238896357 corporate-finance

CORPORATE
FINANCE
Dr. Satish Kumar Matta

INTRODUCTION
Finance is defined as the provision of money at the time it is
required. Every enterprise big or small, needs finance to carry on
and expand its operations. Finance hold the key to all the business
activities and a firm’s success and, in fact its survival dependent
upon how efficiently it is able to acquire and utilize the funds.
Finance has become so important for the business enterprises that
it has given birth to ‘Corporate Finance’ or ‘Financial
Management’ as a separate subject. Corporate finance is that part
of managerial process which is concerned with the planning and
controlling of firm’s financial resources. It is concerned with the
procurement of funds from most suitable sources and making the
most efficient use of such funds. In the earlier stages, corporate
finance was a branch of economics and a separate subject it is of
recent origin. It is still developing and the subject is of immense
importance to the managers because among the most crucial
decisions of the firm are those which relate to finance.

The Financial Manager
A striking feature of large corporations is that the owners (the
stockholders) are usually not directly involved in making business
decisions, particularly on a day-to-day basis. Instead, the
corporation employs managers to represent the owners’ interests
and make decisions on their behalf. The financial management
function is usually associated with a top officer of the firm, such
as a vice president of finance or some other chief financial officer
(CFO). The vice president of finance coordinates the activities of
the treasurer and the controller. The controller’s office handles
cost and financial accounting, tax payments, and management
information systems. The treasurer’s office is responsible for
managing the firm’s cash and credit, its financial planning, and its
capital expenditures. These treasury activities are all related to the
three general questions namely raising of finance through cheapest
source, optimum utilization of raised funds and dividend decision
and our study thus bears mostly on activities usually associated
with the treasurer’s office.

Financial Management Decisions
1. Capital Budgeting: The first question concerns the firm’s long-term
investments. The process of planning and managing a firm’s long-term
investments is called capital budgeting. In capital budgeting, the financial
manager tries to identify investment opportunities that are worth more to
the firm than they cost to acquire. Loosely speaking, this means that the
value of the cash flow generated by an asset exceeds the cost of that asset.
The types of investment opportunities that would typically be considered
depend in part on the nature of the firm’s business. For example, for a
large retailer such as Wal-Mart, deciding whether or not to open another
store would be an important capital budgeting decision. Similarly, for a
software company such as Oracle or Microsoft, the decision to develop
and market a new spreadsheet would be a major capital budgeting
decision. Regardless of the specific nature of an opportunity under
consideration, financial managers must be concerned not only with how
much cash they expect to receive, but also with when they expect to
receive it and how likely they are to receive it. Evaluating the size,
timing, and risk of future cash flows is the essence of capital budgeting.
In fact, whenever we evaluate a business decision, the size, timing, and
risk of the cash flows will be, by far, the most important things we will
consider

Continued:
2. Capital Structure: The second question for the
financial manager concerns ways in which the
firm obtains and manages the long-term financing
it needs to support its long-term investments. A
firm’s capital structure (or financial structure) is
the specific mixture of long-term debt and equity
the firm uses to finance its operations. The
financial manager has two concerns in this area.
First, how much should the firm borrow? That is,
what mixture of debt and equity is best? The
mixture chosen will affect both the risk and the
value of the firm. Second, what are the least
expensive sources of funds for the firm?

Continued:
3. Working Capital Management: The third question concerns
working capital management. The term working capital refers to
a firm’s short-term assets, such as inventory, and its short-term
liabilities, such as money owed to suppliers. Managing the
firm’s working capital is a day-to-day activity that ensures that
the firm has sufficient resources to continue its operations and
avoid costly interruptions. This involves a number of activities
related to the firm’s receipt and disbursement of cash. Some
questions about working capital that must be answered are the
following: (1) How much cash and inventory should we keep on
hand? (2) Should we sell on credit? If so, what terms will we
offer, and to whom will we extend them? (3) How will we
obtain any needed short-term financing? Will we purchase on
credit or will we borrow in the short term and pay cash? If we
borrow in the short term, how and where should we do it? These
are just a small sample of the issues that arise in managing a
firm’s working capital.

