-support-
resources/fundamentals-exams-study-resources/f9/technical-articles/wcm.html
6. https://corporatefinanceinstitute.com/resources/knowledge/finance/working-
capital-management/

Notes
Dr. Atif Ghayas, Lovely Professional University Unit 13: Corporate Governance

CONTENTS
Objectives
Introduction
13.1 Corporate Governance: Meaning
13.2 Theories of Corporate Governance
13.3 Corporate Governance and Human Resources
13.4 Evaluation of Performance of Board of Directors
13.5 Succession Planning: Introduction
13.6 Insider Trading: Introduction
Summary
Keywords
Self Assessment
Review Questions
Further Readings
Objectives
 explain the concept of corporate Governance.
 discuss the Importance of Corporate Governance.
 outline the regulatory framework in India and mandates.
 explain the theories of corporate governance.
 discuss the impact of Corporate Governance on HRM.
 analyze the evaluation procedure of Board of Directors.
 explain succession planning.
 list the steps in succession planning.
 discuss the Corporate Governance issues in Public Sector Undertakings.
 discuss the concept of Insider trading.
 learn from the lessons of corporate failure in Indian corporations.
Introduction
After discussing all the important functions of corporate finance, we will now shift our focus to
Corporate Governance. Corporate Governance is basically a detailed disclosure of information and
an account of an organization’s financial situation, performance, ownership and governance,
relationship with shareholders and commitment to business ethics and values.The relevance of
corporate governance has increased several times since the concept was introduced.Corporate
governance essentially involves balancing the interests of a company's many stakeholders, such as
shareholders, senior management executives, customers, suppliers, financiers, the government, and
the community.

Notes
Corporate Finance
13.1 Corporate Governance: Meaning

Corporate governance is a system of rules, policies, and practices that dictate how a company’s
board of directors manages and oversees the operations of a company. Corporate governance
includes principles of transparency, accountability, and security. It is the interaction between
various participants (Shareholder, Board of Director and Company Management) in shaping
corporation’s performance. It deals with determining ways to take effective strategic decisions and
developed added value to the stakeholder.
The principal Actors: Shareholders, Directors, Managers
Significance of Corporate Governance

 It shows a company's direction and business integrity.
 It helps companies build trust with investors and the community.
 It promotes financial viability by creating a long-term investment opportunity for market
participants.
Need for Corporate Governance

Corporate governance is needed due to the following reasons:
 To monitor the Corporate Performance

 It enhanced Investor’s Trust
 It helps in combating Corruption
 Helps in getting easy finance from Institutions
 Helps in enhancing Enterprise Valuation
 Reduced Risk of Corporate Crisis and Scandals
 Promotes Accountability
Principles in Corporate Governance

Corporate governance is based on various principles:
 Protection of shareholders rights

Notes
 Interests of other stakeholders

 Role and responsibilities of the board
 Responsible and ethical behavior
 Disclosure and transparency in reporting
Benefits of Corporate Governance
 It provides the proper incentives for the board and management to pursue objectives that
are in the interest of the company and shareholders
 It provides Shareholders with greater security on their investment.
 It ensures that shareholders are sufficiently informed on decisions concerning
fundamental issues like amendments of statutes or articles of incorporation, sale of assets,
etc.
Transparency
For a company, this means it allows its processes and transactions observable to outsiders. It also
makes necessary disclosures, informs everyone affected about its decisions, and complies with legal
requirements.Facts to be considered under the head Transparency:
 How transparent is your corporate board?

 Are the directors’ actions readily verifiable by internal and external audit?
 Is their leadership visible from the top to all the way down?
 Is transparency applicable to everyone?
Accountability
Shareholders are deeply interested in who will take the blame when something goes wrong in one
of a company's many processes. And even when everything goes smoothly as expected, knowing
that someone will be held accountable for future mishaps increases shareholders confidence, which
in turn increases their desire to invest more.It’s about having ownership over one’s actions whether
the consequences of those actions are good or bad.When the idea of accountability is approached
with this positive outlook, people will be more open to it as a means to improve their performance.
Facts to be considered under accountability
 How's the level of accountability in your corporate board.

 Are your directors there to simply fill in a seat while going through their board books, or
are they actively engaged in decisions and strategies for your company.
Security
A company is expected to make their processes transparent and their people accountable while
keeping their enterprise data secure from unauthorized access. Companies that experience security
breaches involving the exposure of their client’s personal information quickly lose their credibility.
Facts to be considered under security:
 How high is the awareness level of your company’s directors when it comes to security?
 How high is the awareness level of your company’s employees when it comes to security?
Value Based Organisation

Notes
Corporate Finance
Value Based Organisation is a living, breathing culture of shared core values among all employees.
This is different from the traditional structure which is a more machine-like, business approach that
focuses on an authoritarian type relationship or rigid organizational structure. A values-based
organization is a culture shaped by a clear set of ground rules establishing a foundation and
guiding principles for decision-making, actions and a sense of community. In a values-driven
culture, employees find alignment between their personal values and the organization’s values
creating a unified and motivated workforce. A strongly held values-based culture or purpose will
remain more stable over time characterized by productivity and employee commitment.
Regulatory framework in India and mandates

In recognition of the importance of corporate governance as an integral part of corporate financial
practices, the SEBI has mandated corporate governance in the listing requirement in Clause 49 of
the Listing Agreement.The main elements of this clause relate to:
I. Board of Directors
II. Audit Committee
III. Subsidiary Companies
IV. CEO/CFO Certification
V. Report on Corporate Governance
VI. Compliance
I. Board of Directors
(A) Composition of Board of Directors:
 The Board of Directors of the company should consist of at least 50% non-executive
directors.
 At least one-third or one-half of the Board should comprise independent directors in case
of non-executive and executive chairman respectively.
 An independent director means a non-executive director who:
 apart from receiving directors’ remuneration, does not have any material pecuniary
relationship/ transaction with the company/its promoters/directors/senior management
/ holding company/ subsidiary company and associates.
 is not related to promoters/persons occupying management position at the Board/one
level below that.
 has not been an executive in the preceding three financial years.
 is/was not a partner/executive during the preceding three years of the statutory/internal
audit firm associated with the company/the legal/consulting firm having a material
association with the company.
 is not a material supplier / service provider / customer / lessee of the company.
 is not a substantial shareholder owning two per cent or more of the voting shares.
Nominee directors would be deemed to be independent directors.
(B) Non-executive Directors’ Compensation and Disclosures
 Fee/compensation including stock options, paid to all non-executive directors should be

approved by the shareholders.
(C) Other Provisions as to Board and Committees
 The Board of Directors should meet at least four times a year.

 A director can be a member of 10 committees or act as chairman of five committees across
all companies in which he is a director.

Notes
(D) Code of Conduct:
 The Board should periodically review compliance reports of all laws applicable to the
company.
 It should also lay down a code of conduct for all Board members and senior management,
who should affirm compliance with the code on an annual basis.
II. Audit Committee

(A) Qualified and Independent Audit Committee:
 A qualified and independent Audit Committee should be set up with at least three
member-directors, two-thirds being independent.
 All members should be financially literate (i.e., they should possess the ability to read and
understand the basic financial statements) and at least one member should have
accounting or related financial management expertise.
 The chairman of the audit committee should be an independent director and the company
secretary would be its ex-officio secretary.
(B) Meeting of Audit Committee
 The committee should meet at least four times in a year.

(C) Powers of Audit Committee
 The powers of the Audit Committee should include—investigating any activity within its
terms of reference, seeking information from any employee, obtaining outside legal/other
professional advice and securing attendance of outsiders with relevant expertise.
(D) Role of Audit Committee
 Overview of the financial reporting process to ensure correctness, sufficiency and

credibility of the financial statements;
 to recommend the appointment/ re-appointment/ replacement of auditors and their fee,
review with the management
(a) the annual and quarterly financial statements for submission to the Board for approval
(b) performance of auditors/ adequacy of internal control systems,
 review the adequacy of internal audit function,

 review the findings of any internal investigation into suspected fraud/irregularity/failure
of internal control systems of a material nature,
 look into reasons for substantial default in payment to depositors/creditors/debenture
holders and so on,
 review the functioning of the ‘whistle blower’ mechanism and so on.
(E) Review of Information by Audit Committee
 Management discussion/analysis of financial condition/result of operations

 Statement of significant related party transactions and
 Letter of internal control weaknesses by the auditors.

Notes
Corporate Finance
III. Subsidiary Companies
 A material non-listed Indian subsidiary company should have on its Board, at least one
independent director of the holding company.
 The minutes of its Board meetings should be placed at the Board meeting of the listed
holding company.
 Its financial statements should also be reviewed by the audit committee of the listed
company.
IV. Disclosures
The disclosure requirements of the corporate governance clause pertain to:
 Basis of related party transactions, disclosure of accounting treatment, risk management,

proceeds from public/rights/preferential issues, remuneration of directors, management
discussion/analysis report, and information to shareholders on the
appointment/reappointment of a director.
V. CEO/CFO Certification
The CEO and the CFO should certify to the Board of Directors that:
 the financial statements present a true and fair view

 no transaction is fraudulent, illegal/violative of the code of conduct
 they accept full responsibility for establishing/maintaining internal controls and
 they have indicated to the auditors/audit committee significant changes in internal
control/accounting policies and instances of significant frauds which they became aware
of.
VI. Report on Corporate Governance
 The annual reports should contain a separate section on Corporate Governance.

