Financial Management

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Introduction to Financial Management Definition: Finance is the lifeblood of any business. Financial management involves planning and controlling a company's financial resources to achieve returns on invested capital. Key Activities: Managing manufacturing/service activities Managing human resources Selling products/services Arranging financial resources Functional Departments: Production, Human Resources, Marketing, Finance. Importance: Essential for survival, smooth operations, meeting objectives, and long-term sustainability. Nature of Finance Function Main Goal: Make a profit by investing in income-generating assets. Decisions Involved: Determining fund requirements Determining assets to be acquired (fund deployment) Determining financing patterns Finance Function is Managerial: Involves planning and control of financial resources. Intertwined with other functions: All firm operations involve acquisition and use of funds. Functions of Financial Management Routine Functions (Clerical): Supervision of cash receipts and payments & cash security. Safekeeping of securities, insurance policies, etc. Methodological procedures for new outside financing. Report preparation and record-keeping. Managerial Functions: Financial planning, management, and execution. Raising and deployment of funds. Management of surplus/deficit funds. Cost management and taxation. Approaches to Financial Management Traditional Approach (Pre-1950s) Focus: Confined to money raising for business needs (Corporate Finance). Topics: Financial instruments, banking, insurance. Limitations: Focused on external fund suppliers (investors, banks) rather than internal decision-making. Limited to episodic events (mergers, acquisitions) without attention to day-to-day financial aspects. Focused on long-term financing, ignoring working capital management. Modern Approach (Post-1950s) Shift in Focus: From episodic finance to managerial financial difficulties; from fundraising to efficient fund management. Goal: Improve company value and shareholder wealth through optimal investment, financing, and dividend decisions. Role of Financial Manager: Concerned with smart use of funds and resources. Financial Decisions Net Worth = Assets - Liabilities Company value is influenced by: Internal Factors: Investment activities, financing mix, profit distribution. External Factors: State of the economy, capital market conditions, tax rates. Financial activities are categorized into three key decisions: A) Investment Decision Definition: Most important decision; relates to assets in which money is invested. Types of Assets: Long-term assets (generate return over time) Short-term current assets (convertible to cash within a year) Capital Budgeting Decision (Long-term): Selection of investment plans for capital assets with future benefits. Requires estimating value of investment proposals, assessing risk/uncertainty. Expected return balanced against risk, compared to benchmarks (cut-off rates, cost of capital). Involves current cash outlay for expected future cash inflows. Time value of money is crucial for comparing cash flows at different times. Liquidity Decision (Short-term): Management of current assets for short-term solvency. Objective: Balance profitability and liquidity (opposing concepts). Optimal investment in current assets (cash, inventory, receivables) to avoid deficiency or excessive locking up of funds. B) Financing Decision Definition: Determines the firm's best finance mix (proportion of equity and debt). Key Consideration: Optimal capital structure to maximize shareholder return while minimizing risk. Goal: Debt-equity combination with lowest cost of capital and highest market value of equity. C) Dividend Decision Definition: Determines whether to distribute all profits, reinvest a portion, or distribute the rest. Goal: Maximize the company's stock market value and ensure shareholder satisfaction. Factors: Influence of dividend policy on shareholder wealth, dividend payout ratio, and elements affecting policy in practice. Summary: Financial management applies financial analysis techniques to these three decisions. Objectives of the Firm Shareholders vs. Management: Shareholders (owners) expect best possible returns; management makes decisions impacting profitability and long-term viability. Management's Role: Provide optimum solutions for investment, financing, and dividend decisions to maximize economic advantage for owners. Criteria for Maximizing Economic Advantage: Profit Maximization Wealth Maximization a) Profit Maximization Concept: Actions increasing profit are adopted; actions reducing it are avoided. Arguments for: Aims at utility maximization (measured by profits). Measures economic efficiency. Leads to efficient allocation of resources. Leads to efficient use of important and scarce resources. Limitations: Ambiguity: "Profit" is ambiguous (short-run vs. long-run, total vs. rate, after-tax vs. before-tax, return on equity vs. total capital). Ignores Timing: Doesn't account for when investment rewards arrive (time value of money). Ignores Quality of Benefits: Doesn't consider certainty/fluctuation of earnings (risk). EPS dilution: New projects can dilute EPS if returns are lower than previous earnings. Liquidation Risk: Pursuit of huge profits may lead to high risk and liquidation. Incomplete: Ignores risk and time value of money. b) Wealth Maximization Goal: Maximize the value of the company for its shareholders. Method: Managers strive to maximize the present value of the firm's expected profits. Considerations: Uses discount rate (cost of capital) which considers time and risk. Considers both amount and quality of benefits. Values certain income higher than uncertain income. Values earlier benefits higher than later benefits. Superiority: Superior to profit maximization; uses present value comparison of future benefits vs. cash outflow. Decision Rule: Actions with positive Net Present Value (NPV) build wealth; actions with lower value than cost deplete wealth. For mutually exclusive projects, select the one with the greatest NPV. Symbolic Definition: $$W = \frac{A_1}{(1+k)} + \frac{A_2}{(1+k)^2} + ... + \frac{A_n}{(1+k)^n} - C_0 = \sum_{t=1}^n \frac{A_t}{(1+k)^t} - C_0$$ Where: $A_t$: Stream of benefits (cash inflows) expected at time $t$. $C_0$: Cost of the project. $k$: Discount factor/capitalization rate (reflects time value & risk). $W$: Net wealth of the firm. Implications: Aims at prosperity and perpetuity. Measures company performance. Helps allocate/reallocate scarce resources. Helps discharge other responsibilities (consumer protection, fair wages, safe working conditions, environmental protection, social problems). Leads to efficient use of resources. Considers risks. Risk-Return Trade-off Interlinked Decisions: Financial decisions influence market value by impacting return and risk. Formula: Return = Risk-free rate + Risk premium Components: Risk-free rate: Compensation for time value of money (e.g., return on government securities). Risk premium: Paid for risk coverage. Objective: Maintain a healthy balance between return and risk to optimize market value of shares. Financial Goals and Firm's Objectives Shareholder Wealth Maximization: Not the sole primary goal. Firm's Survival & Growth: Dependent on satisfying clients with high-quality goods and services. Other Objectives: Technology, leadership, market share, image, employee welfare. Wealth Maximization as Second Level: Ensures economic performance meets minimal norms. Management's Role: Balance interests of owners with other stakeholders (creditors, employees, government, society). Conflict of Goals: Management vs. Owners Problem: Management may pursue its own interests (job security) over shareholder wealth maximization. Reason: Separation of ownership and control in joint-stock corporations. Mitigation: Constant scrutiny by owners, employees, creditors, customers, and government limits management's ability to act solely in self-interest. Impact: Management might play it safe, creating adequate rather than maximum wealth, sabotaging shareholder value maximization. Organization Structure of Finance Function Essential Component: Linked to all other management functions (manufacturing, marketing, human resources). Variations: Organized differently based on firm size, business nature, financial executive skill, and philosophy. Titles: Finance Managers, VP Finance, Director Finance, Financial Controllers. Reporting Structure: Financial Manager/Director reports to the Board of Directors. Key Roles: Controllers: Financial accounting, internal audit, taxation, management accounting/control, budgeting, planning/control, economic appraisal. Treasurers: Obtaining financing, maintaining investor/bank/financial institution relationships, short-term financing, cash management, credit administration. Role of Finance Manager Estimate capital requirements for projects and fund them. Maintain liquidity and solvency for short-term and long-term obligations. Maintain contact with stock exchanges, stockholders, bankers, financial institutions. Estimate risk and propose risk-reduction strategies. Consider established practices for credit policy. Report to external agencies (financial institutions, tax authorities, government). Meet legal duties (tax laws, SEBI). Arrange internal audit for suitable checks and controls. Decide dividend policy. All responsibilities aim to maximize shareholder wealth. Finance and Related Disciplines Closely Linked: Uses related disciplines and research fields. Most Important: Accounting and Economics. Other Impacts: Marketing, Production, Quantitative Methods. i) Finance and Accounting Relationship: Accounting is an important input for financial decision-making. Intertwined: Financial managers evaluate past performance and potential directions using accounting data, also for regulatory requirements. Differences: Treatment of Funds: Accounting uses accrual principle (revenue recognized at sale, expenses when incurred); Finance uses cash flows (revenue recognized when received, expenses when paid). Decision Making: Accounting focuses on data gathering/presentation; Finance focuses on financial