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20MB07-Financial management

Unit –II

Financing Decision: Sources of finance – Concept and financial effects of leverage – EBIT – EPS analysis. Cost of Capital: Weighted Average Cost of Capital– Theories of Capital Structure.

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FINANCIAL NEEDS AND SOURCES OF FINANCE OF A BUSINESS

Financial Needs of a Business

Business enterprises need funds to meet their different types of requirements. All the financial needs of a business may be grouped into the following three categories:

Long-term financial needs: Such needs generally refer to those requirements of funds which are for a period exceeding 5-10 years. All investments in plant, machinery, land, buildings, etc., are considered as long-term financial needs. Funds required to finance permanent or hard-core working capital should also be procured from long term sources.
Medium- term financial needs: Such requirements refer to those funds which are required for a period exceeding one year but not exceeding 5 years. For example, if a company resorts to extensive publicity and advertisement campaign then such type of expenses may be written off over a period of 3 to 5 years. These are called deferred revenue expenses and funds required for these are classified in the category of medium-term financial needs.

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FINANCIAL NEEDS AND SOURCES OF FINANCE OF A BUSINESS

Short- term financial needs: Such type of financial needs arise to finance current assets such as stock, debtors, cash, etc. Investment in these assets are known as meeting of working capital requirements of the concern. The main characteristic of short-term financial needs is that they arise for a short period of time not exceeding the accounting period. i.e., one year.

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�CLASSIFICATION OF FINANCIAL SOURCES�

There are mainly two ways of classifying various financial sources (i) Based on basic Sources (ii) Based on Maturity of repayment period�Sources of Finance based on Basic Sources

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Sources of Finance based on Maturity of Payment�

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LONG-TERM SOURCES OF FINANCE�

LONG-TERM SOURCES OF FINANCE

There are different sources of funds available to meet long term financial needs of the business. These sources may be broadly classified into:

• Share capital (both equity and preference) &

• Debt (including debentures, long term borrowings or other debt instruments). The different sources of long-term finance has been discussed as follows:

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Owners Capital or Equity Capital

A public limited company may raise funds from promoters or from the investing public by way of owner’s capital or equity capital by issuing ordinary equity shares. Some of the characteristics of Owners/Equity Share Capital are:-
It is a source of permanent capital. The holders of such share capital in the company are called equity shareholders or ordinary shareholders.
Equity shareholders are practically owners of the company as they undertake the highest risk.
Equity shareholders are entitled to dividends after the income claims of other stakeholders are satisfied. The dividend payable to them is an appropriation of profits and not a charge against profits.
In the event of winding up, ordinary shareholders can exercise their claim on assets after the claims of the other suppliers of capital have been met.
The cost of ordinary shares is usually the highest. This is due to the fact that such shareholders expect a higher rate of return (as their risk is the highest) on their investment as compared to other suppliers of long-term funds.

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Owners Capital or Equity Capital

Ordinary share capital also provides a security to other suppliers of funds. Any institution giving loan to a company would make sure the debt-equity ratio is comfortable to cover the debt. There can be various types of equity shares like New issue, Rights issue, Bonus Shares, Sweat Equity.

(Sweat equity shares are shares issued by a company to its employees or Directors, either at a discount or for consideration other than cash

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Advantages of raising funds by issue of equity shares are:�

(i)It is a permanent source of finance. Since such shares are not redeemable, the company has no liability for cash outflows associated with its redemption. In other words, once the company has issued equity shares, they are tradable i.e. they can be purchased and sold. So, a company is in no way responsible for any cash outflows of investors by which they become the shareholders of the company by purchasing the shares of existing shareholders.

(ii) Equity capital increases the company’s financial base and thus helps to further the borrowing powers of the company. In other words, by issuing equity shares, a company manage to raise some money for its capital expenditures and this helps it to raise more funds with the help of debt. This is because; debt will enable the company to increase its earnings per share and consequently, its share prices.

(iii)A company is not obliged legally to pay dividends. Hence in times of uncertainties or when the company is not performing well, dividend payments can be reduced or even suspended.

(iv)A company can make further increase its share capital by initiating a right issue.

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Disadvantages of raising funds by issue of equity shares are:�

(i) Dividend income is taxable in the hands of the recipient of dividend.
(ii) Investors find ordinary shares riskier because of uncertain dividend payments and capital gains.
(iii) The issue of new equity shares reduces the earning per share of the existing shareholders until and unless the profits are proportionately increased.
(iv) The issue of new equity shares can also reduce the ownership and control of the existing shareholders.