 Non-compliance of any mandatory requirement with reasons and the extent of adoption
of non-mandatory requirements should be highlighted.
 Companies should submit a quarterly report signed by the compliance officer/ CFO, to
the stock exchanges, within 15 days from the close of the quarter in the prescribed format.
VII. Compliance
 The company should annex with the directors’ report to the shareholders, a certificate
from the auditors/company secretaries regarding compliance with the conditions of
corporate governance.
 This should also be sent to the stock exchange, along with the company’s annual report.
 Non-mandatory requirements may be implemented at the discretion of the company.
13.2 Theories of Corporate Governance

There are mainly four theories of Corporate governance.
 The Agency Theory

Notes
 The Stewardship Theory

 The Stakeholder Theory
 The Political Theory
The Agency Theory

Main concern is to develop rules and incentives, to eliminate or minimize the conflict of interests
between owners and managers. The firm devises rules and incentives at is own, in additions to
legal regulations in a country.
The Stewardship Theory

This theory views managers as stewards.They are self-directed and are motivated by high
achievements and responsibility in discharging their duties. In this theory, managers are goal-
oriented and self-motivated.
The Stakeholder Theory

Based on the premise that the fundamental responsibility of managers is to maximize the total
wealth of all stakeholders of the firm, rather than only the shareholders’ wealth.
The Political Theory

This theory states that it is the government that decides the allocation of control, rights,
responsibility, profit etc. between owners, managers, employees and other stakeholders. The
corporate governance efforts will depend on the allocated powers of the stakeholders.
13.3 Corporate Governance and Human Resources

Corporate governance systems are the systems through which a company is controlled and
directed.Strategic human resource management (SHRM) is based on the belief that human resource
decisions must be aligned with the strategy of the company. How does corporate governance
impact the decisions related to strategic human resource management?
Archetypes of Corporate Governance Systems

The shareholder value model:In this model, market logics dominate: the interests of the
shareholders are paramount. The culture is unitary: the firm is a harmonious team (top to bottom)
united in the pursuit of shareholder value.
The communitarian stakeholder model:Pluralist, democratic logics drive this model, which
recognizes and focuses on the legitimate interests of other stakeholders — from employees to the
community at large.
The enlightened shareholder value model:This is a hybrid model that represents a tempered
version of the shareholder value model. The unitary culture built on shareholder value dominates,
but with some (enlightened) recognition for the business case of other interests (e.g., stakeholder
interests, social values).
The employee-ownership model:This is a second hybrid that represents a tempered version of the
communitarian governance model. Employees own or partially own the firm. They recognize the
needs of all stakeholders but are also focused on gaining a return on their investment as
shareholders — in essence, a pluralist culture that combines democratic and market logics.
Each of these different corporate governance typologies impacts a firm’s human resource choices
and the implementation of those choices in different ways.Shareholder value firms have control
and calculative HR policies intended to ensure employee compliance and employee efficiency.A

Notes
Corporate Finance
few high value employees receive a disproportionate level of compensation.Communitarian

stakeholder firms feature a commitment to people.
Communitarian stakeholder firms trade the low-trust board-employee mentality of shareholder
value firms for a dynamic high trust approach.The hybrid models offer a mix of these two HR
approaches. Enlightened shareholder value firms temper the control/calculative practices of
shareholder value firms with commitment/collaborative practices. While a few “star” employees
are highly paid, the firm tries to engage less value-adding and less scarce employees.The employee-
ownership hybrid tempers the high commitment/collaborative practices of the communitarian
stakeholder model with some control/calculative practices. Thus, the firm pushes training and
development but contracts will include transactional features such as incentive-based pay for
performance.
Business Application
Each of the four models has important challenges to overcome. The transactional human resource
relationships of the shareholder value model promote short-termism and low trust. The
communitarian model can be unrealistic — can all stakeholder interests be truly satisfactorily
addressed? The enlightened shareholder value and employee-ownership hybrid models have their
own drawbacks. The inclusive HR rhetoric of the enlightened shareholder value is refuted by
practices such as rewarding a few high-value employees at the expense of job insecurity for the
majority of employees.
Meanwhile, employee-ownership firms promote employee involvement, but as shareholders,
employee owners support transactional HR practices to protect their investment.One way to
overcome these inconsistencies and challenges is through a corporate sustainability frame, which
mandates a set of corporate values and a culture that ensures the long-term survival and prosperity
of the firm. Through independent boards, corporate sustainability not only helps resolve the
challenges described above, but also reinforces the legitimacy of the firm.
 Elements that a corporate sustainable approach to human resources might entail.

 Creating a high trust dynamic across all levels of employment.
 Implementing employee share ownership linked to a long-term commitment to firm and
market value.
 Reinforcing the legitimacy of the firm through sustainability, ethics and diversity.
 Training employees on environmental, ethical and diversity issues.
 Enabling employee involvement in sustainability initiatives and decisions.
Linking performance appraisal and rewards to sustainability, ethics and diversity.Objectives and
culture of sustainability-driven firm provide a potential frame for resolving the tensions
highlighted in different models.
13.4 Evaluation of Performance ofBoard of Directors

The Companies Act, 2013 and SEBI (Listing Obligations and Disclosure Requirements) Regulations,
2015 contain broad provisions on Board Evaluation:
(i) The Board as a whole.

(ii) Individual directors (including independent directors and Chairperson).
(iii) Various Committees of the Board.
The provisions also specify responsibilities of various persons and committees for conduct of such
evaluation and certain disclosure requirements.
Brief overview of the law involved

Clause 49 of the Listing Agreement applicable to listed companies.

Notes
 One of the key functions of the Board is to monitor and review Board Evaluation
framework.
 Performance evaluation of Independent Directors is stipulated.
 The Nomination & Remuneration Committee shall lay down the evaluation criteria of the
Independent Director and evaluation shall be done by the entire Board of Directors
(excluding the director being evaluated).
 The Criteria shall be disclosed in the Annual Report.
 On the basis of the report of performance evaluation, it shall be determined whether to
extend or continue the term of appointment of the independent directors
Purposes of the Board evaluation
 Improving the performance of Board towards corporate goals and objectives.

 Assessing the balance of skills, knowledge and experience on the Board.
 Identifying the areas of concern and areas to be focused for improvement.
 Identifying and creating awareness about the role of directors individually and
collectively as Board.
 Building Team work among Board members.
 Effective Coordination between Board and Management.
 Overall growth of the organization.
Companies Act 2013 and its Rules

In the Board’s Report a statement has to be given indicating the manner in which formal annual
evaluation has been made by the Board of its own performance and that of its committees and
individual directors [Section 134 & Companies {Accounts} Rules 2014].
The Nomination and Remuneration Committee shall identify persons who are qualified to become
directors and who may be appointed in senior management in accordance with the criteria laid
down, recommend to the Board their appointment and removal and shall carry out evaluation of
every director’s performance {Section 178 & Companies [Meetings of Board and its Powers] Rules
2014}
The performance evaluation of independent directors {as defined in these provisions} shall be done
by the entire Board of Directors, excluding the director being evaluated. On the basis of the report
of performance evaluation, it shall be determined whether to extend or continue the term of
appointment of the independent director {Section 149 – Schedule IV & Companies [ Appointment
and Qualification of Directors] Rules 2014}. Code for Independent Directors has been laid down.
{Section 149 – Schedule IV}
Individual director & overall board evaluation process

The criteria are based on the assessment of peer directors and assessment of the overall
performance of the Board.Each director has to complete a evaluation sheet by giving the
appropriate rating number related to:
(i) Performance of individual peer directors

(ii) Overall performance of the Board
Individual Peer Review (by all directors)
a. Whether the Directors uphold ethical standards of honesty and virtue?

Notes
Corporate Finance
b. Whether the Directors have appropriate qualifications to meet the objectives of the
Company?
c. Whether they have financial/accounting or business literacy/skills?
d. Whether they have real estate industry knowledge?
e. How actively and successfully do they refresh their knowledge and skill & are they up-to-
date with the latest developments?
f. How well prepared and well informed are they for Board/Committee meetings?
g. Do they show willingness to spend time and effort learning about the Company and its
business?
h. Is the attendance of Directors at Board/Committee meetings satisfactory?
i. Do they actively participate in the Board /Committee meetings?
j. Can they present their views convincingly, yet diplomatically?
k. Do they listen to the views of others?
l. How cordial are their relationships with other Board/Committee members and Senior
Management?
m. What have been the quality and value of Director’s contributions at Board/Committee
meetings?
n. What has been their contribution to the development of strategy and risk management and
how successfully they have brought their knowledge and experience to bear in the
consideration of these areas?
o. Where necessary, how resolute are they in holding to their views and resisting pressure
from others?
p. How effectively have they followed up matters about which they have expressed concern?
q. How well do they communicate with other Board/Committee members, senior
management and others?
Board/Committee Evaluation (by all directors)
1. Whether Board / Committee have diversity of experiences,backgrounds & appropriate

composition?
2. Whether Board / Committee monitor compliance with corporate governance, laws,
regulations and guidelines?
3. Whether Board / Committee demonstrate integrity, credibility, trustworthiness, an ability to
handle conflict constructively, and the willingness to address issues proactively?
4. Whether Board / Committee dedicate appropriate time and resources needed to execute
their responsibilities?
5. Whether Agenda and related information are circulated in advance of Board / Committee
meetings to allow Directors sufficient time to study and understand the information?
6. Whether written materials provided to Board / Committee members are relevant and
concise?
7. Whether the Chairman encourages inputs on agenda of Board / Committee meetings from
their members, management, the internal auditors, and the independent auditor?
8. Whether meetings of Board / Committee are conducted effectively, with sufficient time
spent on significant matters?
9. How well does management respond to request from the Board/ Committee for clarification
or additional information?