planning, controlling, and decision-making. ii) Economics and Finance Origin: Theory of finance developed from the study of firm theory in economics (1920s). Microeconomics: Financial managers use microeconomics for efficient decision models (e.g., marginal cost and revenue for investment/working capital). Time Value of Money Concept: A rupee today is worth more than a rupee tomorrow due to investment potential and inflation. Importance: Crucial for financial planning, investment decisions, and managing funds. Future Value (FV) Definition: Value of a current asset at a future date based on assumed growth rate. Importance: Helps investors estimate future worth of investments for sound decisions. Factors: External economic factors like inflation can erode future value. Calculation: Can be simple (guaranteed interest rate) or complicated (asset type). Concept: What a sum of money invested today will become over time at a given interest rate. Calculation of Future Value Types: Future value of a lump sum (single deposit). Future value of an annuity (series of constant payments). Tools: Online calculators, financial calculator apps, spreadsheet functions, present value/annuity tables. Simple Annual Interest Formula: $FV = P \times (1 + R \times T)$ $P$: Principal amount. $R$: Interest rate. $T$: Number of years. Compounded Annual Interest Formula: $FV = P \times (1 + R)^t$ $P$: Principal amount. $R$: Interest rate. $t$: Number of years. Future Value of an Annuity Formula: $FV_{An} = A \left[ \frac{(1+r)^n - 1}{r} \right]$ $FV_{An}$: Future Value of annuity. $A$: Constant Periodic flows. $r$: Interest rate period. $n$: Duration of annuity. FVIF for Annuity: The term $\frac{(1+r)^n - 1}{r}$ is the future value interest factor for an annuity ($FVIF_{Arn}$). Present Value (PV) vs. Future Value (FV) Present Value: Calculates the worth of future money today. Process: "Discounting" - for any positive return rate, PV will be less than future value. Discount Rate: Interest rate used to calculate PV of future cash flow. Inverse Relationship: PV is the mirror image of FV. Formula: $PV = FV \times \frac{1}{(1+r)^n}$ Discounting Factor: The term $\frac{1}{(1+r)^n}$ is the discounting factor or present value interest factor ($PVIF_{r,n}$). Common Uses for PV: Calculating value of pension annuity payments vs. lump sum. Determining if business owner's investment meets profit expectations. Valuing a business. Time Value of Money and its Significance Importance: Crucial for financial planning, from asset buy/lease decisions to new equipment investments. Financial Management Standpoint: Helps determine impact of debt on earnings and profits for expansion/growth companies. Essential for managing funds and generating profits due to future uncertainty. Aids financial decision-making (e.g., choosing Project 'A' with higher present value over Project 'B' with later payout). Calculation of Time Value of Money PV of Future Cash Flows: $PV = FV \times (1+r)^{-n}$ or $FV = PV \times (1+r)^n$ $PV$: Present Value. $FV$: Future Value. $r$: Interest rate. $n$: Number of periods. Effect of Compounding Periods on Future Value Compounding frequency significantly impacts FV. More frequent compounding (quarterly, monthly, daily) leads to higher FV. Formula for multiple compounding periods: $FV = PV \times \left(1 + \frac{r}{t}\right)^{xt}$ $PV$: Present Value. $r$: Annual interest rate. $x$: Number of years. $t$: Number of compounding periods of interest per year. Time Value of Money - NPV Calculation Key Concept: Used in Net Present Value (NPV), Compound Annual Growth Rate (CAGR), Internal Rate of Return (IRR). Application: General formulas apply to any series of cash flows. Tools: Financial calculators, spreadsheet programs (Excel functions: PV, FV, IRR, NPV). Discount Rate: Selecting correct rate (e.g., Weighted Average Cost of Capital - WACC) is crucial; wrong decision can render process meaningless. Risk and Return Concept of Investment Risk Definition: In investments, risk means the possibility of an "unexpected" negative or "adverse" return. Risk vs. Risk-less: "Risk-less security" (e.g., government loan) has guaranteed interest and principal. "Risky asset" (e.g., TISCO debentures) has inconsistent returns, poor performance risk, or default risk. Investor Behavior: Many investors are risk-averse, preferring small but certain returns. Risk-taking investors (speculators) choose securities with large but uncertain returns. Risk Definition: Volatility in the flow of income to investors. Evolution of Risk Connotations Early 21st Century: Financial statements used; debt quantity indicated risk. Graham Dodd and Cottle ("Security Analysis"): Emphasized "margin of safety" (intrinsic worth vs. market price) as risk measure. Larger margin of safety = lower risk. Standard Deviation: Widely accepted measure for risk due to allowing probability statements across distributions. Risk Decomposition: Total risk = Systematic risk + Unsystematic risk. Total risk decomposed by causal forces. Sources of Risk Market Risk: Definition: Variation in return caused by changes in market price due to investor reactions to events (social, political, economic, firm-specific) or market psychology. Bull/Bear Markets: Prices rise in bull markets, fall in bear markets. Systematic vs. Non-systematic: Systematic forces cause most stocks to move together; unsystematic prices swings are diversifiable. Interest-Rate Risk: Definition: Variation in return induced by market price changes in fixed income products (bonds, debentures). Relationship: Inversely proportional to interest rates (prices decline when interest rates rise, and vice versa). Impact: Direct on bond prices, indirect on equity shares. Inflation Risk: Definition: Variability in total purchasing power of an asset due to rising general price level; unpredictability of cash flow buying power. Impact: If general price level rises, purchasing power of interest/dividend income drops. Monetary Delusion: Investors may feel wealthier from rising market prices, but purchasing power may erode if inflation is higher. Business Risk: Definition: Fluctuations in expected income due to constantly changing environment (government policy, competitor actions, business cycles). Mitigation: Diversified portfolio across several industries helps. Financial Risk: Definition: Occurs when company capital structure includes debt; debt creates fixed liability, increasing income variability for equity stockholders. Impact: Boosts profitability when company performs well, but causes problems in poor times (inability to satisfy debt). Consequences: Negative information spread, loss of financing, employee departure, customer preference for financially strong firms. Management Risk: Definition: Portion of total return variability caused by managerial actions in companies where owners are not managers. Source: Mistakes or wrong decisions by management. Factors: Ignoring product obsolescence, reliance on single large customer, mishandling criticism/litigation. Agency Theory and Management Risk: Research Focus: Core motives of owners and managers. Conflict of Interest: Owners (principals) delegate to managers (agents), who may abuse authority for self-interest. Agency Cost: Difference in value between owner-controlled and manager-controlled firms. Liquidity Risk: Definition: Inability to sell assets without price reductions and commissions. Liquidity Spectrum: Currency (most liquid) -> government securities/blue-chip stocks -> lesser-known corporations' debt/equity. Impact: Forces investors to sell securities at lower prices when quantity is significant. Social or Regulatory Risk: Definition: Harm to venture from unfavorable legislation, harsh regulatory environment, or nationalization. Examples: Price controls, rent controls. Nature: Political and unpredictable; no industry immune. Other Risks: Monetary value risk, political environment risk (for foreign investments). Foreign Investment Risks: Change in foreign government, repudiation of debt, inability to handle indebtedness. Risk Preferences Risk Aversion: Most managers demand increased reward for increased risk. Risk Indifference: No change in reward for increased risk. Risk-Seeking: Higher reward desired for less risk. Measuring Historical Return Total Return Formula: $$ \text{Total return} = \frac{\text{Cash Payment received during period} + \text{Price change over the period}}{\text{Price of the investment at the beginning}} $$ Price Change: Can be positive, zero, or negative. Formula for Equity Stock: $$ R = \frac{C + (P_E - P_B)}{P_B} $$ Where: $R$: Total return. $C$: Cash payment (dividend). $P_E$: Ending price. $P_B$: Beginning price. Measuring Historical Risk Definition: Possibility that actual outcome differs from expected; variability or dispersion of returns. Measures: Variance ($\sigma^2$) and Standard Deviation ($\sigma$). Standard Deviation Formula: $\sigma = \sqrt{\sigma^2}$ where $\sigma^2 = \frac{1}{n-1} \sum (R_i - \bar{R})^2$ $R_i$: Return from stock in period $i$. $\bar{R}$: Average rate of return. $n$: Number of periods. Interpretation: Squared difference in standard deviation gives greater impact to values distant from the mean. Standard deviation and mean are in the same units. Measuring Expected Return and Risk i) Probability Distribution Concept: Investment returns can vary (e.g., 5%, 15%, 35%), and probabilities of these returns vary. Probability: Likelihood of an event; 80% chance of stock price increase means 80% likelihood. ii) Expected Rate of Return Definition: Weighted average of all possible returns multiplied by their respective probabilities. Formula: $E(R) = \sum_{i=1}^n R_i P_i$ $E(R)$: Expected return. $R_i$: Return from stock under state $i$. $P_i$: Probability that state $i$ occurs. $n$: Number of possible states. iii) Standard Deviation of Return Definition: Dispersion of a variable (risk); calculated by variance or standard deviation. Variance Formula: $\sigma^2 = \sum P_i \times [R_i - E(R)]^2$ $R_i$: Return for $i$-th outcome. $P_i$: Probability of $i$-th outcome. $E(R)$: Expected return. Standard Deviation: Square root of variance ($\sigma = \sqrt{\sigma^2}$), used as equivalent measure since variance is in squared returns. Valuation of Securities Goal: Determine how much a company's