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Preference Share Capital

These are special kind of shares; the holders of such shares enjoy priority, both as regard to the payment of a fixed amount of dividend and also towards repayment of capital on winding up of the company. Some of the characteristics of Preference Share Capital are as follows:

Long-term funds from preference shares can be raised through a public issue of shares.
Such shares are normally cumulative, i.e., the dividend payable in a year of loss gets carried over to the next year till there are adequate profits to pay the cumulative dividends.

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Preference Share Capital

The rate of dividend on preference shares is normally higher than the rate of interest on debentures, loans etc.
Preference share capital is a hybrid form of financing which imbibes within itself some characteristics of equity capital and some attributes of debt capital. It is similar to equity because preference dividend, like equity dividend is not a tax- deductible payment. It resembles debt capital because the rate of preference dividend is fixed.

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Various types of Preference shares can be as below:

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Sl. No.	Type of Preference Shares	Salient Features
1	Cumulative	Arrear Dividend will accumulate.
2	Non-cumulative	No right to arrear dividend.
3	Redeemable	Redemption should be done.
4	Participating	Can participate in the surplus which remains after payment to equity shareholders.
5	Non- Participating	Cannot participate in the surplus after payment of fixed rate of Dividend.
6	Convertible	Option of converting into equity Shares.

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Advantages

There is no risk of takeover as the preference shareholders do not have voting rights except where dividend payment are in arrears.
The preference dividends are fixed and pre-decided. Hence preference shareholders cannot participate in surplus profits as the ordinary shareholders can except in case of participating preference shareholders.
Preference capital can be redeemed after a specified period.

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Disadvantages

(i) One of the major disadvantages of preference shares is that preference dividend is not tax deductible and so does not provide a tax shield to the company. Hence preference shares are costlier to the company than debt e.g. debenture.
(ii) Preference dividends are cumulative in nature. This means that if in a particular year preference dividends are not paid they shall be accumulated and paid later. Also, if these dividends are not paid, no dividend can be paid to ordinary shareholders. The non-payment of dividend to ordinary shareholders could seriously impair the reputation of the concerned company.

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Difference between Equity Shares and Preference Shares are as follows:

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Sl. No.	Basis of Distinction	Equity Share	Preference Share
1	Preference dividend	Equity Dividend is paid after preference dividend.	Payment of preference dividend is preferred over equity dividend
2	Rate of dividend	Fluctuating	Fixed
3	Convertibility	Not convertible	Convertible
4	Voting rights	Equity shareholders enjoy voting rights	They have very limited voting rights

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Retained Earnings�

Long-term funds may also be provided by accumulating the profits of the company and by ploughing them back into business. Such funds belong to the ordinary shareholders and increase the net worth of the company. A public limited company must plough back a reasonable amount of profit every year keeping in view the legal requirements in this regard and also for its own expansion plans. Such funds also entail almost no risk. Further, control of present owners is also not diluted by retaining profits.

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Debentures

Loans can be raised from public by issuing debentures or bonds by public limited companies. Some of the characteristics of debentures are:
Debentures are normally issued in different denominations ranging from ` 100 to ` 1,000 and carry different rates of interest.
Normally, debentures are issued on the basis of a debenture trust deed which lists the terms and conditions on which the debentures are floated.
Debentures are basically instruments for raising long-term debt capital.

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Debentures

The period of maturity normally varies from 3 to 10 years and may also increase for projects having high gestation period.
Debentures are either secured or unsecured.
They may or may not be listed on the stock exchange.
The cost of capital raised through debentures is quite low since the interest payable on debentures can be charged as an expense before tax.
From the investors' point of view, debentures offer a more attractive prospect than the preference shares since interest on debentures is payable whether or not the company makes profits.

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Debentures can be divided into the following three categories based on their convertibility:

(i)Non-convertible debentures – These types of debentures do not have any feature of conversion and are repayable on maturity.

(ii)Fully convertible debentures – Such debentures are converted into equity shares as per the terms of issue in relation to price and the time of conversion. Interest rates on such debentures are generally less than the non-convertible debentures because they carry an attractive feature of getting themselves converted into shares at a later time.

(iii)Partly convertible debentures – These debentures carry features of both convertible and non-convertible debentures. The investor has the advantage of having both the features in one debenture.