Forms of Business Organization
1. Sole Proprietorship: A sole proprietorship is a business owned by one
person. This is the simplest type of /business to start and is the least
regulated form of organization. Depending on where you live, you
might be able to start up a proprietorship by doing little more than
getting a business license and opening your doors. For this reason, there
are more proprietorships than any other type of business, and many
businesses that later become large corporations start out as small
proprietorships.
The owner of a sole proprietorship keeps all the profits. That’s the good
news. The bad news is that the owner has unlimited liability for
business debts. This means that creditors can look beyond business
assets to the proprietor’s personal assets for payments. Similarly, there
is no distinction between personal and business income, so all business
income is taxed as personal income. The life of a sole proprietorship is
limited to the owner’s lifespan, and it is important to note, the amount
of equity that can be raised is limited to the amount of the proprietor’s
personal wealth. This limitation often means that the business is unable
to exploit new opportunities because of insufficient capital. Ownership
of a sole proprietorship may be difficult to transfer because this transfer
requires the sale of the entire business to a new owner.

2. Partnership
A partnership is similar to a proprietorship, except that there are
two or more owners (partners). In a general partnership, all the
partners share in gains or losses, and all have unlimited liability for
all partnership debts, not just some particular share. The way
partnership gains (and losses) are divided is described in the
partnership agreement. This agreement can be an informal oral
agreement or a lengthy, formal written document. The advantages
and disadvantages of a partnership are basically the same as those
of a proprietorship. Partnerships based on a relatively informal
agreement are easy and inexpensive to form. General partners have
unlimited liability for partnership debts, and the partnership
terminates when a general partner wishes to sell out or dies., All
income is taxed as personal income to the partners, and the amount
of equity that can be raised is limited to the partners’ combined
wealth. Ownership of a general partnership is not easily
transferred, because a transfer requires that a new partnership be
formed. A limited partner’s interest can be sold without dissolving

3. Corporations or Companies
The corporation is the most important form (in terms of size) of
business organization. A corporation is a legal “person” separate
and distinct from its owners, and it has many of the rights, duties,
and privileges of an actual person. Corporations can borrow
money and own property, can sue and be sued, and can enter into
contracts. A corporation can own stock in another corporation.
Not surprisingly, starting a corporation is somewhat more
complicated than starting the other forms of business organization.
Forming a corporation involves preparing memorandum of
association and articles of association (or a charter) and a set of by
laws. The articles of association must contain a number of things,
including the corporation’s name, its intended life (which can be
forever), its business purpose, and the number of shares that can
be issued. This information must normally be supplied to the state
in which the firm will be incorporated.

Continued:
For most legal purposes, the corporation is a “resident” of
that state. The by laws are rules describing how the
corporation regulates its own existence. For example, the
by laws describe how directors are elected. These bylaws
may be a very simple statement of a few rules and
procedures, or they may be quite extensive for a large
corporation. The bylaws may be amended or extended from
time to time by the stockholders. In a large corporation, the
stockholders and the managers are usually separate groups.
The stockholders elect the board of directors, who then
select the managers. Management is charged with running
the corporation’s affairs in the stockholders’ interests. In
principle, stockholders control the corporation because they
elect the directors.

Continued:
As a result of the separation of ownership and
management, the corporate form has several advantages.
Ownership (represented by shares of stock) can be readily
transferred, and the life of the corporation is therefore not
limited. The corporation borrows money in its own name.
As a result, the stockholders in a corporation have limited
liability for corporate debts. The most they can lose is what
they have invested. The relative ease of transferring
ownership, the limited liability for business debts, and the
unlimited life of the business are the reasons why the
corporate form is superior when it comes to raising cash. If
a corporation needs new equity, for example, it can sell
new shares of stock and attract new investors.

Approaches to Finance Functions
or
Evolution or Scope of Corporate Finance
(1)Traditional Approach of Financial Function
Limitations:
(i) More emphasis on raising of funds.
(ii)Ignores the financial problems of non-corporate
enterprises.
(iii)More concerned to the problems of raising
financing on the occurrence of special events
(iv) Special attention on long-term financing.
(2) Modern Approach of Finance Function

Objectives or Goals of Corporate
Finance
1. Profit maximization
Criticism of profit maximization on the
following grounds:
(a) Profit is ambiguous/ not clear
(b)Ignores the time value of money
(c) Ignores risk factor
1. Wealth maximization.