equity or net operating assets are worth. Method: Considers current value of future flows (dividend, cash flow, earnings). Forecasting: Explicit forecasting period (analyst calculates PV from projected financials) and post-horizon period (analyst makes simplifying assumption about growth). Definition: Evaluation of various assets (tangible/intangible), securities, liabilities, business. "Value": Material or monetary worth, calculated using medium of trade. Requirements: Understanding factors, professional judgment/experience, objective, value drivers, economic aspects, and best valuation processes. Characteristics of a Good Valuation Fair and reasonable value conclusion. Transparent valuation procedure. Realistic assessment of influencing aspects. Unbiased considerations, no shortcuts. Validation under critical scrutiny. Thorough work by experts. Thorough and complete valuation report. Need for Valuation Importance: Business valuation is crucial for owners to know a company's worth. Expertise: Should be performed by a certified valuation expert. Stock Exchange: Popular source for share value, but prices are unreliable due to demand/supply fluctuations. Factors: Private and institutional investor activities, global opinions. Various Expressions of Value Fair Market Value: Amount at which property would change hands between willing buyer/seller; highest, most likely price. Book Value (Shareholders' Equity): Historical value; Assets - Liabilities on balance sheet. Intrinsic Value: Estimated value of security based on all facts/circumstances; present value of future earnings discounted at current market yield. Replacement Value: Current cost of acquiring comparable new property with equivalent usefulness. Liquidation Value: Net amount realized if firm is shut down and assets sold individually (orderly vs. forcible). Business Valuation Approaches Three major methods: 4.5.1 Income Approach Concept: Valuing future benefits in their present value. Methodologies: Earnings Capitalization Method: Divides predicted earnings by "capitalization rate" (net earnings discount rate minus average sustainable growth rate). Discounted Cash Flow Method: Expresses present value as function of future cash earnings capability. Formula (PV of future sum): $PV = \frac{FV}{(1+r)^n}$ or $FV \times PVF(r,n)$ Formula (PV of annuity): $\text{Annuity Amount} \times PVAF(r,n)$ 4.5.2 Market Approach Concept: Determining value by comparing to market value of similar publicly traded enterprises. Substitution Idea: Compares financial ratios/multiples (price to book, P/E, EV/EBITDA) of the equity in question to rivals. 4.5.3 Asset Approach Concept: Based on substitution principle (sensible buyer won't pay more than cost of comparable substitute). Method: Looks at net asset value (fair market value of assets minus liabilities). Net Asset Value: Total value of company's assets minus total liabilities. Net Assets Per Share: Net assets divided by number of shares outstanding. Use: Useful for valuing stocks in industries where worth is derived from owned assets rather than profit stream. Investment Decision - Required Rate of Return Definition: Long-term commitment of funds to earn a return that compensates for unavailability of funds, inflation, and risk. Goal: Generate profit; requires defining intended rate of return. Relationship: Needed return rises with investment risk. Two Phases: Estimated Return: Second phase; compares initial investment with recurring cash flows. Forecasting Cash Flows: Most complex job for equity shares. The Three-Step Valuation Process Goal: Make investment decisions by comparing expected return to needed rate of return. Two Broad Ways: Top-down (three-step strategy): Economy -> Industry -> Company. Bottom-up (stock selection approach): Focus on individual stocks regardless of market. E-I-C Strategy: Economy-Industry-Company strategy. 4.7.1 Economy Analysis Concept: Business is part of the "general economy". Process: Start appraisal with macroeconomic estimates. Factors: Fiscal policy (tax cuts, government expenditures), monetary policy (money supply, interest rates), political uncertainty, wars, balance of payments, exchange rates, devaluations. Goal: Forecast economy's future path to identify prosperous or defensive industries. 4.7.2 Industry Analysis Concept: Economic changes don't affect all industries equally. Business Cycles: Cyclical industries perform better during expansions, suffer during downturns; non-cyclical industries more stable. Influence: Industry prospects influence individual firm performance. Process: Market research to identify strong industries and reduce search area for investment opportunities. 4.7.3 Company Analysis Concept: Study and compare individual business performance within an industry after industry forecast. Elements: Past performance, industry position, future potential (for cash flow estimation). Objective: Seek undervalued organizations with high growth prospects, not necessarily the "finest firm." The General Valuation Framework Market Monitoring: Investors track price changes for capital gains. Awareness: Price dictates value, both alter randomly. 4.8.1 The Basic Valuation Model Definition: Present value of an asset's predicted returns equals its value. Method: Discount future cash flows at the required rate of return. Valuation Necessitates: Estimated stream of projected cash flows. Required rate of return on investment (differs by security due to risk). Formula: $PV = \frac{CF_1}{(1+r)} + \frac{CF_2}{(1+r)^2} + \frac{CF_3}{(1+r)^3} + \dots + \frac{CF_n}{(1+r)^n}$ $PV$: Present value. $CF$: Cash flow (interest, dividend, earnings). $r$: Risk-adjusted discount rate. Difficulties: Market participants may not accurately gauge cash flow value/risk, expectations may differ, variables change value, no single value generated. Dynamic Nature: Asset prices rise/fall due to buying/selling pressures, affecting capital gains; future income predictions and values need updating. 4.8.2 Value-Price Relationship Price Determination: Price is determined by present value (inherent/economic worth). Pressures: "Buying and selling pressures" push prices closer to true worth. 4.8.3 The Cootner Hypothesis Investor Types: Divides active investors into "professional" and "unsophisticated". Professional Investors: Discover intrinsic worth, take market action on value-price mismatches. Unsophisticated Investors: Act on public news/hot tips, lack comprehension. Impact: Actions of inexperienced investors can stifle trading pressures, requiring professionals to realign prices. 4.8.4 The Dynamic Valuation Process Nature: Never-ending process; present value, risk, discount rates, future income, buy-sell activity reassessed regularly. Steps: Investors estimate intrinsic value, purchase/sell/hold based on trading regulations, creating price movements. Impact: Most recent market price reacting to pressures impacts the future. Valuation of Fixed Income Securities Examples: Bonds, debentures. Intrinsic Value: Determined by predicted cash flows (coupon interest, principal repayment). Method: Calculated by discounting future payments at a suitable discount rate/market yield. Formula: $PV = \sum \frac{C_t}{(1+r)^t} + \frac{TV}{(1+r)^n}$ $PV$: Present value of security today. $C_t$: Coupons or interest payments per period $t$. $TV$: Terminal value repayable at maturity. $r$: Appropriate discount rate or market yield. $n$: Number of years of maturity. Key: Discount rate is current market interest rate (opportunity cost). Semi-Annual Payments: Adjust formula by dividing $C$ and $r$ by 2, and multiplying $n$ by 2. Estimating Returns on Fixed Income Securities Measures: Coupon rate, current yield, yield to maturity. Current Yield Formula: $\text{Current yield} = \frac{\text{Stated (coupon) interest rate per year}}{\text{Current market price}}$ Yield-to-Maturity (YTM): Definition: Compounded rate of return on a bond acquired at current market price and held to maturity. Method: Equates market price with discounted value of future interest payments and terminal principal. IRR: YTM is the Internal Rate of Return (IRR) of initial investment and periodic payments. Formula: $MP = \sum_{i=1}^n \frac{C_t}{(1+YTM)^t} + \frac{TV}{(1+YTM)^n}$ Approximate YTM Formula: $\text{Approximate YTM} = \frac{\text{Coupon Interest} + [(MP_n - MP_t)/N]}{[MP_n + MP_t]/2}$ $MP_n$: Market price at maturity. $MP_t$: Market price at beginning. Interest Effect: Interest paid is tax-deductible, lowering effective cost of debt. Valuation of Preference Shares Nature: Considered eternal securities, but can be convertible, callable, redeemable. Risk: Less risky than equity (fixed dividends), riskier than bonds (paid after bonds). Intrinsic Value Formula (Perpetuity): $V_p = \frac{C}{K_p}$ $V_p$: Value of perpetuity. $C$: Constant annual payment (preference dividend D). $K_p$: Required rate of return for perpetuity (Kps). Value Changes: Value changes inversely to the required rate of return. Yield: Can compute yield from current market price. Valuation of Equity Shares Focus: Present value principles. Approaches: Efficient market, technical, fundamental. Present Value of Expected Stream of Benefits Primary Focus: Present value of future benefits. Issues for Equity Shares: Benefits (dividends, cash flows, earnings) are not specified or perfectly known. Requires probabilistic framework for calculation. Past Data: Updated for future projections to estimate growth rate. Dividend Valuation Model Concept: Uses dividends as cash flow stream to assess intrinsic value. Scenarios: Zero-growth Case: Dividends do not grow. $V = \frac{D_0}{K}$ (where $D_0$ is constant dividend, $K$ is cost of capital). Constant Growth Case: Dividends grow at a uniform rate $g$. $V = \frac{D_0(1+g)}{K-g} = \frac{D_1}{K-g}$ (where $D_1$ is next period's dividend). Multiple-Growth Case: Dividends grow at varying rates; indefinite future divided into phases (e.g., erratic growth then stable growth). P/E Approach to Equity Valuation Method: Straightforward, commonly used. Steps: Estimate future earnings per share. Determine typical price-earnings ratio. Expected price = EPS $\times$ P/E ratio. Practical Use: Compute industry average P/E or similar firms' P/E, then multiply by stock's predicted earnings. Factors: Growth rates and risk impact P/E. Cost of Capital Definition: Rate of compensation paid for money invested in business; minimum rate of return a firm must earn on investments to maintain value. Opportunity Cost: The return expected by the promoter for their own money. Characteristics of Cost of Capital Expressed as a rate of return, not amount. Represents minimum rate of return to maintain firm value. Calculated based on actual cost of different capital components. Usually related to long-term capital funds. Used operationally as a discount rate for future cash inflows. Always related to risk. Components of Cost of Capital Return at Zero Risk Level (Risk-free returns, $r_0$) Premium for Business Risk ($b$) Premium for Financial Risk ($f$) Equation: $K = r_0 + b + f$ Cost of Capital with Business Risk > Cost of Capital with no risk. Cost of Capital with Financial Risk > Cost of Capital with Business Risk > Cost of Capital with no risk. Business Risk and Financial Risk Business Risk: Associated with every business; chance of loss or less-than-expected profit due to factors beyond control (demand changes, preferences, new products, economic factors). Financial Risk: Arises from improper financial mix; inability to pay financial obligations (interest, loans) due to high debt proportion. Overall Cost of Capital Definition: Weighted arithmetic average of costs of various long-term finance sources. Formula: $R_a = \sum p_i R_i$ $R_a$: Average cost of capital. $p_i$: Proportion of $i$-th source of finance. $R_i$: Cost of $i$-th source of finance. General Cost of Capital Formula: $P = \sum_{t=1}^n \frac{C_t}{(1+R)^t}$ $P$: Net funds received from source. $C_t$: Expected receipt from source at year $t$. $R$: Cost of capital. Basis: Costs measured on post-tax basis. Classification of Cost of Capital Explicit Cost: Discount rate equating PV of expected incremental cash inflows with PV of cash outflows; "rate of return of financing opportunity." Implicit Cost: Rate of return foregone from best alternative investment opportunity. Average Cost: Weighted average of costs of each component of funds. Marginal Cost: Weighted average cost of new funds raised. Future Cost: Expected cost of raising new funds (more relevant for decision-making). Historical Cost: Cost incurred in the past. Specific Cost: Cost of individual components of capital. Combined Cost: Average cost of capital inclusive of all sources. Opportunity Cost of Capital: Return foregone by choosing present investment over alternatives. Significance of Cost of Capital Financial Decision Making: Central to financial decision making. Acceptance Criterion: Basis for financial appraisal of new capital expenditure proposals. Optimal Capital Structure: Helps managers determine optimal mix of capital. Performance Evaluation: Basis for evaluating top management's financial performance. Dividend Policy: Helps in formulating dividend and capital policy. Capitalization Rate: Can serve as capitalization rate for new firms. Computing Cost of Capital of Individual Components Sources: Long-term debt, preference share capital, equity share capital, retained earnings. Specific Cost: After-tax cost of financing for each source. 5.6.1 Cost of Long-Term Debt Definition: Minimum return rate for debt-financed investments to maintain firm value. Concept: Rate of discount equating PV of post-tax interest and principal repayments with net proceeds. Types: Issued at par, premium, or discount; perpetual or redeemable. Formula (at par): $K_d = (1 - T) R$ $K_d$: Cost of Long-Term Debt. $T$: Tax Rate. $R$: Interest Rate. Formula (premium/discount): $K_d = \frac{I}{N_p} (1 - T)$ $N_p$: Net proceeds. $I$: Annual Interest Payment. Formula (redeemable debt): $K_d = \frac{I + \frac{(R_v - S_v)}{N}}{\frac{(R_v + S_v)}{2}} (1 - T)$ $R_v$: Redeemable value. $S_v$: Sale value less discount and flotation costs. $N$: Number of years to maturity. Underwriting Costs: Adjusted like discounts in net proceeds. 5.6.2 Cost of Preference Shares (Capital) Definition: Rate of return on preferred stocks to keep earnings available to residual stockholders unchanged. Estimation: Divide stipulated dividend per share by current market price. Formula (perpetual): $\text{Cost of Preference Capital} = \frac{\text{Dividend}}{\text{Face Value} - \text{Issue Cost}}$ Formula (redeemable): $K_p = \frac{D + \frac{(R - NP)}{N}}{\frac{(R + NP)}{2}}$ $K_p$: Cost of Preference Capital. $D$: Dividend paid per share. $R$: Redemption Value. $NP$: Net proceeds. $N$: Redemption period. 5.6.3 Cost of Equity Capital Definition: Cost for investor to buy shares of company; return on investment. Difficult to Measure: Not out-of-pocket cost, based on expected future dividends, relationship between market price/earnings, price differentials due to stock exchange fluctuations. Methods of Computing Cost of Equity Capital E/P Ratio Method: $K_e = \frac{E_0}{P_0} \times 100$ $E_0$: Current Earnings per share. $P_0$: Current Market Price per share. Limitations: Earnings don't represent expectations, not constant, diverse connotations. Circumstances: No debt, all earnings paid to shareholders, no growth. E/P Ratio + Growth Rate Method: $K_e = \frac{E_0(1+b)^3}{P_0}$ $(1+b)^3$: Growth factor. $b$: Growth rate. D/P Ratio Method: $K_e = \frac{D_0}{P_0} \times 100$ $D_0$: Dividend per share. Circumstances: $K_e$ unchanged, investors value dividend, shares purchased at par. D/P + Growth Rate Method: $P = \frac{D_1}{K_e - g}$ or $K_e = \frac{D_1}{P} + g$ $D_1$: Dividend expected at year end 1. $g$: Constant annual growth rate. Realized Yield Method: Based on return actually earned by shareholders; uses historical data (last 5-10 years). Security's Beta Method (CAPM): $K_e = \text{Riskless rate} + \text{Risk premium} \times \text{Beta}$ Beta: Risk attendant with the security; measures volatility relative to market. Risk-free rate: E.g., government securities. 5.6.4 Cost of Retained Earnings Concept: Not cost-free; represents opportunity cost (dividend income foregone by shareholders). Minimum Cost: Cost of equity capital ($K_e$). Ezra Solomon's Approach: $K_r = K_e (1-T_s)(1-B)$ $K_r$: Cost of retained earnings. $T_s$: Shareholders' Tax Rate. $B$: Percentage Brokerage Cost. 5.7 Weighted Cost of Capital Definition: Average of costs of each fund source, weighted by proportion in capital structure. Choice of Weights: Book Values: Based on accounting values. Market Values: Preferred as they approximate current value. Historic Weights: Based on actual data (book or market). Target Weights: Reflect desired capital structure proportions; preferred for theoretical accuracy. Marginal Weights: Based on financing mix for new capital. 5.8 Some Misconceptions about Cost of Capital Cost of capital is academic/impractical. Equal to dividend rate. Retained earnings are cost-free or significantly less than external equity. Depreciation generated funds have no cost. Defined in terms of accounting-based manner. Low when heavily financed by debt. These are baseless; viability of projects depends on cost of capital. Funding agencies evaluate proposals based on it. It is practical and essential for financial decision-making. Investment Appraisal Methods Need: Evaluate investment projects to ensure resources yield anticipated results. Capital Budgeting vs. Current Expenditure: Capital budgeting projects are large, with significant time lag between outlay and benefits. Current expenditures are for day-to-day operations. Methodical Approach to Capital Budgeting: Formulate long-term goals. Identify investment opportunities. Classify projects and recognize dependencies. Estimate current and future cash flows. Control expenditures and monitor project execution. Establish decision rules for acceptance/rejection. Need for Investment Decisions Achieve Goals: Survival, expansion, market share, leadership. Economic Opportunities: Expansion of manufacturing to meet demand, achieve economies of scale. Replacement of assets due to technical breakthroughs, cost reduction, efficiency. Buy, rent, or lease specific items. Factors Affecting Investment Decisions Ezra Solomon's Data Needs: Capital outlay, projected earnings, capital availability/cost-cutting, criteria for project selection. Estimation of Capital Outlays and Future Earnings: Capital investments (long-term) vs. capital expenditures (short-term). Expenditures: Advance spending, land, building, machinery, training, franchise, inventory. Operating costs: Labor, repairs, rent, insurance, stationery, taxes, fuel. Additional: Depreciation, interest charges. Sources of Capital: Internal Capital: Retained profit, depreciation, taxation provision, reserves. External Capital: Short-term (trade credit, bank overdrafts); Long-term (debt, equity). Selection of Projects: Invest funds to maximize returns; profitability is critical. Types of Investment Proposals Long-Term: Investment choice, projects, proposals related to deployment of long-term resources (10+ years). Reasons for Long-Term Investments: Expansion, diversification, replacement/modernization, R&D. Expansion: Increasing output requires more capital, increasing variable costs, current assets. Diversification: Entering new lines of business (e.g., ITC into hoteliering). Replacement: Machinery wear/obsolescence; modernization/renovation to improve efficiency. Research and Development: Improve efficiency, develop new products. Investment Appraisal Process Significance: Fundamental analysis to reveal long-term potential of fund investment. Proposals: Involve huge sums, higher risk, irreversibility. Considerations Before Appraisal: Amount and timing of initial investment outlays. Amount and timing of subsequent investment outlays. Economic life of the project. Salvage value at project end. Amount and timing of cash inflows. Initial Investment Outlay: Total money required; includes design, survey, consultant expenses, working capital costs. Subsequent Investment Outlay: Maintenance, replacement, upgrading costs. Economic Life of a Project Definition: Duration of earnings flow created by the project. End of Economic Life: Cost of replacement/remodeling becomes unfeasible. Project viability affected by obsolescence. Rising maintenance costs exceed estimated disposal value. New technology necessitates new investment. Salvage Value Definition: Value of equipment at project's end; treated as an inflow. Operating Cash Flows Sales Revenue: Determined by units sold and selling price; additional/incremental revenues must be considered. Production Costs: Fixed and variable costs; only incremental costs matter. Other Direct Costs: Selling, promotion, rent, other expenses. Investment Appraisal Methods Purpose: Decide desirability of investment proposals, rank them. Characteristics of Sound Method: Rank investment proposals. Distinguish acceptable/unacceptable projects. Solve choosing among alternatives. Recognize time value of money (bigger/earlier benefits preferred). Provide criteria for project selection. Consider cash flow patterns. 