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Other types of Debentures with their features are as follows:�

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Sl. No.	Type of Debenture	Salient Feature
1	Bearer	Transferable like negotiable instruments
2	Registered	Interest payable to registered person
3	Mortgage	Secured by a charge on Asset(s)
4	Naked or simple	Unsecured
5	Redeemable	Repaid after a certain period
6	Non-Redeemable	Not repayable

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Advantages of raising finance by issue of debentures are:�

The cost of debentures is much lower than the cost of preference or equity capital as the interest is tax-deductible. Also, investors consider debenture investment safer than equity or preferred investment and, hence, may require a lower return on debenture investment.
Debenture financing does not result in dilution of control.
In a period of rising prices, debenture issue is advantageous. The fixed monetary outgo decreases in real terms as the price level increases. In other words, the company has to pay a fixed rate of interest.

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The disadvantages of debenture financing are:�

Debenture interest and the repayment of its principal amount is an obligatory payment.
The protective covenants associated with a debenture issue may be restrictive.
Debenture financing enhances the financial risk associated with the firm because of the reasons given in point (i).
Since debentures need to be paid at the time of maturity, a large amount of cash outflow is needed at that time.

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Difference between Preference Shares and Debentures

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Basis of difference	Preference shares	Debentures
Ownership	Preference Share Capital is a special kind of share	Debenture is a type of loan which can be raised from the public
Payment of Dividend/Interest	The preference shareholders enjoy priority both as regard to the payment of a fixed amount of dividend and also towards repayment of capital in case of winding up of a company	It carries fixed percentage of interest.
Nature	Preference shares are a hybrid form of financing with some characteristic of equity shares and some attributes of Debt Capital.	Debentures are instrument for raising long term capital with a fixed period of maturity.

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Loans from Financial Institutions:

Financial Institution: National

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Sl. No.	Name of the Financial Institution	Year of Establishment	Remarks
1	Industrial Finance Corporation of India (IFCI)	1918	Converted into a public Company
2	State Financial Corporations (SFCs)	1951	-
3	Industrial Development Bank of India (IDBI)	1954	Converted into Bank
4	National Industrial Development Corporation (NIDC)	1954	-

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5	Industrial Credit and Investment Corporation of India (ICICI)	1955	Converted into Bank and Privatised
6	Life Insurance Corporation of India (LIC)	1956	-
7.	Unit Trust of India (UTI)	1964	-
8	Industrial Reconstruction Bank of India (IRBI)	1971	-

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Financial Institution: International Institutions

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Sl. No.	Name of the Financial Institution	Year of Establishment
1	The World Bank/ International Bank for Reconstruction and Development (IBRD)	1944
2	The International Finance Corporation (IFC)	1956
3	Asian Development Bank (ADB)	1966

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Bridge Finance: Bridge finance refers to loans taken by a company normally from commercial banks for a short period because of pending disbursement of loans sanctioned by financial institutions
The venture capital financing refers to financing of new high risky venture promoted by qualified entrepreneurs who lack experience and funds to give shape to their ideas.

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COST OF CAPITAL

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Weighted Average Cost of Capital (WACC)

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COST OF CAPITAL MEANING

Cost of capital is the return expected by the providers of capital (i.e. shareholders, lenders and the debt-holders) to the business as a compensation for their contribution to the total capital.

This cost of capital expressed in rate is used to discount/ compound the cashflow or stream of cashflows. Cost of capital is also known as ‘cut-off’ rate, ‘hurdle rate’, ‘minimum rate of return’ etc. It is used as a benchmark for:

•Framing debt policy of a firm.

•Taking Capital budgeting decisions.

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COST OF LONG-TERM DEBT

External borrowings or debt instruments do no confers ownership to the providers of finance. The providers of the debt fund do not participate in the affairs of the company but enjoys the charge on the profit before taxes. Long term debt includes long term loans from the financial institutions, capital from issuing debentures or bonds etc.

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Features of debentures or bonds:

(i)Face Value: Debentures or Bonds are denominated with some value; this denominated value is called face value of the debenture. Interest is calculated on the face value of the debentures. E.g. If a company issue 9%Non- convertible debentures of Rs100 each, this means the face value is Rs 100 and the interest @ 9% will be calculated on this face value.