MEANING AND DEFINITION
“The finance function is the process of acquiring and
utilizing funds by a business”. – R.C. Osborn
According to Ezra Solomon, “Financial management is
concerned with the management decisions that result in the
acquisition and financing of long term and short term
credits of a firm. As such it deals with the situations that
require selection of specific assets as well as the problem
of size and growth of an enterprise. The analysis of these
decisions is based on the expected inflows and outflows of
funds and their effects upon managerial objectives”.
According to Joseph L Massie, “Financial management is
the operational activity of a business that is responsible for
obtaining and effectively utilizing the funds necessary for
efficient operations”.

Continued:
In the words of Joseph F. Bradley, “Financial
management is that area of business management devoted
to a judicious use of capital and careful selection of
sources of capital in order to enable a spending unit to
move in the direction of reaching its goals”.
According to James C. Van Horne, “Financial
management is concerned with acquisition, financing and
management of assets with some overall goal in mind”.
The most acceptable and popular definition of financial
management as given by S.C. Kuchal is that, “Financial
management deals with procurement of funds and their
effective utilization in the business”.

FUNCTIONS OF FINANCIAL MANAGEMENT
There are three basic functions of financial management. These are (i)
raising of finance, (ii) investing it in assets and (iii) distributing returns
earned from assets to shareholders. These three functions are
respectively known as financing decision, investing decision and
dividend policy decision. While performing these functions, various
other functions have also to be performed such as:
1. Determining the financial needs
2. Financial control
3. Routine functions
(a)Supervision of cash receipts and payments and safeguarding of cash
balance.
(b)Opening bank accounts and managing them.
(c)Safeguarding of securities, insurance policies and other valuable
documents.
(d)Maintaining record and preparation of reports.
(e)Establishing a proper system of internal audit.

TIME VALUE OF MONEY
Shareholders contribute their funds in the firm and in
considerations expect some future benefit either in the form of
dividend or increased value of shares. Most of the financial
decision, such as procurement of funds or acquisition of assets
affects firm’s cash flow at different interval of time. If a firm
raise fund through borrowings for present needs, these will have
to be returned in future as interest and principal. Similarly funds
can be raised through issue of share capital, but it will have to
pay dividend on the share capital in future. On the other hand if
a firm acquires an asset today, it will require immediate cash
outflow, but the benefit of this asset will be received in future.
While taking this type of decision, the firm will have to compare
the total of cash inflows with the total cash outflows. For this the
firm have to make appropriate adjustment for time otherwise it
may take faulty decisions.

CONCEPT OF TIME VALUE OF MONEY
“Time Value of Money’ is the value of a unit of money at different time intervals. The
value of money received today is different from the value of money received after some
time in the future. In other words, the value of money changes over a period of time.
An important financial principle is that the value of money is time dependent. Since a
rupee received has more value, rational investors would prefer current receipts to future
receipts. That is why this phenomenon is also referred to as “Time Preference of
Money’. This principle is based on the following four reasons:
• Inflation: Under inflationary conditions the value of money, expressed in terms of its
purchasing power over goods and services, declines.
Risk: Money received today is certain. However, money receivable at a future date is
less certain and has some degree of risk attached to it. This factor reminds us the
famous English saying “A bird in hand is worth two in the bush”.
• Personal Consumption Preference: Many individuals have a strong preference for
immediate rather than delayed consumption. The promise of a bowl of rice next week
counts for little to the starving man.
• Investment Opportunities: Money like any other desirable commodity has a price,
given the choice of Rs.100 now or the same amount in one year’s time, it is always
preferable to take the Rs.100 now because it could be invested over the next year at
(say) 18% interest rate to produce Rs.118 at the end of one year. If 18% is the best risk-free
return available, then you would be indifferent to receiving Rs.100 now or Rs.118
in one year’s time. Expressed another way, the present value of Rs.118 receivable one
year hence is Rs.100.