6.6.1 Traditional Methods Pay Back Period: Definition: Time to recover initial investment through net cash flow. Formula: $P = E + B/C$ $P$: Payback period. $E$: Years preceding final recovery. $B$: Balance amount to recover. $C$: Cash flow during final recovery year. Preference: Shorter period is better. Limitation: Ignores timing and amount of cash inflows after payback period. Accounting Rate of Return (ARR): Definition: Rate of return based on financial accounting methods for annual earnings. Formula: $\text{ARR} = \frac{\text{Profit after tax}}{\text{Book value of the investment}}$ Limitations: Ignores time value of money, quality/pattern of benefits, scrap value; subject to accounting manipulation. 6.6.2 Discounted Cash Flow Methods Purpose: More objective basis for evaluating investments; consider magnitude and timing of cash flows. Techniques: Net Present Value (NPV), Internal Rate of Return (IRR), Profitability Index. Net Present Value (NPV) Method: Concept: Calculates present value of future income using compound interest. Formula: $PV = \frac{P}{(1+r)^n}$ Decision: Accept if total PV of cash inflow exceeds current outflow. Limitations: Difficult to compute/understand, challenging to select discount rate, not reliable for varying outlays. Internal Rate of Return (IRR) Method: Definition: Discounting rate at which sum of PV of future cash inflows equals current cash outflows. Formula (Interpolation): $IRR = LRD + \frac{NPV_L}{PV} \times R$ $LRD$: Lower rate of discount. $NPV_L$: Net Present Value at lower rate. $PV$: Difference in PVs at lower/higher rates. $R$: Difference between two discount rates. IRR through Payback Reciprocal: Quick approximation for constant cash flows. Limitations: Requires time-consuming calculations, assumes cash flows reinvested at IRR (may not be realistic). Net Present Value Vs. Internal Rate of Return (IRR) Similarities: Both consider time value of money, total cash flows, and produce consistent accept/reject decisions for conventional/independent projects. Differences: Mutually Exclusive Projects: NPV preferred as it maximizes shareholder wealth. Non-Conventional Investments: NPV preferred due to multiple IRRs. Interpretation: IRR is a percentage, NPV is an absolute number. Profitability Index (PI) Definition: Ratio of present value of net cash inflows to outflows. Formula: $\text{Profitability Index} = \frac{\text{Present Value of Cash inflows}}{\text{Present Value of Cash outflows}}$ Decision: Accept if PI > 1. Relationship with NPV: PI > 1 if NPV is positive; PI Depreciation, Tax, and Inflows Depreciation: Not included in DCF calculations as it's a non-cash expense; reduces taxable income (tax shield). Cash Inflows: Assumed to be after income taxes. Limitations of Appraisal Techniques Approximation: Investment value is approximated, not precise. Estimates: Relies on estimated factors (e.g., cash flows, asset life). Uncertainty: Forecasted cash flows are "half-truths"; sales volume/price estimation is a major source of error. Economic Life: Difficult to estimate due to environmental, technological, marketing factors. Soundness: Depends on proper technique choice and common sense. Management of Working Capital Definition: Investment in short-term assets (cash, securities, receivables, inventory). Purpose: Continue day-to-day operations without interruption. Operating Cycle: Time from raw material procurement to cash collection. Shorter cycle = less money invested. Concepts of Working Capital Gross Working Capital Definition: Firm's investment in current assets (circulating capital). Advocates' Reasons: Profits from fixed/current assets, both financed by borrowed funds; total current assets are important for operations. Net Working Capital Definition: Current assets - Current liabilities. Solvency: Positive NWC indicates solvency; negative NWC indicates illiquidity. Optimal: Balance between profitability and liquidity. Financing: Fixed portion of NWC should be financed by permanent sources (equity, long-term debt). Experts' Support: Current assets over liabilities judge financial soundness; meets contingencies. Kinds of Working Capital Fixed, Regular, or Permanent Working Capital: Minimum level of current assets always required, permanently tied up in business. Variable, Fluctuating, Seasonal, Temporary, or Special Working Capital: Needed above permanent WC due to changes in production/sales, seasonal fluctuations, or unforeseen events. Components of Working Capital Current Assets: Cash, accounts receivable, inventory, marketable securities. Current Liabilities: Trade credit, expenses payable, short-term borrowings, advances from customers, taxes payable. Current Assets Explained Cash: Essential for operations; needs to be invested optimally to avoid opportunity cost. Accounts Receivable: Arises from credit sales; requires management to avoid bad debts and ensure cash flow. Inventory: Significant part of working capital; requires control to balance holding costs and sales demand. Marketable Securities: Short-term investments for surplus cash; provide liquidity and return. Importance of Working Capital Management Significance: Crucial for internal/external analysts due to direct association with day-to-day operations. Consequences of Deficiency: Technical insolvency, business failure, inability to execute profitable ventures, loss of reputation. Consequences of Excess: Unnecessary accumulation of inventories, liberal credit policy, managerial inefficiency, speculative profits. Goal: Maintain optimal working capital level. Determinants of Working Capital Nature of Business: Trading/financial (high WC), manufacturing (mid WC), public utilities (low WC). Size of Business: Larger scale = more WC. Manufacturing Cycle: Longer cycle = more WC tied up in inventory. Business Fluctuations: Seasonal/cyclical demand impacts temporary WC. Production Policy: Consistent production leads to inventory accumulation, affecting WC. Turnover of Circulating Capital: Pace of operating cycle affects WC requirements. Credit Terms: Credit policy influences receivables (WC); credit from suppliers influences payables. Growth and Expansion: Higher volume/growth requires more WC funds. Operating Efficiency: Better resource utilization reduces WC needs, expedites cash cycle. Price Level Changes: Rising prices increase WC investment. Other Factors: Net profit margin, appropriation policy (retained profits), transportation/communication modes. Approaches to Managing Working Capital Conventional Approach: Properly manage components (inventory, receivables, payables) to avoid idle funds or scarcity. Operating Cycle Approach: Determine WC based on length of operating cycle and required expenditure. Measuring Working Capital Factors: Influenced by elements discussed above. Calculation: Detailed example provided in text for specific business type. Example: Sriram Tricycles Ltd. Cost Sheet: Materials (40%), Labour (30%), Overhead (10%) of selling price. Production: 60,000 tricycles/year (5,000/month). Inventory: Raw materials (1 month), finished goods (2 months), WIP (0.5 month). Credit: Half sales on credit (2 months); suppliers credit (1 month). Labour Payment Lag: 1 month. Overhead: 50% non-production staff. Selling Price: Rs. 2000/tricycle. Buffer Cash: 20% for contingencies. Working Capital Management under Inflation Challenge: Maintain current activity level with rising capital needs. Strategies: Use substitute raw materials. Boost labor productivity (incentive programs). Examine controlled costs (advertising, managerial wages). Shorten operational cycle (faster turnover, debtor realization). Develop policy for slow-moving/outmoded inventory. Pay creditors on time to strengthen bargaining power. Efficiency Criteria Profitability: Determined by WC management. Criteria: Creditor Confidence: Ability to repay short-term obligations. Inventory Turnover: Achieve highest possible. Customer Credit: Reasonable terms, not abused. Supplier Credit: Obtain appropriate terms. Safeguards: Prevent overtrading/undertrading. Indices for Measuring Efficiency Current Ratio (CR): Current Assets / Current Liabilities. Indicates capacity to manage daily business. Optimal 2:1 ratio, but depends on industry. Quick Ratio (QR): Liquid Assets / Current Liabilities. Liquid assets = current assets - non-quickly realizable assets (inventory, sticky debts). Optimal 1:1 ratio, but depends on industry. Cash to Current Assets: Cash / Current Assets. Cash doesn't earn profit, so proportion should be low. Sales to Cash Ratio: Sales / Average cash balance. Maximizes sales with least cash. Average Collection Period: (Debtors / Credit Sales) $\times$ 365. Days company allows customers to settle bills. Average Payment Period: (Creditors / Credit purchases) $\times$ 365. Days company enjoys credit from suppliers. Inventory Turnover Ratio (ITR): Sales / Average Inventory. Times inventory cycled to reach sales goal. Working Capital to Sales: WC needed for given sales amount. Aids management in preserving WC for anticipated sales growth. Working Capital to Net Worth: WC relationship with owner funds. Overtrading: High ITR, low CR. Undertrading: Low ITR, high CR. Determining the Optimal Cash Balance Idle Cash: Non-profitable investment. Cash Shortfall: Loss of opportunities, creditworthiness. Goal: Identify optimal cash balance. Fluctuation: Cash balance fluctuates; analyze max, min, avg requirements. Opportunity Cost: Cash can be used for assets, mitigates financial risks. Financial Manager's Role: Devise model for optimal cash