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(ii) Interest (Coupon) Rate: Each debenture bears a fixed interest (coupon) rate (except Zero coupon bond and Deep discount bond). Interest (coupon) rate is applied to face value of debenture to calculate interest, which is payable to the holders of debentures periodically.
(iii) Maturity period: Debentures or Bonds has a fixed maturity period for redemption. However, in case of irredeemable debentures maturity period is not defined and it is taken as infinite.
(iv) Redemption Value: Redeemable debentures or bonds are redeemed on its specified maturity date. Based on the debt covenants the redemption value is determined. Redemption value may vary from the face value of the debenture.
(v) Benefit of tax shield: The payment of interest to the debenture holders are allowed as expenses for the purpose of corporate tax determination. Hence, interest paid to the debenture holders save the tax liability of the company. Saving in the tax liability is also known as tax shield. The example given below will show you how interest paid by a company reduces the tax liability:

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Example - 1: There are two companies namely X Ltd. and Y Ltd. The capital of the X Ltd is fully financed by the shareholders whereas Y Ltd uses debt fund as well. The below is the profitability statement of both the companies:

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	X Ltd. (` in lakh)	Y Ltd. (` in lakh)
Earnings before interest and taxes (EBIT)	100	100
Interest paid to debenture holders	-	(40)
Profit before tax (PBT)	100	60
Tax @ 35%	(35)	(21)
Profit after tax (PAT)	65	39

A comparison of the two companies shows that an interest payment of 40 by the Y Ltd. results in a tax shield (tax saving) of RS 14 lakh (RS 40 lakh paid as interest × 35% tax rate). Therefore, the effective interest is Rs 26 lakh only.

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Based on redemption (repayment of principal) on maturity the debts can be categorised into two types (i) Irredeemable debts and (ii) Redeemable debts

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Cost of Irredeemable Debentures�

The cost of debentures which are not redeemed by the issuer of the debenture is known as irredeemable debentures. Cost of debentures not redeemable during the life time of the company is calculated as below:

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Net proceeds mean issue price less issue expenses. If issue price is not given then students can assume it to be equal to current market price. If issue expenses are not given simply assume it equal to zero.

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A1) When debt is issued at par:

NP = Face value-Issued expenses

A2) When debt issued at premium:

NP = Face value + Premium – Issue expenses

A3) When debt issued at discount:

NP = Face value – Discount – Issue expenses

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Cost of Redeemable Debentures (using approximation method)

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A company issued 10,000, 10% debentures of Rs 100 each at par on 1.4.2012 to be matured on 1.4.2022. The company wants to know the cost of its existing debt on 1.4.2017 when the market price of the debentures is Rs 80. COMPUTE the cost of existing debentures assuming 35% tax rate.

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A company issued convertible debentures ₹ 1000 lakhs. Each debentures has a face value of ₹100 and carries a rate of interest of 12% . The company realised ₹97 per debenture. The interest is payable annually. What is the cost of debentures to the company?

When the debentures is redeemed at par after 5 years?
When the debentures is redeemable at a premium of 5% after 5 years?
The corporate tax is 30%

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When the debentures is redeemed at par after 5 years?�

Given I = 12% X face value = 12% x100 = ₹12

face value = ₹100

n = 5 years

t (tax rate ) = 30% = 0.3

NP = ₹97

K_d = 12 (1-0.30) + (100-97)/5

____________________ = 8.4 +0.6 / 98.5 = 9/9.85 = 0.09137 = 9.137%

(100+97)/2

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When the debentures is redeemable at a premium of 5% after 5 years?�

Face value = ₹100 plus 5% premium = 100 + 100*5%= 100+5 =105

K_{d =} 12 (1-0.30)+ (105-97)/5

_{_____________________________}

(105+97)/2

₌ 8.4 +1.6/101 = 0.0991 = 9.9%

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COST OF PREFERENCE SHARE CAPITAL

The preference shareholders are paid dividend at a specified rate on face value of preference shares. Payment of dividend to the preference shareholders are not mandatory but are given priority over the equity shareholder. The payment of dividend to the preference shareholders are not charged as expenses but treated as appropriation of after-tax profit. Hence, dividend paid to preference shareholders does not reduce the tax liability to the company. Like the debentures, Preference share capital can be categorised as redeemable and irredeemable. Accordingly cost of capital for each type will be discussed here

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Cost of Irredeemable Preference Shares�

The cost of irredeemable preference shares is similar to calculation of perpetuity. The cost is calculated by dividing the preference dividend with the current market price or net proceeds from the issue. The cost of irredeemable preference share is as below:

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= 10/95 = 0.1053 = 10.53 &

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Cost of Redeemable Preference Shares

Preference shares issued by a company which are redeemed on its maturity is called redeemable preference shares. Cost of redeemable preference share is similar to the cost of redeemable debentures with the exception that the dividends paid to the preference shareholders are not tax deductible. Cost of preference capital is calculated as follows:

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A public limited company made an issue of 10,000 preference shares under the following terms
each preference share has the face value of ₹100
rate of preference dividend is 10% payable annually
the preference shares redeemable after 10 years at par
net amount realised per share is ₹95
what is the cost of the preference capital ?