Notes
10. Whether proper minutes are maintained of each meeting of Board / Committee?
11. Whether Board / Committee meetings are held with enough frequency to fulfil the Board’s
/Committee’s duties?
12. Whether Board / Committee {as required} consider the quality and appropriateness of
financial/ accounting and reporting, including the transparency of disclosures?
13. Whether Board / Committee consider the statutory audit plan and provide
recommendations?
14. Whether Board / Committee ensure that management takes action to achieve resolution
when there are repeat comments from statutory auditors?
15. Whether adjustments to the financial statements that resulted from the statutory audit are
reviewed by the Audit Committee, regardless of whether they were recorded by
management?
16. Whether Board / Committee oversee the role of the statutory auditors and have an effective
process to evaluate the auditor’s qualifications and performance?
17. Whether Board / Committee review the audit fees paid to the statutory auditors?
18. Whether Board / Committee consider internal audit reports, management’s responses, and
steps toward improvement?
19. Whether Board / Committee oversee the process and are notified of communications
received from governmental or regulatory agencies related to alleged violations or areas of
non-compliance?
20. Whether the contributions of the Board / Committee to ensuring robust and effective risk
management are adequate?
Model criteria for evaluation of independent directors
 Each Independent director shall be evaluated by all other directors of the Board but not by
him/her.
 Rating Criteria for peer review as stated hereinabove shall also apply to Independent
directors to the extent there is no overlapping with the Rating Criteria of Independent
Directors as stated hereinafter.
 Whether Independent director/s follow/s Professional Conduct, carry out their Roles and
Functions and Duties as required in section 149 and Schedule IV of the Companies Act
2013:
Evaluation based on professional conduct
1. Upholds ethical standards of integrity and probity?

2. Acts objectively and constructively while exercising their duties?
3. Exercises his/her responsibilities in a bona fide manner in the interest of the Company?
4. Devotes sufficient time and attention to his/her professional obligations for informed and
balanced decision making?
5. Not allow any extraneous considerations that will vitiate his/her exercise of objective
independent judgment in the paramount interest of the Company as a whole, while
concurring in or dissenting from the collective judgment of the Board in its decision
making?

Notes
Corporate Finance
6. Does not abuse his/her positions to the detriment of the Company or its shareholders or
for the purpose of gaining direct or indirect personal advantage or advantage for any
associated person?
7. Refrains from any action that would lead to loss of his/her independence?
8. Where circumstances arise which make an independent director lose his/her
independence, whether the ID has immediately informed the Board accordingly?
9. Assists the Company in implementing the best corporate governance practices?
Evaluation based on Role and functions
10. Helps in bringing an independent judgment to bear on the Board’s deliberations especially
on issues of strategy, performance, risk management, resources, key appointments and
standards of conduct?
11. Brings an objective view in the evaluation of the performance of Board and management?
12. Scrutinizes the performance of management in meeting agreed goals and objectives and
monitor the reporting of performance?
13. Satisfies himself/herself on the integrity of financial information and those financial
controls and the systems of risk management are robust and defensible?
14. Taken actions to safeguard the interests of all stakeholders, particularly the minority
shareholders?
15. Balances the conflicting interest of the stakeholders?
16. During the Board/ Committee meetings along with other members determines
appropriate levels of remuneration of executive directors, key managerial personnel and
senior management have a prime role in appointing and where necessary recommend
removal of executive directors, key managerial personnel and senior management?
17. Moderates and arbitrates in the interest of the Company as a whole, in situations of
conflict between management and shareholder’s interest?
Evaluation based on Duties
18. Undertakes appropriate induction and regularly update and refresh his/her skills,
knowledge and familiarity with the Company?
19. Seeks appropriate clarification or amplification of information and, where necessary, take
and follow appropriate professional advice and opinion of outside experts?
20. Strive to attend all meetings of the Board of Directors and of the Committees of which
he/she is a member?
21. Participates constructively and actively in the Committees of the Board in which he/she is
chairperson or member?
22. Strives to attend the general meetings of the Company?
23. Has concerns about the running of the Company or a proposed action, whether he/she
ensures that these are addressed by the Board and, to the extent that they are not resolved,
insist that their concerns are recorded in the minutes of the Board meeting?
24. Does not unfairly obstruct the functioning of an otherwise proper Board or Committee of
the Board?
25. Gives sufficient attention and ensure that adequate deliberations are held before
approving related party transactions and assure himself/herself that the same are in the
interest of the Company?

Notes
26. Ascertains and ensures that the Company has an adequate and functional vigil mechanism
and also ensures that the interests of a person who uses such mechanism are not
prejudicially affected on account of such use?
27. Reports concerns about unethical behaviour, actual or suspected fraud or violation of the
Company’s Code of Conduct?
28. Acts within his/her authority, assist in protecting the legitimate interests of the Company,
shareholders and its employees?
29. Does not disclose confidential information, including commercial secrets, technologies,
advertising and sales promotion plans, unpublished price sensitive information, unless
such disclosure is expressly approved by the Board or required by law?
Model compliances
 The Nomination & Remuneration Committee of the Board shall lay down the evaluation
criteria of the Independent Director and evaluation shall be done by the entire Board
(excluding the director being evaluated).
 All evaluation shall be done annually.
 Criteria and Evaluation shall be disclosed in the Annual Report of the Company.
 On the basis of the report of performance evaluation, it shall be determined by the
Nomination & Remuneration Committee & Board whether to extend or continue the term
of appointment of the independent director subject to all other applicable compliances.
Review
These criteria shall need to be reviewed by the Nomination & Remuneration Committee and the
Board from time to time.
13.5 Succession Planning: Introduction

Succession planning or replacement planning is a strategy for passing on leadership roles to an
employee or group of employees. It ensures that businesses continue to run smoothly after a
company's most important people move on to new opportunities, retire, or pass away.
How Succession Planning Works
 It involves evaluating each leader’s skills, identifying potential replacements both within
and outside the company.
 In the case of internal replacements, training those employees so that they’re prepared to
take over.
 Succession plans should be reevaluated and updated each year.
 In large corporations, the board of directors will typically oversee succession planning.
 In large corporations, succession planning impacts not just owners and employees,
but shareholders as well.
 For small businesses, succession planning means training the next generation to take over
the business.
Recruitment
 It starts with proper hiring practices with the goal of choosing candidates that are capable
of rising through the ranks as time goes on.

Notes
Corporate Finance
 For example, an experienced person from another company might be hired and groomed
for an executive-level position.
Training
 Training includes the development of skills, company knowledge, and certifications.

 The training might include having employees cross-train and shadow various positions or
jobs in all the major departments.
 The cross-training process can help identify the employees that are not up to the task of
developing multiple skill sets needed to run the company.
Benefits of Succession Planning

There are various benefits of succession planning for the organization:
 Fulfillment of leadership gaps

 Handle attrition
 Avoid uninspiring results in executive recruitment
 Economy
 Uncovering the weaknesses
 Rapid recruitment to meet growth needs
 Planning for the disaster
 Motivates the employees
 Strengthens departmental relationships
 Development of new skills and adjusting development programs accordingly
Steps in Succession Planning

Succession planning involves various steps:
Step 1: Planning:
 Planning a blueprint of how the succession plan is to be implemented.

 The long-term vision and goals of the organization are identified and the current
personnel policies and procedures are studied.
 Essential to integrate the plan with the aspirations of the senior employees who are being
groomed for succession.
Step 2: Analysis:
 Future challenges and skills the CEO would need are analyzed.
 Current supply of manpower should be studied in relation to the anticipated demand.
 It is necessary to identify the overall long term talent needs of the company and not just of
a particular position.
Step 3: Identification of Talent Pools:
 May be measured by the use of performance evaluation tools like 360° Feedback, critical
incident methods and rating scales.
 Also, necessary to evaluate the employee’s capacity to perform in more responsible jobs in
future.

Notes
 The skill sets of the employees should be compared with the skills needed for the key
leadership roles and any gaps between the two should be identified.
Step 4: Development Planning:
 After the gaps have been identified, the next step involves creating development plans.
 The development plan includes the formal development procedures, coaching and
mentoring, special job assignments, learning projects, etc.
 The employee’s progress will be monitored against the plan.
Step 5: Implementing the Succession Plan:
 The succession plan should be linked to the HR processes like compensation, recruitment,
performance planning, workforce planning, etc.
 It is a long-term plan, and sometimes the succession planning process is started from the
time a brilliantly outstanding employee begins his career.
 For. E.g., Jack Welch was being groomed for senior positions from the time he started his
career.
Difference between Career Planning and Succession Planning

The main difference between Career planning and succession planning is that career planning
covers all levels of employees.Whereas,Succession planning is generally meant for higher-level
executives.Succession planning is essential for the survival and success of an organization.It
provides opportunities to the existing potential employees to advance their careers.While creating a
succession plan, every key executive is asked to identify few employees at junior levels who have
the potential to replace them when needed.
Career planning consists of charts representing the possible career paths for different categories of
employees; whereas succession planning involves succession charts for a specific high- level
position, such as general manager.The career paths for different types of jobs:
 A supervisor has to achieve different milestones, such as assistant manager, deputy

manager, and manager, to become a chief manager.
 A lecturer has to pass from the designations of associate professor, professor, dean of
faculty, and pro-vice chancellor to acquire the position of vice chancellor.
Corporate Governance in Public Sector Undertakings.

Public enterprises in India are classified under three categories:
1. Departmental Undertaking,
2. Statutory corporations financed by Government,
3. Government companies set up under the Companies Act, 2013 or Public-Sector
undertakings.
Contribution of PSUs
PSUs were created as vehicles for industrial and regional development, creation of basic
infrastructure networks, and employment generation. PSUs have done exemplary work for the
upliftment of local communities by addressing their education and drinking water needs through
CSR initiatives. GOI has taken several steps to improve their performance including through better
corporate governance.