quantity; establish minimum cash level. Shortage Costs: Deferring payments, missing cash discounts. Cash Balance Formula: Closing balance = Beginning Balance + Receipts - Disbursements. Challenge: Reduce total expenses if receipts/disbursements vary. Optimal Working Cash Balance 0 Working Cash Balance C Total costs Opportunity cos Transaction costs Point of Minimum total costs Point C: Minimum of opportunity and transaction costs. M: Ideal working cash balance. Control Theory: For unpredictable cash flows, model with max/min optimal balances. Higher variability = higher min cash balance. Investment of Idle Cash: Invest in interest-earning assets to produce income while maintaining liquidity. Investment Criteria: Free of default risk, short maturity, adequate marketability. Management of Cash Flows Goal: Manage cash flows effectively. a) Speeding up Collections Objective: Shorten interval between sale and cash collection. Strategies: Deposit money into single account (or primary account if multiple centers). Minimize time between customer payment and bank credit (lock box system). Utilize digital banking (NEFT, RTGS, IMPS) for quick fund reception. b) Recovering Dues Objective: Reduce money held in receivables. Strategies: Ensure receivables don't become overdue, offer discounts for early payment, consistent follow-up. c) Controlling Disbursements Objective: Delay disbursements to provide financing benefit. Strategies: Utilize trade credit (free financing), defer payments until deadline, use cheque book float. d) Investment of Idle Cash Balances Objective: Invest idle cash to produce income while maintaining liquidity. Considerations: Benefits of carrying more cash vs. drawbacks of not carrying it. Forecasting: Cash flows are not 100% accurate; difficult to estimate due to competition, tech advancements, etc. e) Investment Criteria Requirement: Invest surplus cash in methods providing income, speedy re-conversion to cash. Criteria: Free of default risk, short maturity, adequate marketability (price, time). Key Words (Working Capital) Operating Cycle: Time from raw material purchase to finished product sale. Gross Current Assets: All current assets including cash. Net Current Assets: Current assets minus current liabilities. Fixed Working Capital: Permanently invested working capital. Fluctuating Working Capital: Above fixed minimum, varies with period. Inventory Turnover: Times average inventory sold during a period. Current Ratio: Current Assets / Current Liabilities. Quick Ratio: Liquid Assets / Current Liabilities. Debtors Turnover: Average debtors / Average turnover. Average Collection Period: Average time between credit sale and cash collection. Average Payment Period: Average time between credit purchase and payment. Credit Policy: Norms for giving credit to customers. Credit Terms: Terms extended by firm to debtors. Financial Markets Definition: Place where buyers and sellers exchange goods, services, financial products. Classification: Product market, factor market, financial market. Role: Channel funds from surplus to deficit units, promote economic efficiency, facilitate capital formation. Functions of Financial Markets Economic Functions: Transfer resources, increase earnings, productive use of funds, channel savings into capital formation. Financial Functions: Provide funds to borrowers, offer earning assets to lenders, provide liquidity for claims. Other Functions: Price discovery, risk management, wider participation, integration of markets, direct flow of funds. Types of Financial Markets Classification: Based on maturity (Money Markets, Capital Markets), organization (Organized, Unorganized). 8.3.1 Money Market Definition: Market for overnight to short-term money (less than 1 year maturity). Features: Financial assets are close substitutes for money, low transaction cost, high creditworthiness of participants. Indian Money Market: Organized (banks, PDs, MMFs) and unorganized (indigenous bankers, moneylenders). Objectives: Facilitate equilibrium of demand/supply of short-term funds, central bank intervention, easy access for users/suppliers. Instruments: Call/notice money, commercial bills, Treasury Bills, Commercial Papers, Certificates of Deposit, Repo Market. 8.3.2 Capital Markets Definition: Markets for long-term securities (equity, debt) issued by deficit units to surplus units. Functions: Improve capital allocation, lower transaction costs, encourage ownership, mobilize long-term savings, provide risk-capital, disseminate information. Primary Markets Definition: Deals with issuance of new securities (IPO). Funding: Corporations, governments, PSUs, banks, financial institutions raise funds. Secondary Markets Definition: Trading of already-issued securities (stock exchanges). Types: Auction-based (stock exchange) or dealer-based (OTC). Function: Provides efficient platform for trading, price discovery. 8.3.3 Equity Markets Definition: Market for ownership shares in a company. Value: Share price reflects relative value based on earning potential, economic conditions, growth, financial analysis. Purpose: Facilitate flow of funds from investors to corporations, finance ventures. 8.3.4 Debt Markets Definition: Issuance, trading, settlement of fixed income securities (bonds, debentures). Indian Debt Market: Dominated by Government Securities (G-Sec). Functions: Resource mobilization, government financing, monetary policy transmission, liquidity management, reduced borrowing cost. G-Sec Market: Sovereign, credit risk-free, fixed coupon, wide maturity range. Corporate Debt Market: Innovations (securitized products, floating rate instruments), but secondary market underdeveloped. Debentures: Financial claims issued by company, fixed interest, principal repayment on maturity. Bonds Market: Negotiable certificates of indebtedness. Zero Coupon Bond: Issued at discount, repaid at face value, no periodic interest. Convertible Bond: Option to convert to equity. Callable Bonds: Company can redeem on specific date. Puttable Bonds: Investor can seek redemption. 8.3.5 Derivative Market Definition: Financial instruments whose value derives from an underlying asset. Purpose: Mitigate risk from commodity price vagaries. Types: Forwards, futures, options, swaps. OTC Market: Direct negotiation, tailor-made contracts, high risk of default. Organized Market: Standardized, regulated, transparent, clearing house guarantees. 8.3.6 Commodities Market Definition: Market where commodities are traded (bullion, metals, energy, agricultural products). Features: Vibrant, active, liquid market indicates healthy economy. Evolution: Organized financial market place due to asset price volatility. Technology: Satellite technology, digital communication, electronic trading platforms. 8.3.7 Foreign Exchange Market Regulation: RBI regulates; guidelines for trading. Purpose: Hedging risk from currency movements using derivative transactions. 8.3.8 Other Markets Loan Markets: Banks/financial institutions provide credit to corporate sector for trading, manufacturing, etc. Insurance Markets: Private sector insurance for life and general; pooled funds invested in long-term securities. Retirement Savings Markets: Funds pooled by provident funds, pension funds; invested in long-term securities for old age. Mutual Funds: Reduce transaction cost for small investors; professional management. Savings and Investment Markets: Retail financial savings products (banks, chit funds, Nidhis). Participants in Financial Markets 8.4.1 Participants in Money Markets Main Players: RBI, Discount and Finance House of India, Mutual Funds, Banks, Corporate Investors, NBFC, State Governments, Provident Funds, Primary Dealers, STCI, PSUs, NRIs. Central Bank (RBI): Apex monetary institution; regulates, makes policy, acts as government bank, issues currency, manages foreign exchange. Commercial Banks: Major participants; borrow/lend money, mobilize savings, meet short-term WC needs, provide other services. Indigenous Financial Agencies: Moneylenders, indigenous bankers; finance trade, lend against property, high interest rates, flexible policies. Discount Houses: Discount trade bills, provide liquidity, deal in short-term government securities. Acceptance Houses: Provide liquidity (discounting bills), offer banking facilities, short-term loans, advice. 8.4.2 Participants in Capital Markets Classification: Banking Institutions, Non-Banking Financial Institutions. Banking Institutions: Commercial banks, cooperative banks, land development banks, foreign banks, regional rural banks. Commercial Banks: Accept deposits, meet long-term fund requirements, provide finance for special purposes (vehicles, gold). Co-operative Banks: Provide financial assistance to agriculturalists. Non-Banking Financial Institutions: Investment banks, merchant banks, investment companies, insurance companies, development banks, pension funds, private sector finance companies. Investment Banks: Garner savings, direct funds to business, market securities, advise. Merchant Banks: Financial advisory, intermediary services (corporate/project counselling, capital restructuring, issue management, portfolio management, credit syndication). Investment Companies: Collect funds (units, shares, debentures) and invest in securities based on objective. Insurance Companies: Provide funds for investment, manage policyholder savings. Development Banks: Provide long-term finance for industrial development. Pension Funds: Pool long-term funds for retirement. Private Sector Finance Companies: Raise funds via shares, debentures, deposits; provide short-term credit. Sources of Finance Classification: Time: Long-term, Medium-term, Short-term. Ownership: Owned, Borrowed. Source of Generation: Internal, External. Long Term Sources Definition: Funds needed for more than 5-10 years. Purpose: Acquisition of fixed assets, long-term investments. 9.3.1 Equity Capital Definition: Owner's equity, prerequisite to start company. Nature: Residual owners, unrestricted claim on income/assets, voting power. Risk Capital: Equity shareholders exposed to risk, but opportunities for higher returns. Advantages: Permanent capital, enhances debt capacity, no legal obligation for dividends (cash conservation). Disadvantages: High cost, high risk (uncertainty), dilutes EPS, reduces promoter control. 