Answer : 0.1077

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Cost of Equity Share Capital (Ke)

Equity capital does not carry any cost .but this is not true. the market share price is a function of return that equity shareholders expect and get. If the company does not meet their requirements it will have an adverse effect on the market share price. Also it is relatively the highest cost of capital. Due to relative higher risk ,equity shareholder expect higher return , hence the cost of capital is also high
The cost of equity capital is the return which is expected by its investors.
In order to provide expected returns to the equity shareholders, company must earn minimum rate of return which is necessary to have a constant market price of the shares. The expectations of the shareholders must be considered before issuing new equity shares for raising additional capital.

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Just like any other source of finance, cost of equity is expectation of equity shareholders. We know that value is performance divided by expectations. If we know value and performance, then we can calculate expectation as a balancing figure.
Here performance means the amount paid by the company to investors, like interest, dividend, redemption price etc. In case of debentures and preference shares amount of interest or dividend is fixed but in case of equity shares it is uncertain.
Therefore, there is no single method for calculation of cost of equity.

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Different methods are employed to compute the cost of equity share capital.

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Dividend Price Approach�

This is also known as Dividend Valuation Model. This model makes an assumption that the dividend per share is expected to remain constant forever. Here, cost of equity capital is computed by dividing the expected dividend by market price per share as follows:

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Earnings/ Price Approach

this approach co-relate the earnings of the company with the market price of its share. Accordingly, the cost of equity share capital would be based upon the expected rate Earnings/ Price Approach:

Where,
E = Current earnings per share P = Market share price of earnings of a company.

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Growth Approach or Gordon’s Model�

As per this approach the rate of dividend growth remains constant. Where earnings, dividends and equity share price all grow at the same rate, the cost of equity capital may be computed as follows:

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A company has paid dividend of ₹1 per share (of face value of ₹10 each) last year and it is expected to grow @ 10% next year. CALCULATE the cost of equity if the market price of share is ₹55.

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Realized Yield Approach

According to this approach, the average rate of return realized in the past few years is historically regarded as ‘expected return’ in the future. It computes cost of equity based on the past records of dividends actually realised by the equity shareholders. Though, this approach provides a single mechanism of calculating cost of equity, it has unrealistic assumptions like risks faced by the company remain same; the shareholders continue to expect the same rate of return; and the reinvestment opportunity cost (rate) of the shareholders is same as the realised yield. If the earnings do not remain stable, this method is not practical.

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Mr. Mehra had purchased a share of Alpha Limited for ₹1,000. He received dividend for a period of five years at the rate of 10 percent. At the end of the fifth year, he sold the share of Alpha Limited for ₹ 1,128. You are required to COMPUTE the cost of equity as per realised yield approach.

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Capital Asset Pricing Model (CAPM) Approach

CAPM model describes the risk-return trade-off for securities. It describes the linear relationship between risk and return for securities.
The risks, to which a security is exposed, can be classified into two groups:
(i) Unsystematic Risk: This is also called company specific risk as the risk is related with the company’s performance. This type of risk can be reduced or eliminated by diversification of the securities portfolio. This is also known as diversifiable risk.
(ii) Systematic Risk: It is the macro-economic or market specific risk under which a company operates. This type of risk cannot be eliminated by the diversification hence, it is non-diversifiable. The examples are inflation, Government policy, interest rate etc.
As diversifiable risk can be eliminated by an investor through diversification, the non-diversifiable risk is the risk which cannot be eliminated; therefore, a business should be concerned as per CAPM method, solely with non-diversifiable risk.
The non-diversifiable risks are assessed in terms of beta coefficient (b or β) through fitting regression equation between return of a security and the return on a market portfolio.

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Thus, the cost of equity capital can be calculated under this approach as:

Cost of Equity (Ke)= Rf + ß (Rm − Rf)

Where,

Ke = Cost of equity capital

Rf = Risk free rate of return

ß = Beta coefficient

Rm = Rate of return on market portfolio

(Rm – Rf) = Market risk premium

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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%.

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Ke = Rf + ß (Rm − Rf)

Ke = 0.10 + 1.75 (0.15 − 0.10)

= 0.10 + 1.75 (0.05) = 0.1875 or 18.75%

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COST OF RETAINED EARNINGS�

Like other source of fund, retained earnings involve cost. It is the opportunity cost of dividends foregone by shareholders.