Notes
Corporate Finance
Corporate Governance Framework

Provisions as contained in the Companies Act, 2013; SEBI guidelines on Corporate Governance; and
DPE guidelines on Corporate Governance for Central Public-Sector Enterprises provide the
Corporate Governance framework for listed PSUs in India. SEBI guidelines are not applicable to
non-listed PSUs.
Provisions contained in Companies Act, 2013:
 Companies Act 2013 replaced Companies Act, 1956.

 The Ministry of Corporate Affairs has also notified Companies Rules, 2014 on
management and Administration, Appointment and Qualification of Directors, Meetings
of Board etc.
 The Companies Act, 2013 and the Companies Rules provide framework for Corporate
Governance for all companies including PSUs.
Some of the important requirements which have been laid down are with regard to:
1. Qualifications for Independent Directors along with the duties and guidelines for
professional conduct (Section 149(8) and Schedule IV thereof).
2. Mandatory appointment of one-woman director on the board of listed companies [Section
149(1)].
3. Mandatory establishment of certain committees like Corporate Social Responsibility
Committee [Section (135)], Audit Committee [Section 177(1)], Nomination and
Remuneration Committee [Section 178(1)], and Stakeholders Relationship Committee
[Section 178(5)].
4. Holding of a minimum of four meetings of Board of Directors every year in such a manner
that not more than 120 days shall intervene between two consecutive meetings of the
Board [Section 173(1)].
SEBI Guidelines on Corporate Governance
 SEBI is the capital market regulator in India.

 It amended Clause 49 of the Listing Agreement in 2014 in order to align it with the
Corporate Governance provisions specified in the Companies Act, 2013.
 It is applicable to all companies, including PSUs, which are listed on a recognized stock
exchange.
DPE guidelines on Corporate Governance for Central Public-Sector Enterprises
 The Department of Public Enterprises (DPE) issued first ever guidelines on Corporate
Governance in November 1992 for PSUs which were voluntary in nature.
 These have been revised from time to time.
 These guidelines are mandatory and are applicable to all PSUs – listed or not listed.
 The guidelines issued by DPE has covered areas like composition of Board of Directors,
composition and functions of Board committees like Audit Committee, Remuneration
committee, details on subsidiary companies, disclosures, reports and the schedules for
implementation.

Notes
 DPE has also incorporated Corporate Governance as a performance parameter in the

MoUs of all PSUs.
Issues in Corporate Governance of PSUs

To increase competitiveness and improve investor confidence, it is important for PSUs to embrace
corporate governance standards which would ensure further growth in an ethical and transparent
manner. The major hinderance in achieving desired level of competitiveness is governance deficit
due to certain key issues:
Autonomy of the Board
 A competent and autonomous Board is important for success of any corporate.

 However, Ministerial diktats may sometimes influence the Board agenda in case of PSUs.
 Without full autonomy, it is difficult to have a structured performance evaluation system
for the Board members and fix accountability.
Ownership policy
 There is no ownership policy in place.

 It is needed to clearly lay down role and responsibilities of the Government towards
minority shareholders and other stakeholders such as employees, vendors, customers and
communities.
 The Organization for Economic Cooperation and Development states that “the
government should develop and issue an ownership policy that defines the overall
objectives of state ownership, the state’s role in corporate governance of state-owned
enterprises and how this policy is likely to be implemented.”
 The ownership policy should be clearly disclosed and communicated to fix accountability.
Appointment of independent, non-executive directors and women directors
 Legal provisions and Guidelines issued by SEBI and DPE have laid down requirements for
the constitution of PSUs Board to ensure their independence and gender diversity.
 It has been established that properly structured Board is necessary for ensuring objectivity
of Board’s decisions.
 Out of the top 27 PSUs, according to a recent study, 25% do not meet the criteria for
independence of the Board and nearly 25% do not have a woman director.
Non-compliance with legal requirements and SEBI and DPE Guidelines
 Many of the top PSUs are falling behind in complying with minimum requirements
contained in Clause 49 and DPE Guidelines.
 Even the compliance audit conducted by the Comptroller and Auditor General of India
has highlighted this issue.
Excessive regulation
 Besides Parliament, PSUs are also accountable to other authorities like Comptroller &
Auditor General of India, (CAG); Central Vigilance Commission, (CVC); Competition
Commission of India, (CCI); and Right to Information Act, (RTI) etc.

Notes
Corporate Finance
 Over regulation has not only created accountability problems but has also killed corporate
governance.
Ways to improve Corporate Governance in PSUs
 As PSUs are India’s most important national assets, It has been the constant endeavor of
the Government to improve governance in PSUs.
 But it has not been able to reorient its role away from day-to-day management of PSUs
towards exercising its core ownership rights based on sound corporate governance
principles.
Professionalize PSUs Boards
a. PSU boards should include candidates from the private sector as well.
b. PSU CMDs should be actively consulted for the selecting and appointing independent and
non-executive directors on PSU boards. The role of the Public Enterprises Selection Board
(PESB) requires to be reconsidered in this context.
c. Give PSUs boards greater decision-making authority with regard to decisions on executive
compensation, performance management systems and initiation and execution of projects.
Government should minimize its involvement to policy matters and matters of national
interest only.
d. A mechanism to evaluate the board's overall functioning should be instituted.
Reorient the State's Ownership Role
a. Administrative ministries should focus on core ownership functions and limit their day-
to-day role.
b. Improve the performance monitoring or MOU system.
c. The ownership policy should clearly spell out how will it be applied in matters that have
ramifications for minority.
Ensure Compliance with Legal requirements & SEBI and DPE Guidelines
 The government should deal firmly with non-compliance of corporate governance norms
by both listed and unlisted PSUs.
 Provisions with regard to constitution, appointment of chairman and meetings of Audit
Committee should be strictly adhered to.
13.6 Insider Trading: Introduction

Insider trading is dealing in securities of a listed company by any person who has knowledge of
material inside information which is not available to general public.It is breach of a fiduciary duty
or other relationship of trust, and confidence.It is a crime if made to get wrongful gain or avoid
losses.An example of an insider may be a corporate executive who has access to an financial report
before it is publicly released.

Notes
Definition
The Securities and Exchange Board of India (Prohibition of Insider Trading) Regulations 1992, does
not directly define the term Insider Trading. But it defines the term "Insider", "Connected Person"
and "Price Sensitive Information". Insider Trading is the trading of securities of a company by an
Insider using company's non-public, price sensitive information while causing losses to the
company or profit to oneself.
 Insider: a "connected person" or a person possessing or having access to unpublished

price sensitive information.
 Connected person: one who has been associated with the company in any capacity such as
a director, officer or employee or in a contractual or fiduciary relationship with the
company; and includes a list of "deemed connected persons"
 Unpublished price sensitive information (UPSI): any information relating to securities of
a company that is not generally available and, upon being available, is likely to materially
affect the price of the company's securities.
It includes matters such as financial results, dividends, changes in capital structure, significant
corporate transactions and changes in key managerial personal.
Examples of Insider Trading:

The CEO of a company shares important information about the acquisition of his company to a
friend who owns a substantial shareholding in the company. The friend acts upon the information
and sells all his shares before the information is made public.A high-level employee overhears
some conversation about a merger and understands its market impact and consequently buys the
shares of the company in his father’s account.
Examples of Price Sensitive Information
 Financial results of the company.

 Intended declaration of Dividends.
 Issue of shares by way of public rights, bonus, etc
 Any major expansion plans or execution of new projects.
 Amalgamation, mergers and takeovers.
Reasons to control Insider Trading

To protect general investors:
 The manipulation of market by using Insider trading generally causes great losses to a
company
To protect the interest and reputation of the company:
 Once a company faces a problem of Insider Trading, investors tend to lose confidence in the
company and stop investing in the company.
To maintain confidence in the stock exchange operations:
 If any Insider gets a chance to get past the laws, it decreases the investors’ confidence in the
stock exchange operations itself.
To maintain public confidence in the financial system:
 To have a healthy economy, a proper financial system is a must and for that, confidence in
the market is of utmost importance.

Notes
Corporate Finance
Penalties in case of Insider Trading

SEBI may impose a penalty of not more than Rs. 25 Crores or three times the amount of profit made
out of Insider Trading; whichever is higher.SEBI may initiate criminal prosecution; or SEBI may
issue order declaring transactions in Securities based on unpublished price sensitive information; or
SEBI may issue orders prohibiting an insider or refraining an insider from dealing in the securities
of the company.
Insider Trading & Corporate Governance

Insider trading has many governance implications, affecting:
 The organization of companies.