9.3.2 Preference Shares Nature: Quasi-equity (both equity and debt characteristics); fixed dividends, no voting rights (usually). Advantages: Fixed dividend income, no major control problem, cumulative dividends, maintains equity control, lower cost of capital than equity. Disadvantages: No voting rights, fixed dividend even with low profits, permanent burden (cumulative), EPS decrease if firm earns less than cost of capital, dividends not tax deductible. 9.3.3 Debentures Definition: Principal source of long-term funds; evidence of debt. Nature: Creditors of company, fixed interest, no voting rights, claim over assets before equity. Types: Convertible, non-convertible, secured, unsecured. Redeemable: With maturity period; requires Debenture Redemption Reserve. Advantages: Long maturity, no interference in affairs, fixed/lower interest, tax-deductible interest, priority in liquidation. Disadvantages: Interest payable even without profit, restricts further financing (secured), legal proceedings on default. 9.3.4 Retained Earnings Definition: Ploughing back profits for future expansion/diversification. Advantages: Lowest cost of fund, no flotation cost, no obligation for payment, increases share value, operational freedom. Disadvantages: May lead to monopolistic attitude, over-capitalization (inefficient), misuse by management, uncertain source. 9.3.5 Venture Capital Definition: Equity/quasi-equity in new companies for novel ideas. Nature: Early-stage investment in high-growth, high-risk projects. "Hands-on" Investment: Investor mentors promoters. Returns: From successful projects, capital gains. Features: Equity for new companies, high capital gain objective, funding for new/rapid growth, high returns compensate for losses. 9.3.6 Leasing Definition: Alternate financing method to acquire assets; owner (lessor) grants use to lessee for rent. Assets: Land, buildings, equipment, machinery, vehicles. Advantages: Convenient for short-term needs, avoids obsolescence risk, lessor provides maintenance, specialized lessors offer better prices. Disadvantages: Higher cost than other sources, no ownership, asset must be returned, no changes allowed, no ownership after lease period. 9.3.7 Hire Purchase Definition: Acquiring capital asset without immediate payment; user pays in installments, option to purchase after all payments. Ownership: Passes after final installment. Default: Seller can recover asset. Short Term Sources of Finance Trade Credit: Definition: Credit facility extended by one trader to another for goods/services. Nature: Short-term liability; short-term deferment of cash payments. Advantages: Readily available, boon to small buyers, extendable, convenient, long-term source if continuous. Disadvantages: May induce overtrading, limited funds, costly. Commercial Paper: Definition: Unsecured instrument for companies with good credit to raise money. Nature: Promissory note, transferable, issued at discount, maturity less than a year. Advantages: Lower cost than working capital loan, liquid. Factoring: Definition: Management service for receivables; outright sale of receivables to a Factor. Non-recourse Factoring: Factor assumes risk of bad debts. Recourse Factoring: Firm makes good on bad debts. Advantages: Improves cash flow, reduces admin cost, eliminates bad debt losses (non-recourse), advisory services. Disadvantages: Image may suffer, not useful for one-time sales, increases cost of finance. Public Deposits: Definition: Money accepted from public under Companies Act, 2013. Advantages: Easy fund mobilization, better interest rate for investors. Disadvantages: Unsecured, repayment uncertainty, risk of false information. Financing through Financial Institutions Term Loan: Definition: Medium/long-term loans for capital assets, expansion. Nature: Secured by tangible assets (land, building, machinery). Bank Credit: Definition: Major source of funds from banks/DFIs. Nature: Flexible source, easy to mobilize. Overdrafts: Draw more than balance, interest on utilized amount. Cash Credit: Borrow against tangible assets up to a limit. Bills Discounting: Definition: Seller of goods discounts bill of exchange with bank. Advantages: Lower cost than cash credit, certainty of payment. Disadvantages: Fees, no assistance for unpaid bills. Letter of Credit (L/C): Definition: Bank's undertaking to pay seller on behalf of buyer. Nature: Safeguards seller, bank commits payment. Emerging Sources of Finance Asset Securitization: Definition: Converting illiquid assets into financial claims. Advantages: Improves operating cycle, firm receives profit, assesses loan quality, brings liquidity. Disadvantages: Complicated, expensive, may hamper future fundraising, loss of direct control. Angel Financing: Definition: Equity ownership interest in early-stage, high-growth companies. Nature: "Hands-on" investment, investor mentors promoters. Crowd Funding: Definition: Internet-based mechanism for startups to raise funds from multiple funders. Reward: Discount, perks, equity. Advantages: Wider investor community access, no burden for interest/principal repayment. Disadvantages: Public disclosure of business ideas, potential for copying, limited influence for investors. Small Business Credit Cards: Definition: Revolving credit for business owners. Advantages: Qualify without credit history, financial cushion, rewards/cash back. Disadvantages: High interest rates, personal liability, security risks, variable interest rates. Capital Structure Definition: Mix of different types of finance (debt and equity) to total capitalization. Components: Common/preferred stock, bonds, debentures, term loans, earned revenue, capital surpluses. Capital Structure Planning Purpose: Design suitable capital structure considering profitability and solvency. Goal: Maximize market price of equity shares. Factors: Industry norms, financial manager's judgment, market imperfections. Features of an Appropriate Capital Structure Shareholders' Interests: Maximize long-term market price of equity shares. Profitability: Maximize leverage at lowest possible cost. Solvency: Avoid excessive debt; ensure funds for debt charges. Flexibility: Adaptable to changing circumstances; easy to modify or raise funds. Factors: Specific characteristics of company, importance placed on different criteria. Determinants of Capital Structure Leverage or Trading on Equity: Definition: Use of fixed-cost sources (debt, preference shares) to fund assets. Impact: If return on debt-financed assets > cost of debt, EPS rises. Consideration: Debt is typically cheaper than preference shares, interest is tax-deductible. EBIT-EPS Analysis: Tool for analyzing impact of leverage on EPS. Cost of Capital: Objective: Lowering cost of capital is beneficial. Debt vs. Equity: Debt is cheaper (tax-deductible interest); preference shares are less expensive than equity. Limitations: Excessive debt increases financial risk, raising cost of capital. Retained Earnings: Cheaper than new issues (no personal taxes, no flotation costs). Cash Flow: Conservatism: Determine fixed charges based on ability to generate cash. Fixed Expenses: Interest, preference dividends, principal payments. Impact: Companies with stable cash inflows can use more debt. Control: Equity Dilution: Fresh equity issue can dilute control of existing shareholders. Management's Attitude: May prefer ploughing back earnings to build up corporation. Closely Held vs. Publicly Traded: Control is key for closely held firms, less so for widely distributed public firms. Flexibility: Definition: Ability to adjust financial structure to changing situations. Goal: Raise funds without undue delay/expense, redeem capital when justified. Size of the Company: Small Business: Difficult to obtain long-term financing, inflexible structures, rely on own capital. Large Corporation: More leeway, access to low-interest loans, various securities. Marketability: Definition: Ability to sell security in given timeframe. Impact: Market sentiment (debt vs. equity issues) influences capital structure. Floatation Costs: Definition: Costs incurred when raising money. Debt vs. Equity: Debt issuance costs typically lower than equity. Dividend Theories Dividend Decision: How much profit to distribute vs. retain. Impact: Affects firm growth, value, cost of capital. Contradicting Views: Dividend decision is irrelevant. Dividends are relevant. 12.3 Relevance Theories of Dividend Support: Dividend policy impacts firm value. 12.3.1 Traditional Theory (Graham and Dodd) Premise: Stock market favors liberal dividends; shareholders prioritize current dividends over capital gains. Impact: Firms with higher current dividends have higher market value. Formula: $P = M(D + E/3)$ $P$: Market price per share. $D$: Dividend per share. $E$: Earnings per share. $M$: Multiplier. 12.3.2 Walter's Model Premise: Dividend policy hinges on firm's internal rate of return ($r$) and cost of capital ($k$). Assumptions: Financing only through retained earnings, constant $r$ and $k$, 100% earnings distribution/reinvestment, constant initial earnings/dividends, long firm life. Formula: $P = \frac{D + (E-D)r/k}{k}$ $P$: Market price per share. $D$: Dividend per share. $E$: Earnings per share. $r$: Rate of return on investment. $k$: Cost of capital. Implications: Growth Firms ($r > k$): Reinvest 100% earnings (0% dividend payout) to maximize value. Normal Firms ($r = k$): Indifferent to dividend policy; 100% dividend payout preferred. Declining Firms ($r Criticism: Unrealistic assumptions (no external financing, constant $r$, constant $k$). 12.3.3 Gordon's Model Premise: Supports dividend relevance for growth/declining firms, irrelevance for normal firms. Assumptions: Only equity capital, financing through retained earnings, constant $r$ and $k$, perpetual earnings, no corporate taxes, constant retention ratio, $k > g$. Formula: $P_0 = \frac{E_1(1-b)}{k-br}$ $P_0$: Market price at year 0. $E_1$: Earnings per share at year 1. $b$: Retention ratio. $k$: Cost of capital. $r$: Return on investment. $br = g$: Growth rate. Implications: Similar to Walter's model regarding growth, normal, declining firms. Criticism: Uncertainty increases with futurity, so discount rate cannot be constant; investors prefer dividends (less risky) to capital gains. 