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Cost of equity of a company is 20%. Rate of floatation cost is 5%. Rate of personal income tax is 30%. Calculate cost of retained earnings.

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Problem

The cost of capital (after tax) of a company is the specific sources is as follows:

Cost of Debt	4.00%
Cost of Preference shares	11.50%
Cost of Equity Capital	15.50%
Cost of Retained Earnings	14.50%
(assuming external )

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Cont………

Capital Structure are Sources	Amount
Debt	3,00,000
Preference Shares	4,00,000
Equity Share Capital	6,00,000
Retained Earnings	2,00,000
	15,00,000

Calculate the weighted average cost of capital using ‘Book Value Weight’.

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Solution:

Computation Of Weighted Average

Cost Of Capital Under Book Value Weights

Sources (a)	Amount (b)	Proportion(c)	After tax cost(d)	Weighted cost (e) = (c) X (d)
Debt	300000	0.200(20%)	0.0400	0.0080
Preference Share capital	400000	0.267(26.7%)	0.1150	0.0307
Equity Share Capital	600000	0.400(40%)	0.1550	0.0620
Retained Earnings	200000	0.133(13.3%)	0.1450	0.0193
	1500000	1.000(100%)		0.1200

WEIGHTED AVERAGE COST OF CAPITAL : 12%

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Alternative Approach

Computation Of Weighted Average Cost Of Capital

Sources (a)

Amount (b)

Cost (c)

Total cost (d) = (b) X (c)

Debt

300000

4.00%

12000

capital

Preference Share 400000

11.50%

46000

15.50%

93000

Equity Share Capital 600000

Retained Earnings 200000

14.50%

29000

1500000

180000

WEIGHTED AVERAGE COST OF CAPITAL = 180000/1500000 = 12%

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Leverages

In Financial Management, Leverage means the influence of one financial variable over some other related variable It is used to explain firm’s ability to use fixed cost to magnify the returns to its owner. Leverage exist s has fixed costs. If there is fixed costs & if there is uncertainty to generate risk. There are two types of risk & these are 1. Operating Risk / Business Risk 2. Financial Risk

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The term leverage refers to a relationship between two interrelated variables. In a business firm, these variables may be costs, output, sales, revenue, EBIT, Earning per share etc. Thus, leverage reflects the responsiveness or influence of one variable over some other financial variables. In leverage analysis, the emphasis is on the measurement of the relationship of two variables rather than on measuring these variables. It is important to remember that leverage arises from the existence of fixed costs in a company.

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In simple terms, leverage may be defined as the % change in one variable divided by the % change in some other variable. Here, the numerator is the dependent variable (y) and the (x) is the independent variable.

Algebraically, Leverage =% Change in the dependent variable / % Change in Independent variable.

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MEANING AND TYPES OF LEVERAGE

Leverage : Profit or loss arise in the organisation due to the involvement of fixed cost.
Fixed cost is divided into two types
Operating fixed cost
Financial fixed cost
Operating fixed cost means profit or loss arise in the organisation due to the involvement of operating fixed cost

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Operating fixed costs are expenses that a business incurs regardless of the level of production or sales. These costs are fixed in the short-term and do not vary with changes in output or sales volume. Some examples of operating fixed costs include:
Rent and lease payments for office space, warehouses, or other facilities.
Salaries and wages for management and administrative staff.
Insurance premiums for business liability, property, or employee health insurance.
Depreciation of fixed assets such as equipment, machinery, or vehicles.
Property taxes on owned assets such as buildings and land.
Utilities such as electricity, water, and gas.
Internet and telephone expenses.
Operating fixed costs are important to consider when determining a business's breakeven point, as they represent the minimum level of revenue needed to cover these expenses and begin generating profit. It is also important to keep these costs as low as possible in order to maximize profit margins.

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Financial fixed cost means profit or loss arises in the organisation due to involvement of financial fixed cost

Financial fixed costs refer to the expenses that a business must pay regardless of its level of production or sales, and which are related to financing and capital structure. Unlike operating fixed costs, which are related to the day-to-day operation of the business, financial fixed costs are not directly related to the production of goods or services.
Examples of financial fixed costs include:
Interest payments on loans or bonds
Lease payments on finance leases
Preferred stock dividends
Fees associated with issuing and servicing debt or equity instruments
Insurance premiums for credit protection
Financial fixed costs can have a significant impact on a business's profitability, as they must be paid regardless of how well the business is performing. They are an important consideration when analysing a business's financial health and evaluating its ability to service its debt and other financial obligations.