 The duties of directors of managing boards and supervisory boards and other corporate
insiders.
 The permitted flow of information within companies.
 The disclosure duties imposed to companies.
 The main problem in insider trading is conflict of interests and the misuse of power –in
this case it relates to the power over privileged information.
 Therefore, there is a strong connection between corporate governance and insider trading.
Mechanism to Prevent Insider Trading

The Securities and Exchange Board of India (SEBI) has prescribed internal controls on sharing of
information.
 It has decided to hold company promoters, irrespective of their shareholding

status, responsible for violation of insider trading norms if they possess unpublished price-
sensitive information (UPSI) regarding the company without any ‘legitimate’ purpose.
 SEBI has specified that the term “legitimate purpose” will include sharing of the UPSI in the
ordinary course of business by an insider with:
 Partners, collaborators, lenders, customers, suppliers, merchant bankers, legal advisors,
auditors, insolvency professionals or other advisors or consultants, provided that such
sharing has not been carried out to evade or circumvent the prohibitions of these
regulations.
 Simply put, a promoter who is not an advisor in official capacity or does not hold any
position on the board will not be considered a person having “legitimate purpose” to hold
the UPSI.
 It has recommended that the board of directors shall ensure that a structured digital
database is maintained containing the names of such persons or entities, as the case may be,
with whom the information is shared.
Lessons from Corporate Failure

“Strong corporate governance is indispensable to resilient and vibrant capital markets and is an
important instrument of investor protection. It is the blood that fills the veins of transparent
corporate disclosure and high-quality accounting practices. It is the muscle that moves a viable and
accessible financial reporting structure.”Report of Kumar Mangalam Birla Committee
on Corporate Governance constituted by SEBI (1999). Recently, many large Indian companies were
impacted due to Corporate Governance failure like:
 Jet Airways (India) Limited

Notes
 Interglobe Aviation Limited (Indigo)

 Yes Bank Limited
 Dewan Housing Finance Corporation Limited (DHFL)
 Punjab and Maharashtra Co-operative Bank Limited
1. Jet airways (India) limited

About Company:
 Jet Airways was one of the largest airlines in India, Headquartered in Mumbai.
 Mr. Naresh Goyal is the Founder of Jet Airways.
Issue
 Company became a highly debt-ridden.

 Lenders denied to release further funds to keep carrier flying due to continues increase in
debt level.
 Consequently, Jet Airways closed reservations to international services, from April 2019 and
suspended all operations citing financial issues.
 Moreover, it has left approx. 20,000 employees.
Reasons for failure:
Mismanagement:
 Heavy losses and increase in debt of the company due to the poor decision making and
management of company.
 Board of directors could not contribute to operating and financing decisions as the decision
of the company lacked transparency.
High Costs: Purchasing Jets at high cost.
 Ignoring advice of the experts.

Positioning:
 Jet Airways catered to the corporates and failed to recognise that other low-cost carriers
were attracting price sensitive customers.
Failure to get money from investors:
 Failure to find a strategic investor to pump money in to Jet Airways is another reason the
failure.
2. Yes Bank Limited

About Company:
 Founded in the year 2004, Yes Bank Limited is an Indian private sector bank, founded by
Rana Kapoor and Ashok Kapur.
 India’s fourth largest private sector bank.
 High quality, customer centric and service driven Bank.
Issue
 In the year 2015, RBI conducted an asset quality review to check and clean up the rising
toxic loan problem in the country’s financial sector.

Notes
Corporate Finance
 Several banks were asked to report loan divergences (the difference between the RBI’s
assessment of bad loans and the one reported by the bank) in their quarterly results.
 Yes Bank Ltd had managed to keep a check on its non-performing assets (NPAs).
 RBI found out some serious issues related to loan divergence and NPAs at Yes Bank Ltd,
during the AQR review in 2015.
 Yes Bank consistently showed NPAs below 2%.

 The gross NPAs reported by the bank in Financial Year 2016 were at Rs. 748.98 Crores.
 It turned out that the NPAs identified by RBI were at Rs. 4925.68 Crores.
 A 557% higher NPA was observed during the AQR review with respect to actual reported.
 The Gross NPA % disclosed by Yes Bank as on March 2016 stood at 0.76%.
 This Gross NPA actually should have been at 5.01% as per RBI observations.
 RBI also observed very astounding deviation of 1166% for Net NPAs.
 The Net NPA % disclosed by Yes Bank was at 0.29% for Mar 2016, which according to RBI
should have been 3.67%.
 After AQR review, RBI detected a large deviation of Rs. 4,176 crore in the reported gross
NPAs in the books of accounts of Yes Bank for 2015-16.
 RBI detected gross NPAs at Rs. 8,373.8 crore for Yes Bank for 2016-17 against the declared
gross NPAs at Rs. 2,018 crore.
 RBI has considered this as the governance and compliance failures and violations of
statutory and regulatory rules at Yes Bank Ltd.
3. Interglobe Aviation Limited

About the company:
 Interglobe Aviation Limited is one of the largest Indian Airline Company, headquartered
in Gurgaon, Haryana, India.
 It was founded by Rakesh Gangwal and Rahul Bhatia in 2006.
Issue:
 Rakesh Gangwal alleged serious governance lapses by its co-founder Rahul Bhatia.
 Rahul Bhatia had denied about any such governance failures.
 Gangwal reach out to Securities Exchange Board of India for its intervention.
 Gangwal further alleged that the Company is not adequately following core principles and
values of governance.
 Gangwal also questioned certain related party transactions and said that the Shareholder’s
Agreement provides Rahul Bhatia controlling rights over Indigo.
 The Company did not follow due process for Related Party Transaction approvals and other
Corporate Governance measures.
Summary
 Corporate governance is a system of rules, policies, and practices that dictate how a
company’s board of directors manages and oversees the operations of a company. Corporate
governance includes principles of transparency, accountability, and security. It is the

Notes
interaction between various participants (Shareholder, Board of Director and Company

Management) in shaping corporation’s performance. It deals with determining ways to take
effective strategic decisions and developed added value to the stakeholder.
 Principles in Corporate Governance:
o Protection of shareholders rights
o Interests of other stakeholders
o Role and responsibilities of the board
o Responsible and ethical behavior
o Disclosure and transparency in reporting
 Regulatory framework in India and mandates
o In recognition of the importance of corporate governance as an integral part of corporate

financial practices, the SEBI has mandated corporate governance in the listing requirement
in Clause 49 of the Listing Agreement. The main elements of this clause relate to:
o Board of Directors
o Audit Committee
o Subsidiary Companies
o CEO/CFO Certification
o Report on Corporate Governance
o Compliance
 There are mainly four theories of corporate governance.
o The Agency Theory
o The Stewardship Theory
o The Stakeholder Theory
o The Political Theory
 The Companies Act, 2013 and SEBI (Listing Obligations and Disclosure Requirements)
Regulations, 2015 contain broad provisions on Board Evaluation:
o The Board as a whole.
o Individual directors (including independent directors and Chairperson).
o Various Committees of the Board.
 Succession planning or replacement planning is a strategy for passing on leadership roles to
an employee or group of employees. It ensures that businesses continue to run smoothly
after a company's most important people move on to new opportunities, retire, or pass
away.
 The main difference between Career planning and succession planning is that career
planning covers all levels of employees.Whereas,Succession planning is generally meant for
higher-level executives.Succession planning is essential for the survival and success of an
organization.It provides opportunities to the existing potential employees to advance their
careers. While creating a succession plan, every key executive is asked to identify few
employees at junior levels who have the potential to replace them when needed.
 Insider trading is dealing in securities of a listed company by any person who has
knowledge of material inside information which is not available to general public. It is
breach of a fiduciary duty or other relationship of trust, and confidence. It is a crime if made
to get wrongful gain or avoid losses. An example of an insider may be a corporate
executive who has access to a financial report before it is publicly released.

Notes
Corporate Finance
Keywords
Corporate Governance, Succession Planning, Insider Trading, Board evaluation, Directors
evaluation
SelfAssessment
1. Corporate governance is a form of
A. external regulation
B. self-regulation
C. government control
D. charitable action
2. Which of the following is/are feature of corporate governance?
A. Non-universality
B. Accountability
C. Ambiguity
3. Corporate governance is a approach
A. Top-down
B. Bottom-up
C. Hybrid
D. Scientific
4. Which among the following is the role of board of directors?
A. manage inventory
B. understanding human behavior
C. budgeting
D. Overseas strategy implementation and performance
5. Persons who take the procedural steps to set up a company and who make business
preparations for the company are known as
A. directors
B. shareholders
C. registrars
D. promoters
6. Under the__________, both internal and external corporate governance mechanism intended
to induce managerial actions that maximize profit and shareholder value
A. Shareholder theory
B. Agency theory
C. Stakeholder theory
D. Corporate governance theory
7. The corporate governance structure of a company reflects the individual companies
A. Cultural & economic system

B. Legal & business system
C. Social & regulatory system
D. All of the above
8. CEO stands for
A. Chief Executive Officer

Notes
B. Chief External Officer

C. Chief Environmental Officer
D. Current Executive Officer
9. Which of the following is a true statement related to corporate governance?
A. It refers to the manner in which an entity is managed and governed.