12.4 Irrelevance Theory - MM Hypothesis Premise: Dividend decision does not affect firm's value. Basis: Firm value depends only on earnings from investment policy. Assumptions (Perfect Capital Market): Free information, rational investors, fixed investment policy, no transaction/flotation costs, divisible securities, known investment opportunities, no taxes (or equal taxes on dividends/capital gains). Conclusion: Under perfect market, rate of return equals discount rate; price adjusts so return from dividends/capital gains equals discount rate. Criticism (Relaxed Assumptions): Tax Differential: Taxes on dividends/capital gains differ. Floatation Costs: Raising new capital is expensive, making retained earnings cheaper. Transaction and Monitoring Costs: Selling shares incurs costs; monitoring firm performance is costly. Perfect Capital Market: Information asymmetry, uncertainty in future share prices. Uncertainty and Preference for Dividend: Investors prefer steady income from dividends. Diversification: Investors may prefer dividends to invest elsewhere. 12.5 Summary (Dividends) Contradicting Views: Impact of dividend decision on firm value and cost of capital. Traditional View: Liberal dividend policy enhances firm value. Walter's & Gordon's Models: Categorize firms (normal, growth, declining) and suggest optimal payout ratios. MM Model: Firm value independent of dividend decision. 12.7 Keywords (Dividends) Capital Gain: Profit from appreciation in market value of a capital asset. Bonus Shares: Shares issued free to existing shareholders by capitalizing reserves. Stock Dividend: Dividend payment in shares. Stock Split: Increase number of shares outstanding by issuing more shares. Reverse Split: Decrease number of shares outstanding by merging them. Dividend Policy: Company's policy for structuring dividend payout. Earnings per Share (EPS): Company's profit / outstanding shares. Dividend per Share (DPS): Total dividends / ordinary shares. Dividend Payout Ratio: Percentage of earnings paid as dividends. Retention Ratio: Percentage of net income retained to grow business. 13.5 Types of Dividend Policies Objective: Maximize market value of company, satisfy shareholders, attract investors. 13.5.1 Stable Rupee Dividend Policy Definition: Fixed amount per share, unaffected by earnings variations. Suitability: For companies with stable earnings. 13.5.2 Incremental Dividend Policy Definition: Shareholders expect dividend growth, unrelated to EPS. Suitability: For companies with steady earnings progression. 13.5.3 Stable Dividend Payout Ratio Policy Definition: Fixed percentage of earnings paid as dividends. Nature: Dividends fluctuate with earnings. 13.5.4 Residual Dividend Policy Support: Dividend irrelevance theory. Process: Determine capital budget, finance with retained earnings, pay dividend from remaining earnings. Types: Pure Residual Dividend Policy: Distribute all remaining earnings; results in fluctuating dividends. Smoothed Residual Dividend Policy: Gradually change dividends for steady progression; combines residual policy with steady change. 14.1 Introduction (Behavioral Finance) Traditional Finance: Assumes rational investors, efficient markets. Behavioral Finance: Challenges traditional assumptions; acknowledges irrational behavior due to cognitive mistakes and emotional bias. Focus: Study of how psychology influences financial decisions and investor behavior. 14.2 Scope of Behavioural Finance Market Anomalies: Explains bubbles, calendar effects, other irregularities. Investor Personality: Identifies types of investors, helps devise financial instruments to hedge biases. Investment Advisors: Enhances skill set by understanding investor goals, systematic advice, balancing risk/return. Risk & Hedging: Identifies risks and helps develop hedging strategies in volatile markets. 14.3 Characteristics of Behavioural Finance Framing: Decision-makers' perception of a problem and its outcomes. Heuristics: Rules of thumb that can lead to errors. Emotions: Human needs, desires, fears, fantasies drive decisions. Impact on Market: Markets not always efficient; rational investors exploit mispricing. Behavioural Considerations Biases and Heuristics: Present in all humans; awareness helps control emotional responses. Limitation of Knowing: Information overload can lead to confusion; focus on quality of information. Focus on Facts: Judge asset prices on facts, not noise; focus on enterprise value. Overcoming Loss Aversion: Sell loss-making investments, learn from mistakes. Information at Face Value: Think critically about information presentation, avoid projecting immediate events. Control Emotions: Be aware of psychological biases (herd investing, mental accounting). Investment Horizon: Diversify portfolios, set/adhere to buying/selling targets. 14.4 Branches of Finance Standard Finance: Theories: Contemporary portfolio theory, efficient market hypothesis (EMH). EMH: All information reflected in security price; active traders can't outperform market. Behavioural Finance: Alternative Theory: Explains emotional and psychological aspects of investing. Themes: Overconfidence, cognitive dissonance, regret theory, prospect theory. 14.5 Financial Theories Traditional vs. Behavioral Finance: Traditional: Based on arbitrage principles, quantitative methods, rational investors, efficient markets. Behavioral: Based on prospect theory, psychological aspects, irrational behavior, frame dependence. 14.9 Decision Making Errors and Biases Investors: "Normal" but prone to errors. Buckets: Self-deception, heuristic simplification, emotion, social influence. Biases: Representativeness, anchoring, overconfidence, loss aversion, regret aversion, confirmation, hindsight, herding, mental accounting, gambler's fallacy, money illusion, experiential, familiarity. 15.1 Introduction (Financial Restructuring) Objective: Creation and maximization of value. Expansion: Build capacity, increase production units. Sources: Equity, debt, asset securitization, venture capital. Financial Security: Legal document representing claim on issuer (ownership, creditorship, hybrid). 15.2 Corporate Restructuring Definition: Broad term including financial restructuring, debt restructuring, capital structure changes. Reasons: Expand/diversify activities, maximize value, respond to unfavorable conditions (disinvestment, downsizing). Examples: Mergers, acquisitions, takeovers. 15.4 Methods of Financial Restructuring Buyback of Shares. Conversion of Debt/Preference Shares into Equity. Corporate Debt Restructuring. Leveraged Buyouts. Equity Restructuring. Divestiture. Disinvestment. Changes in Capital Structure. 15.5 Buyback of Shares Definition: Company buys its own shares to reduce outstanding shares. Reasons: Utilize surplus cash, improve EPS, increase promoter shareholding, enhance return on capital, boost confidence, signal positive market. Regulations (Companies Act, 2013 & SEBI): Articles of Association must authorize buyback. Special Resolution (or Board Resolution for up to 10%). Max 25% of paid-up capital/free reserves. Debt-equity ratio cannot exceed 2:1. Only fully paid-up shares. Declare insolvency (Form SH-9). Maintain Register (SH-10), submit return (SH-11). Extinguish shares within 7 days. 6 months cooling period for fresh issue. No offer within 1 year of previous buyback. Complete within 1 year of resolution. Transfer amount to Capital Redemption Reserve. Cannot buyback through subsidiaries, investment/group companies, or if defaulted on payments. 15.6 Conversion of Debt/Preference Shares into Equity Method: Convert debt or preference shares into equity. Regulations: Permitted under Companies Act, 2013 (Section 62(3)). History: Enabled by government allowing convertible debentures/preference shares. 15.7 Corporate Debt Restructuring (CDR) Scheme: Introduced by Government of India to provide relief to borrowers. Purpose: Avoid classification as Non-Performing Assets (NPA). Eligibility: Multiple banking accounts, outstanding exposure > Rs. 10 crores. Exclusions: Single financial institution, frauds, willful defaulters, filed recovery suits. Impact: Significant for banking industry; concerns about NPA classification. 15.8 Leveraged Buyouts (LBOs) Definition: Acquiring controlling interest using substantial debt. Nature: Lenders acquire majority interest through collateral. Popularity: Not very popular in India due to Companies Act restrictions and RBI regulations. Features: Lender guarantee, heavy debt, debt-secured loans, attractive for private equity, generates cash surpluses, strong management. Pre-requisites: Deferred major expenditures, cash flows dedicated to debt service, stable operating cash flows, adequate physical assets/brand names, competent management. 15.9 Equity Restructuring Definition: Reorganization of capital to strengthen equity base. Forms: Stock dividend, stock split, spin-off, rights offering. Reasons: Boost shareholder confidence, correct market mispricing. Reasons for Shareholder Agreement: Correction of overcapitalization, liquidity option (buyback), increasing efficiency, confidence building, wiping out losses, proper debt-equity ratio, raising fresh resources. Regulations (Companies Act, 2013, Section 66): Reduction of share capital if authorized by Articles of Association. 15.10 Divestiture Definition: Selling or disposing of a part of the business. Reasons: Excess load shedding, operational infeasibility, refocus on core business, meet future technological changes, strengthen operational ability, raise resources, reduce political instabilities. 15.11 Disinvestment Definition: Withdrawing investment (sale of assets, shares). Prominence: In India, government disinvests from Public Sector Enterprises (PSEs). 15.12 Changes in the Total Capital Structure Concept: Firms may change capital structure (buyback, debt conversion, etc.). Historical Context: Shift from higher debt (tax deduction) to equity (vibrant market, profitability). Trend: More firms repaying debt, aiming for 100% equity. Total Reconstruction Steps: Determine total valuation by capitalizing prospective earnings. Determine new capital structure to reduce fixed charges. Valuation of old securities and exchange for new securities.