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Types of Leverage

There are three commonly used measures of leverage in financial analysis. These are:
(i) Operating Leverage: It is the relationship between Sales and EBIT and indicated business risk.
(ii) Financial Leverage: it is the relationship between EBIT and EPS and indicates financial risk.
(iii) Combined Leverage: It is the relationship between Sales and EPS and indicated total risk.

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OPERATING LEVERAGE:-
It is the ability of the firm to use fixed operating costs to magnify the effects of changes in sales on its EBIT ( Earnings before interest & tax).The firm can measure its operating Risk through operating leverage.
Measurement of Operating Leverage:-

DOL = % Change in EBIT /% Change in Sales

Contribution /EBIT

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Degree of Operating Leverage (DOL):Degree of Operating Leverage may be defined as percentage change in EBIT with respect to percentage change in sales quantity.

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FINANCIAL LEVERAGE:-

It is the ability of the firm to use fixed financial charges (e.g Interest) to magnify the effects of changes in EBIT on the Firm’s EPS.(Earning per Share). The firm can measure its Financial Risk through financial leverage

Measurement of Financial Leverage:

DFL = % Change in EPS

% Change in EBIT

DFL = EBIT

EBT

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COMBINED LEVERAGE:-

It is the ability of the firm to use fixed costs both fixed & financial which magnifies the effect of change in sales volume on the EPS of the firm. The firm can measure its total Risk through combined leverage
Measurement of Combined Leverage:- DCL =% Change in EPS/

% Change in Sales �Or

Contribution /EBT

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1. From the following information compute sales:-
DOL – 2; DFL – 3; Interest – Rs. 3,00,000 & contribution is 40% of sales.

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SOLUTION -�

Degree of Financial Leverage ( DFL) = EBIT/EBT
Or, we can say 3 = EBIT/EBIT – Rs. 3,00,000

Or, 3EBIT – 9, 00,000 = EBIT

OR, EBIT = Rs. 4, 50,000
Again we have,
Degree of Operating Leverage (DOL) = Contribution/EBIT

Or, 2 = Contribution/ 4, 50,000

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Or, Contribution = Rs. 9, 00,000
Now, Contribution = 40% of Sales (given) Or,
Sales = Contribution

40%

= 9,00,000

40%
= Rs. 22, 50,000.(ANS.)

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Calculate DFL , DOL , DCL From the following information
Quantity produced = 5000 units
Variable cost per unit = ₹ 200
Selling price per unit = ₹ 500
No.of equity shares = 500000
Total fixed cost = ₹9000000
Interest = ₹75000
Preference dividend = ₹ 50000
Corporate tax = 50%
Equity earnings = ₹163500

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CAPITAL STRUCTURE�

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MEANING OF CAPITAL STRUCTURE�

Capital structure is the combination of capitals from different sources of finance. The capital of a company consists of equity share holders’ fund, preference share capital and long term external debts. The source and quantum of capital is decided keeping in mind following factors:
1. Control: capital structure should be designed in such a manner that existing shareholders continue to hold majority stake.
2. Risk: capital structure should be designed in such a manner that financial risk of the company does not increases beyond tolerable limit.
3. Cost: overall cost of capital remains minimum.

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Practically, it is difficult to achieve all of the above three goals together, hence, a finance manager has to make a balance among these three objectives.
However, the objective of a company is to maximise the value of the company and it is prime objective while deciding the optimal capital structure. Capital Structure decision refers to deciding the forms of financing (which sources to be tapped); their actual requirements (amount to be funded) and their relative proportions (mix) in total capitalisation.

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The Capital Structure decision affects the financial risk and value of the firm. Capital structure theories help us to understand the relationship between the capital structure, cost of capital and value of a firm.

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Net Income (NI) Approach

Net Income (NI) Approach – Durand presented the Net Income Approach which suggested that capital structure is relevant to the valuation of a firm. This means that a change in capital structure of a firm will lead to a change in a firm`s market value and overall cost of capital (Weighted average cost of capital). According to this approach, a firm must finance its activities more from debt capital and less from equity capital to reduce the overall cost of capital and maximize the value of the firm. This is because cost of debt financing is cheaper that equity financing as the theory assumes that cost of debt and cost of equity are independent to the capital structure. In other words, a change in financial leverage of a firm will lead to a corresponding change in

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firm`s WACC (weighted average cost of capital) and market value of shares. Therefore a firm must increase its financial leverage (proportion of debt) in order to decrease its WACC and increase the market value of its shares.