B. It excludes entity management.
C. It requires entities to have a board of directors.
D. It is a uniquely distinct concept from those charged with governance.
10. Section 173 of Companies Act deals with meetings of the board
A. 2013
B. 2015
C. 2011
D. 2009
11. _________________ is the ongoing process of identifying future leaders in an organisation
A. Career Planning
B. Man Power Planning
C. Succession Planning
D. Staffing
12. Succession Planning is developing employees in a structured plan to __________
A. Replace Leaders
B. Replace Management
C. Support Leaders
D. Support Management
13. The process of succession planning doesn’t include
A. Studying current workforce

B. Focusing only on talented employee
C. Forecasting future trend
D. Review Organization strategic plan
14. To be successful Succession planning must be a part of
A. HR process
B. Career planning process
C. Man power planning process
D. Organisation planning process
15. A proper succession planning must ideally first identify __________
A. Critical Position
B. High talents
C. Proper person to be trained
D. Skills to be developed
16. Kingfisher airlines is owned by the Bengaluru based
A. United Breweries Group

B. Quick Jet
C. Menzies Aviation Bobba
D. Star Air

Notes
Corporate Finance
17. Satyam Computers Services Limited was the first India company to publish its financial
statements by following
A. Indian Accounting Standards (AS 32)

B. Interim Financial Reporting
C. International Financial Reporting Standards
D. Indian Accounting Standards (AS 36)
18. PNB scam was done by
A. Nirav Modi
B. Vijay Malya
C. Satyam
D. Harshad Mehta
19. Which of the following is insider trading?
A. You sell your company's stock because you know it is about to announce poor earnings
B. Your company starts supplying parts for a customer's secret major product, so you buy the
client's stock
C. You dump a company's shares after your broker confidentially tells you the CEO at that
company just sold stock, but the sale has not yet been publicly reported
D. All of the above
20. ________ trading occurs when a company employee or company advisor uses material non-
public information to make a profit by trading in the securities of the company.
A. Interior
B. Intra-office
C. Insider
D. Inter-office

1. B 2. B 3. A 4. D 5. D
6. C 7. D 8. A 9. A 10. A
11. C 12. A 13. B 14. A 15. A
16. A 17. C 18. A 19. D 20. C
Review Questions
1. Discuss Corporate Governance and its principles.
2. Explain the steps involved in Succession Planning.
3. Discussion Insider Trading with example.
4. Briefly explain the points in the evaluation of performance of board of Directors.
5. Briefly explain the points to be considered in the evaluation of performance of individual
directors.
Further Readings

Notes
McGraw-Hill.
Publishing
3. Berk, Jonathan. & DeMarzo, Peter. & Harford, Jarrad. & Ford, Guy. & Mollica, Vito.
4. https://corporatefinanceinstitute.com/resources/knowledge/other/corporate-
governance/
5. https://corporatefinanceinstitute.com/resources/knowledge/trading-
investing/what-is-insider-trading/

Notes


CONTENTS
Objectives
Introduction
14.1 Business Environment: Meaning
14.2 Dimensions of Business Environment
14.3 Corporate Valuation
14.4 Corporate Valuation Approaches
14.5 Factors Affecting Valuation
14.6 Changes in the Business Environment
14.7 Impact of changes in Business Environment on Valuation
14.8 Impact on Valuation
14.9 Sustainability
14.10 Pillars of Sustainability
14.11 ESG Factors
Summary
Keywords
Self Assessment
Review Questions
Further Readings
Objectives
 explain the business environment.
 understand the approaches of Corporate Valuation.
 discuss the Impact of Changing Business environment on Corporate Valuation.
 explain business sustainability.
 understand ESG criteria.
 analyse the link between ESG factors and corporate valuation.
Introduction
Business environment is dynamic in nature and it directly affect the business performance. Hence it
becomes important to analyze how the changing business environment is affecting the corporate
valuation. Hence, now we will discuss about the impact of changing environment on corporate
valuation. We will also cover how climate change and other sustainability issues are impacting
valuation of the companies. Role of each pillar of sustainability viz. Social, Environmental and
Governance (ESG) issues will also be discussed in this chapter.

Notes
Corporate Finance
14.1 Business Environment: Meaning

Business environment refers to the sum total of all individuals, institutions and other forces that are
outside the control of a business enterprise, but that may affect its performance. The economic,
social, political, technological and other forces which operate outside a business enterprise are part
of the business environment. Moreover, the individual consumers or competing enterprises as well
as the governments, consumer groups, competitors, courts, media and other institutions working
outside an enterprise constitute its environment.
Examples:
 Increase in taxes can make things expensive to buy.

 Technological improvements may make existing products obsolete.
 Political uncertainty may create fear in the minds of investors.
 Changes in fashions may shift demand in the market.
 Increased competition may reduce profit margins of firms.
14.2 Dimensions of Business Environment

Business environment is an umbrella term which consists of several types of environments such as
Economic, Social, Technological, Political and legal environment. Let’s discuss each of these
environments one by one.
Economic Environment
Economic environment consists of the factors such as interest rates, inflation rates, changes in
disposable income of people, stock market indices and the value of currency. These factors have a
direct impact on the management of the business firm. Short- term and long-term interest rates
significantly affect the demand for product and services whereas, a rise in the disposable income of
people creates increasing demand for products.Similarly, high inflation rates increase the costs of
business.
Social Environment
This type of environment includes forces like customs, traditions, values, social trends, society’s
expectations from business.In business terms, the values mean freedom of choice in the market,
business’s responsibility towards the society and non-discriminatory employment practices.Social
trends present various opportunities and threats to business enterprises. For example, the health-
and fitness trend has become popular which is affecting many businesses.
Technological Environment
Technological Environment includes forces relating to innovations which provide new ways of
producing goods and services. For e.g. There are modifications in the ways in which companies
advertise their products.Manufacturers also have flexible manufacturing systems. Customers can
look for flight times, destinations and fares and book their tickets online.
Political Environment
This type of environment includes political conditions such as general stability and peace in the
country and the specific attitudes that elected government representatives hold towards business.
The significance of political conditions in business success lies in the predictability of business
activities under stable political conditions. On the other hand, there may be uncertainty of business
activities due to political unrest and threats to law and order.
Legal Environment
It includes various legislations passed by the Government, administrative orders issued by
government authorities, court judgments as well as the decisions rendered by various commissions
and agencies at every level of the government.It is mandatory for the management of every
enterprise to obey the law of the land.For e.g.,packets of cigarettes carry the statutory warning
‘Cigarette smoking is injurious to health’.

Notes
14.3 Corporate Valuation

After the discussion on the types of business environments, let us now discuss the term corporate
valuation. A business valuation is a general process of determining the economic value of a
business. Business valuation can be used to determine the fair value of a business for reasons like
purchase or sale of business, Secure external financing or adding new shareholders.
14.4 Corporate Valuation Approaches

There are three types of approaches or ways through which we can quantify the business valuation.
a) Asset-based approaches
b) Earning value approaches
c) Market value approaches
a) Asset-Based Approaches
Asset based approach will total up all the investments in the company. It can be done in one of two
ways:
 A going concern asset-based approach lists the business's total assets, and subtracts its
total liabilities (Book value).
 A liquidation asset-based approach determines the net cash that would be received if all
assets were sold and liabilities paid off.
Imagine that Company A had Rs. 1,000 Crores in assets and Rs. 300 Crores in liabilities. Using
going concern approach, you would subtract liabilities from assets to arrive at the company's value.
In this case, the value would be Rs. 700 Crores.Using the liquidation asset-based approach, you
would take the company's assets and see what price you could receive if you sold everything. If
your balance sheet shows Rs. 1,000 Crores in assets, but you could only sell the assets for Rs. 900
Crores, then the value of the company would be Rs. 600 Crores.
b) Earning value approaches

An earning value approach is based on the idea that a business's value lies in its ability to produce
wealth in the future.Capitalizing earnings determines an expected level of income for the company
using a company's record of past earnings, normalizes them for unusual revenue or expenses, and
divides the annual income by a capitalization rate.If a business had an income of Rs. 1 crore last
year and the average capitalization rate in the industry is 5%, you could estimate value by dividing
Rs. 1 crore by 5%. The resulting value would be Rs. 20 crores.
Another earning value method involves discounting future earnings instead of working with past
earnings. To use this approach, you would first project the company's cash flows coming years.
Then you would calculate what is called the "terminal value" of the company, which is the value of
the company beyond the forecasted period of earnings. Once you have the estimated cash flows
and the terminal value, you would discount those values back to the current day using an
appropriate discount rate for the company.
c) Market Value Approach

Market value approaches to business valuation attempt to establish the value of a business by
comparing the company to similar ones that have recently sold. The idea is similar to using real
estate comparable, to value a house.

Notes
Corporate Finance
14.5 Factors Affecting Valuation

The valuation of a company is affected by several factors. The valuation of a company will be
determined by a combination of factors such as:
i. Historical financial performance:

This factor takes into consideration the financial performance of the company in the last few
years. During the business sales process, the buyer will look at profit and loss statements,
balance sheets, and tax returns.
ii. Future growth potential

The firm’s future growth potential is also an important factor. It includes the questions like how
much a buyer can grow the company and What are the key trends affecting the industry? And
also, how much will be the revenues and profits in the future, and why?
iii. Size of customer base

The size of the customer base is an indication of the amount of diversification, and therefore an
indication of risk. A customer base that is well diversified and large in number would lower the
perceived risks in the minds of buyers.
iv. Dependence on owner

The owners of most small businesses do not intend to stay with the business after the sale. For
small business sales, the less dependent the business is on the owner, the higher the business
valuation can be.
v. Competitive advantages
A business location in a high-traffic area may give the company a competitive advantage; this
location will be of greater value in a sale than a business location in a lower-traffic area.
14.6 Changes in the Business Environment

The changes in the business environment are happening due to the following reasons mainly:
 Rapidly changing technology.

 Increasing purchasing power of customers.
 Greater access to capital.
 Effects of Globalization.
 Political factors.
Metrics for Business Impact

We can quantify the impact of the changing business environment on the corporate valuation
through the following measures:
 Effect on the market share

 Number of markets in which a firm participates
 Number of new markets
 Sales growth
 Size of the average sale

Notes
14.7 Impact of changes in Business Environment on Valuation

Changes in business environment mainly causes the following effect on the business firm. They
may lead to the following results in a firm:
 Changes in Growth rate.

 Changes in Risk Class.
 Change in future Cash flows.
 Change in the Cost of Capital.
Climate Change
Currently, climate change is the most pressing issue in the entire world. It refers to the long-term
shifts in the earth’s weather patterns that can be caused by natural phenomena or human activity.
The term is used to mean rising average global temperatures caused by the concentration of
greenhouse gas emissions.
Risks created by climate change includes acute changes to the environment such as extreme heat
and storms, wildfires and sea-level rise, desertification and changes in precipitation patterns.
Climate change also gives rise to transition risks as a result of the actions needed by governments
and consumers to mitigate climate change. Both these risks have the potential to disrupt business
operations and impact a company’s revenues, costs, risk profile and ultimately its value.
Impact on corporate valuation

From the corporate point of view, climate change is an important issue as it can significantly affect
the business performance. Climate change risks and opportunities can impact revenues, costs and
risk profiles of companies as well as investment attractiveness. The value of a company is defined
by the present value of the stream of cash flows that can be produced in the future taking into
account the size of the cash flows, their timing and the risk associated with achieving them. There is
an inherent uncertainty as to the exact impact the climate change will have on a business’s financial
projections and future cash flows and how this needs to be considered in the company's valuation.
Let’s discuss the probable impact of the climate change on the following sectors:
Building and Construction

This sector gets affected by the rises in energy prices.Moreover, it could come under increasing
consumer pressure to reduce waste generated during construction.Economic development in
emerging economies can translate into substantial demand for new, greener housing and
infrastructure.
Chemicals
Chemical sector will face increasing consumer pressure to be more water-efficient, and to better
manage emissions of chemical waste. Demand is set to rise for chemicals used in high-performance
insulation, energy-efficient lighting, renewable energy technologies.
Power
Global electricity demand is increasing, hence, the coal’s global share of total power generation is
expected to decrease, while renewables are set to increase. The ‘decarbonization’ of electricity will
present opportunities for the sector to advance renewable energy technologies.
Extractives
The operational costs of this sector are increasing. The legislation to extend protected areas that
support marine and terrestrial biodiversity may limit the extractive areas.Whereas, the
opportunities may come through an increased demand for certain minerals and metals used in
renewable energy and energy efficiency technologies.
Finance

Notes
Corporate Finance
The property and casualty insurers will likely see increasing claims due to severe weather. On the
other hand, the capital needed to address climate change will result in a greatly-expanded market
for financing.Financial institutions will need to enhance coordination with the scientific community
to ensure access to environmental data and analysis.
Food and Beverage
High levels of water usage and heavy reliance on ecosystem services render this sector especially
vulnerable to environmental change. As the markets for organic food and beverages is increasing,
companies certified as sustainable food producers can also tap into growing customer demand.
Healthcare
Biodiversity loss will limit the discovery of natural compounds used in new
medicines.Approximately one fourth of the global disease burden can be attributed to
environmental factors and the demand for healthcare services could rise further.
Information and Communication Technology (ICT)
ICT companies’ operating costs will rise due to the increases in energy prices. Concerns about the
environmental impacts of the sourcing of key materials in developing countries may lead to
increasing consumer and regulatory pressure on the industry.
Tourism
Extreme weather events, impacts of climate change, water scarcity, and declining biodiversity can
make particular destinations more or less attractive.Demand is set to grow globally, especially the
market for nature-based tourism and eco-tourism.
Transport
Regulations to reduce greenhouse gas emissions can increase costs.Complying with regulations to
reduce levels of air pollution could also add to operational costs.Demand for cleaner transportation
options will rise.
14.8 Impact on Valuation

Climate change and business valuations are directly linked. When determining the value of a
business, one must consider all the risks and opportunities, of which climate change is one. Climate
change will have significant and lasting impacts on the economic growth and prosperity. It is a
defining factor in companies’ long-term prospects because of its effect on cash flow assumptions,
terminal values and exit values. These factors make it a business risk and a mainstream business
issue. Let’s discuss the impact of climate change in each of these factors:
i. Operating Costs
For many companies, climate risks are substantive financial risks because they have a direct impact
on the production and distribution of their goods and services.Global efforts to reduce carbon
emissions will place different levels of stress on the cash flows and valuations of businesses in
different industries.
ii. Influencing Cashflows
Anticipating impact on prices, cost and demand.Responding quickly to shifts in demand
orregulatory changes.Positioning to capitalize on new opportunities and or increase brand value
and brand power.Outperforming against peers and improved long-term returns.
iii. Investment decisions
Investors are understanding how physical risks as well as the ways climate policy, technology and
changing consumer preferences will impact prices, costs and demand across the entire
economy.This concern is leading to a reassessment of risk and asset values as climate change
considerations become part of investment decisions.
Influencing Discount rate
Reduced degree of exposure to physical and transition risks.Increased attractiveness to
investors.Reduced exposure to geopolitical risk.Reduced share volatility.

Notes
Financing decisions
Climate risk is also a systemic risk. Central banks and other supervisory authorities are
nowconsidering climate change as a risk to financial stability. Some of the biggest risks of climate
change will be social instability, mass migration and health impacts brought on by physical climate
impacts.
Influencing Capital Structure
Reduced cost of financing.Increased availability of financing and leverage.
Affecting Shareholder Value:

Climate change issues affects the shareholder value through the changes in the cashflows from
operations, discount rate and the debt levels.
14.9 Sustainability
Sustainability is the ability to exist and develop without depleting natural resources for the
future.The United Nations defined sustainable development as: “Development that meets the needs
of the present without compromising the ability of future generations to meet their own needs”.
Resources are limited, and should be used conservatively and carefully to ensure that there is
enough for future generations, without decreasing present quality of life. A sustainable society
must be socially responsible, focusing on environmental protection and dynamic equilibrium in
human and natural systems.
Importance of Sustainability
The sustainability has emerged as the most important factor for the business in the recent past due
to the following reasons:
 It improves trust and engagement between staff, investors, customers and other
stakeholders.
 It helps in attracting and retaining employees.
 It helps in building credibility and improves relationships.
 It encouragesinnovation that benefits other measurements.
Examples of Sustainability Practices:

Notes
Corporate Finance
Recently, Nike has focused on reducing waste and minimizing its footprint.Adidas has created a
greener supply chain and targeted specific issues like dyeing and eliminating plastic bags.Pepsi and
Coca-Cola have increasing focus on water stewardship and setting targets on water
replenishment.Unilever and Nestlé have both taken on major commitments.Unilever notably on
organic palm oil and its overall waste and resource footprint.Nestlé in areas such as product life
cycle, climate, water efficiency and waste.
14.10 Pillars of Sustainability

There are mainly three pillars of Sustainability namely, Economy and Society and the Environment.
Sustainability can be depicted using three concentric circles. It is also referred to as Triple Bottom
Line.
Environmental Protection
It includes points such as reduction of carbon footprints, water usage, non-decomposable
packaging, and wasteful processes as part of a supply chain. These processes can often be cost-
effective, and financially useful as well as important for environmental sustainability.
Social Development
The points under this pillar are: Treating employees fairly and ensuring responsible, ethical, and
sustainable treatment of employees, stakeholders, and the community in which a business operates.
Involves fairly-paid, adult employees who can operate in a safe environment.
Economic Development
This includes factors such as: To be economically sustainable, a business must be profitable and
produce enough revenues to be continued into the future. Rather than making money at any cost,
companies should attempt to generate profit in accordance with other elements of sustainability.

Notes
Measuring Sustainability
Sustainability is measured by assessing performance of the three main principles
altogether.Although, there is no universal measurement of sustainability exists, many organizations
are developing industry-specific tools and practices.
How does Sustainability affect Business?

Sustainability enables an organization to attract employees, shareholders and customers who are
invested in the goals of sustainability and share these values.The sustainability can have positive
impact on a business’ image as well as revenue.Investors, customers and employees are demanding
that businesses have a positive impact on the environment and society.
Value Drivers
Sustainable business activities may positively impact one or more of the value drivers and in turn
enhance business value. Value drivers refers to any factor that can be measured and controlled and,
in turn, affects the value of the business. The value drivers can be:
 Cost Saving
 Talent Attraction and Retention
 Brand And Reputation
 Customer Attraction and Retention
 License to operate
 Access to capital
 Productivity
Theories of Sustainability and Value

There are two conflicting theories of sustainability and the firm value. Value creating theory and
the value destroying theory. The value-creating theory predicts that integration of ESG factors into
corporate strategies reduces firm risk and promotes long-term value creation. Whereas, the value-
destroying theory predicts that social responsibility may impair opportunities to maximize the
profit that are not in the best interest of shareholders.
14.11 ESG Factors

ESG stands for Environmental, Social and Governance factors.It refers to the three key factors when
measuring the sustainability and ethical impact of an investment in a company. Most socially
responsible investors check companies out using ESG criteria to screen investments.
a. Environmental criteria
Examines how a business performs as a steward of our natural environment. It focuses on:
• Waste and pollution

• Resource depletion
• Greenhouse gas emission
• Deforestation
• Climate change

Notes
Corporate Finance
b. Social criteria
Looks at how the company is governed. It focuses on:
• Tax strategy
• Executive remuneration
• Donations and political lobbying
• Corruption and bribery
• Board diversity and structure
c. Governance criteria
Looks at how the company is governed. It focuses on:
• Tax strategy
• Executive remuneration
• Donations and political lobbying
• Corruption and bribery
• Board diversity and structure
ESG links to cash flow in five important ways due to the following reasons:
i. It helps in facilitating top-line growth.

ii. It helps in reducing costs.
iii. Helps in minimizing regulatory and legal interventions.
iv. Leads to increasing employee productivity.
v. Helps in optimizing investment and capital expenditures.
i. Top-line Growth
A strong ESG proposition helps companies tap new markets and expand into existing ones. When
governing authorities trust corporate actors, they are more likely to award them the access,
approvals, and licenses that afford fresh opportunities for growth.
ii. Cost Reductions

Executing ESG effectively can help combat rising operating expenses which can affect operating
profits due to:
• Lower energy consumption
• Reduce water intake
iii. Reduced regulatory and legal interventions

Helps reduce companies’ risk of adverse government action. It also helps to achieve greater
strategic freedom through deregulation and earn subsidies and government support.
iv. Employee productivity uplift

A strong ESG proposition can help companies attract and retain quality employees.It also helps in
enhancing employee motivation by instilling a sense of purpose and thus, increasing the
productivity overall. Employee satisfaction is positively correlated with shareholder returns.