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Assumptions of NI Approach

Corporate taxes do not exist
The cost of debt is less than cost of equity i.e.

K_d <K_e

An increase in debt does not change the confidence of investors in the business

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Valuation of a Firm according to NI Approach

(1) Value of a firm (V)

V = S + B

Here,

V = Value of the Firm
S = Market value of Equity
B = Market value of Debt

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(2) Market Value of Equity (S)
S = NI/K_e
Here,
NI = Earnings available for shareholders

K_e = Equity Capitalization rate

(3) Overall cost of Capital (K_o )

K_o = EBIT/V

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Net Operating Income (NOI) Approach

Net Operating Income (NOI) Approach – Contrary to the NI approach the NOI approach suggests that the capital structure decision of a firm is an irrelevant factor to the valuation of a firm i.e. any change in debt or financial leverage of a firm does not affect the market value of its shares
According to this approach the WACC and total value of a firm are independent and are not affected by any change in financial leverage or capital structure decision. However, it`s market value is dependent upon the operating income and risks associated with the business. As financial leverage can only affect the income earned by debt and equity share holders and not the operating income of a firm, therefore any change in financial leverage or capital structure will not affect the value of a firm.

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Assumptions of NOI Approach

Corporate taxes do not exist
Overall cost of capital remains constant
Cost of debt is constant
A change in debt/equity ratio does not affect the overall cost of capital

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Traditional approach

This approach is the midway of NI approach and NOT approach and also known as intermediate approach
According this approach the value of firm can be increased initially or cost of capital can decrease by using more debt as the debt is cheaper source of fund than equity
After the optimum capital structure can be reached by a proper debt –equity mix
But after a particular point if the proportionate of debt is increased then the overall cost of capital start increasing and market value begin decline

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MM Approach – 1958: without tax:

The Modigliani-Miller approach is similar to the net operating income (NOI) approach. In other words, according to this approach, the value of a firm is independent of its capital structure.
However, there is a basic difference between the two. The NOI approach is purely conceptual. It does not provide operational justification for irrelevance of the capital structure in the valuation of the firm. While MM approach supports the NOI approach provides justification for the independence of the total valuation and cost of capital of the firm from its capital structure. In other words, MM approach maintains that the overall cost of capital does not change in the debt equity mix or capital structure of the firm.

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ASSUMPTIONS:�

(i)Capital markets are perfect. This means

(a) Investors are free to buy and sell securities.

(b) The investors can borrow without restriction on the same terms on which the firm can borrow;

(d) The investors behave rationally; and

(e) There are no transaction costs.

(ii) The firms can be classified into homogeneous risk classes all firms within the same class will have the same degree of business risk.

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(iii) All investors have the same expectation of a firms net operating income (EBIT) with which to evaluate the value of any firm.
(iv) The dividend pay-out ratio is 100%. In other words, there are no retained earnings.
(v) There are no corporate taxes. However, this assumption has been removed later.

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Proposition of MM Approach

Proposition I : The firms value depends upon investment decision not on financing decision . Therefore , total market value of all firms , levered or unlevered firms having the same business risk remains the same
Value of levered firm = value of unlevered firm
A company that has no debt is called an unlevered firm; a company that has debt in its capital structure is a levered firm.
Value of levered firm (Vg) = Value of unlevered firm (Vu)

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(ii) Proposition II : A firm having debt in capital structure has higher cost of equity than an unlevered firm. The cost of equity will include risk premium for the financial risk. The cost of equity in a levered firm is determined as under:
K_e = K_o + (K_o – K_d) Debt

Equity

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iii) Proposition III : The structure of the capital (financial leverage) does not affect the overall cost of capital. The cost of capital is only affected by the business risk

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ARBITRAGE PROCESS
The arbitrage process is the operational justification of MM hypothesis. The term “Arbitrage’ refers to an act of buying an asset or security in one market having lower price and selling it in another market at a higher price. The consequence of such action is that the market price of the securities of the two firms exactly similar in all respects except in their capital structures cannot for long remain different in different markets. Thus, arbitrage process restores equilibrium in value of securities.

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MM Approach- 1963: with tax�

In 1963, MM model was amended by incorporating tax, they recognised that the value of the firm will increase, or cost of capital will decrease where corporate taxes exist. As a result, there will be some difference in the earnings of equity and debt- holders in levered and unlevered firm and value of levered firm will be greater than the value of unlevered firm by an amount equal to amount of debt multiplied by corporate tax rate.

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