Notes
v. Investment and asset optimization

A strong ESG proposition can enhance investment returns by allocating capital to more promising
and more sustainable opportunities. It also leads to avoid investments that may not pay off because
of longer-term environmental issues.
Conclusion
Various studies have shown that there is a positive impact of sustainability and ESG factors on the
firm’s Value. ESG factors helps in business growth, reducing the costs, minimizing regulatory and
legal interventions, increasing employee productivity and optimizing investment and capital
expenditures.All these factors in turn, affect the value of the corporation.
Summary
 Business environment refers to the sum total of all individuals, institutions and other
forces that are outside the control of a business enterprise, but that may affect its
performance. The economic, social, political, technological and other forces which operate
outside a business enterprise are part of the business environment. Moreover, the
individual consumers or competing enterprises as well as the governments, consumer
groups, competitors, courts, media and other institutions working outside an enterprise
constitute its environment.
 Business environment is an umbrella term which consists of several types of environments
such as Economic, Social, Technological, Political and legal environment.
 A business valuation is a general process of determining the economic value of a business.
Business valuation can be used to determine the fair value of a business for reasons like
purchase or sale of business, Secure external financing or adding new shareholders.
 There are three types of approaches or ways through which we can quantify the business
valuation.
o Asset-based approaches
o Earning value approaches
o Market value approaches
 The valuation of a company is affected by several factors. Historical financial performance,
Future growth potential, Size of customer base, Dependence on owner, Competitive
advantages
 The changes in the business environment are happening due to the following reasons
mainly: Rapidly changing technology, Increasing purchasing power of customers, Greater
access to capital, Effects of Globalization, Political factors.
 Changes in business environment mainly causes the following effect on the business firm.
They may lead to the following results in a firm:
o Changes in Growth rate.
o Changes in Risk Class.
o Change in future Cash flows.
o Change in the Cost of Capital.
 Currently, climate change is the most pressing issue in the entire world. It refers to the
long-term shifts in the earth’s weather patterns that can be caused by natural phenomena
or human activity. The term is used to mean rising average global temperatures caused by
the concentration of greenhouse gas emissions.

Notes
Corporate Finance
 Climate change risks and opportunities can impact revenues, costs and risk profiles of
companies as well as investment attractiveness. The value of a company is defined by the
present value of the stream of cash flows that can be produced in the future taking into
account the size of the cash flows, their timing and the risk associated with achieving
them.
 Climate change will have significant and lasting impacts on the economic growth and
prosperity. It is a defining factor in companies’ long-term prospects because of its effect on
cash flow assumptions, terminal values and exit values. These factors make it a business
risk and a mainstream business issue.
 Sustainability is the ability to exist and develop without depleting natural resources for
the future.A sustainable society must be socially responsible, focusing on environmental
protection and dynamic equilibrium in human and natural systems.
 There are mainly three pillars of Sustainability namely, Economy and Society and the
Environment. Sustainability can be depicted using three concentric circles. It is also
referred to as Triple Bottom Line.
 Sustainability enables an organization to attract employees, shareholders and customers
who are invested in the goals of sustainability and share these values. The sustainability
can have positive impact on a business’ image as well as revenue. Investors, customers
and employees are demanding that businesses have a positive impact on the environment
and society.
 There are two conflicting theories of sustainability and the firm value. Value creating
theory and the value destroying theory. The value-creating theory predicts that integration
of ESG factors into corporate strategies reduces firm risk and promotes long-term value
creation. Whereas, the value-destroying theory predicts that social responsibility may
impair opportunities to maximize the profit that are not in the best interest of
shareholders.
 ESG stands for Environmental, Social and Governance factors. It refers to the three key
factors when measuring the sustainability and ethical impact of an investment in a
company. Most socially responsible investors check companies out using ESG criteria to
screen investments.
Keywords
Business environment, ESG, Climate change, Sustainability, Corporate Valuation, Value drivers,
SelfAssessment
1. Corporate wealth maximization is the value maximization for_____
A. Equity shareholders
B. Stakeholders
C. Employees
D. Debt capital owners
2. Which of the following are the dimensions of the business environment:
A. Economic & Social

B. Technological & Economic

Notes
C. Legal & Social

D. All of the above
3. Which of the following are the impact of govt. policy changes on business & industry?
A. Increased competition
B. Need for change
C. Demanding customers
D. All of the above
4. Which of the following is not a component of specific forces of business environment?
A. Technological conditions
B. Customers
C. Employees
D. Investors
5. __________ are generally considered as controllable factors.
A. Internal factors
B. External factors
C. Cost of production
D. None of these
6. What does ESG stand for?
A. Environmental, sustainable, green

B. Ethical, social, goals-based
C. Environmental, social, governance
7. ESG links to cash flow in five important ways:
A. Facilitating top-line growth.

B. Reducing costs.
C. Minimizing regulatory and legal interventions.
D. All of the above
8. Which of the following options is not incorporated as sustainable development parameters?
A. Gender disparity and diversity

B. Inter and intra-generational equity
C. Carrying capacity
9. Modern concept of sustainable development focuses more on
A. economic development

Notes
Corporate Finance
B. social development
C. environmental protection
D. all of the above
10. The advantages of business sustainability are:
A. Improves trust and engagement between staff, investors, customers and other stakeholders.
B. Attracts and retains employees.
C. Builds credibility and improves relationships.
D. All of the above
11. CSR stands for
A. Corporate Search and Rescue

B. Corporate Social Responsibility
C. Corporate Sensitive Reliability
D. Corporate Social Reality
12. The stakeholder view of social responsibility states that organizations must respond to the
needs of
A. employees and customers

B. shareholders and owners
C. all interested parties
D. all those who might sue the organisation
13. A socially responsible mutual fund will only purchase stocks in companies that
A. A. have a no-smoking policy in place

B. B. have a culturally diverse management team
C. C. hire some job candidates who are HIV positive
D. D. have good social performance.
14. Why, according to stakeholder theory, is it in companies' best interests to pay attention to their
stakeholders?
A. If firms only act in their own self-interest employees may feel exploited
B. If firms only act in their own self-interest government might put more regulation on them
C. If firms only act in their own self-interest customers might not like the image that the
company portray
D. If firms only act in their own self-interest and inflict harm on stakeholders then society
might withdraw its support
15. What is the triple bottom line?
A. An accounting tool that looks at the impact on people, planet and profits
B. A management strategy which states all the attention should be on profits
C. An accounting tool that looks at cost, profit and loss
D. A management strategy which focuses on corporate social responsibility

1. A 2. D 3. D 4. A 5. A
6. C 7. D 8. D 9. D 10. D

Notes
11. B 12. C 13. D 14. D 15. A
Review Questions
1. Analyze the impact of climate change on the corporate valuation
2. List the different types of business environments
3. Explain the concept of sustainability. List the three pillars of sustainability.
4. Discuss in brief the various value drivers in the context of business firm
5. Explain the concept of ESG. List the points to be considered under each of its component.
Further Readings
1. https://corporatefinanceinstitute.com/resources/knowledge/other/esg-
environmental-social-governance/
2. https://www.investopedia.com/terms/e/environmental-social-and-governance-
esg-criteria.asp
3. https://www.cfainstitute.org/en/research/esg-investing

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Corporate Finance

Unit 1: Financial Management 1

Unit 01: Financial Management

 Understand the meaning of Corporate Finance

1.1 Classification of finance

Lovely Professional University 1

1.2 Corporate Finance

The three Important Activities that Govern Corporate Finance:

1. Investments & Capital Budgeting

1.3 Evolution of finance

Traditional Phase Transitional Phase Modern Phase

2 Lovely Professional University

Unit 01: Financial Management

 Arranging, formation, issuance of funds.

 Nature of financial management was similar to same as Traditional phase.

 The scope of financial management got broadened.

1.4 Finance Functions

Investment Decision Financing Decision Dividend Decision

Lovely Professional University 3

Short-term Financial Decision: Liquidity Decision

1.5 Role of a finance manager

Understanding Capital Markets

4 Lovely Professional University

Unit 01: Financial Management

Understanding Capital Markets

1.6 The Basic Goal: Creating Shareholder Value

Lovely Professional University 5

(b) Wealth Maximization

Favorable Arguments for Wealth Maximization

Profit Maximization V/s Shareholder Wealth Maximization

1.7 Organization of Finance Functions

6 Lovely Professional University

Unit 01: Financial Management

Board of Chief Executive Treasurer

The Financial Functions Within a Corporation

Chief Executive Officer(CEO)

1.8 Agency issues

Lovely Professional University 7

Principal Conflict of Interests Agent

Types of Agency problem:

Solving Agency issues

1.9 Business ethics and social responsibility

8 Lovely Professional University

Unit 01: Financial Management

Arguments for Social Responsibility

Lovely Professional University 9

Arguments Against Social Responsibility

Reality of Social Responsibility

Kinds of Social Responsibility:

10 Lovely Professional University

Unit 01: Financial Management

Lovely Professional University 11

 A firm has social responsibility towards different stakeholders. It has responsibilities

2. Profits do not have to be shared in which of the following organization type

3. ________is the limitation of Traditional approach of Financial Management.

4. Financial decisions of an individual like planning application of income, deciding on mode

5. Which of the following option/s is/are true about Corporate Finance:

6. Which one of the following is a short-term financial decision?

12 Lovely Professional University

Unit 01: Financial Management