Continued:
After explaining various reasons for time preference
for money, let us take an example. For example, a
firm wants to invest in a machine costing Rs.
10,00,000 now (cash out flow in zero period). The
machine will give a cash inflow of Rs. 4,00,000
each, at the end of coming three years, hence making
a total cash inflow of Rs.12,00,000 over three years.
In this particular example cash inflows are occurring
at different interval of time and hence are not
comparable because of the time value of money
principle. However, these cash flows can be made
comparable by using discounting cash flow method.

SIMPLE INTEREST
Simple interest is the interest calculated on the
original principal only for the time during which the
money lent is being used. Simple interest is paid or
earned on the principal amount lent or borrowed.
Simple interest is ascertained with the help of the
following formula:
Interest = Pnr
Amount = P(1 + nr)
Where,
P = Principal
r = Rate of Interest per annum (r being in decimal)
n = Number of years

CONTINUED:
Illustration
What is the simple interest and amount of Rs.8,000
for 4 years at 12% p.a.
Solution
Interest = Pnr
= 8,000 x 4 x 0.12 = Rs.3,840
Amount (i.e. principal + Interest)
= P (1 + nr)
= 8,000 [1+ (4 x 0.12)]
= 8,000 (1+ 0.48)
= 8,000 x 1.48
= Rs.11,840

VALUATION TECHNIQUE
• By compounding the various cash flows to a future date, or
• By discounting the various cash flows to the present date.
• Compound Value Concept
• The compound value concept is used to find out the future value of
various cash flows. In case of this concept, the interest earned on the
initial principal becomes a part of principal at the end of the
compounding period. This interest earned on interest is known as
compounding effect and hence compounding technique. The term
compounded value is also referred to as terminal value i.e. value at the
end of a period.
The importance of compound value concept can be understood by the
famous statement given by Albert Einstein, “I do not know what the
seven wonders of the world are, but I know the eighth ………
compound interest”.
For example, if Rs. 1000 is invested at 10% compound interest for two
years, the return for first year will be Rs. 100 and for the second year
interest will received on Rs. 1100 (i.e. 1000 + 100) The total amount due
at the end of second year will become Rs. 1210 (i.e. 1000+100+110).
This can be understood better with the following illustration:

CONTINUED:
Illustration: Rs. 10,000 is invested at 10% compounded annually
for three years. Calculate the compounded value after three
years.
Solution:
Amount at the end of 1st year will be:
10,000 + (10,000 × .10) = Rs. 11,000
or 10,000 × (1.10) = Rs. 11,000
Amount at the end of 2nd year will be:
10,000 + (11,000 × .10) = Rs. 12,100
or 11,000 × (1.10) = Rs. 12,100
Amount at the end of 3rd year will be:
12,100 + (12,100 × .10) = Rs. 13,310
or 12,100 × (1.10) = Rs. 13,310
This compounding procedure will continue for an indefinite
time period.

APPLICATION OF COMPOUNDING TECHNIQUE
The above compounding technique can be used
for calculating:
• The future value of single present cash flow.
• The future value of a series of unequal cash flows
over a period of time.
• The future value of a series of equal cash flows
over a period of time.
• The future value of a cash flow when
compounding is done more than once in a year.

1. The Future Value of Single Present
Cash Flow
The future value of single present cash flow can be
calculated with the help of following mathematical
formula:
A = P (1 + i) n
Where,
A= Amount at the end of ‘n’ period
P = Principal amount at the beginning of the ‘n’period
i = Rate of interest per payment period (in decimal)
n = Number of payment periods

CONTINUED:
What sum will amount to Rs.5,000 in 6 years time at 8 % per annum.
Solution
A = P (1 + i) n
= 5,000 (1 + 0.08) 6
= 5,000 (1.08) 6
= 5,000 x 1587
= Rs.7,935
Alternatively, this example can be solved by using future value interest factor
table. Use of this table is quite useful as computation by this formula becomes
difficult and time consuming if the number of years becomes large. This table
gives the compounding value of future value of Re. 1 for various combinations
of ‘i’ and ‘n’. The compounding value or future value from the table can be
calculated by using the following fornula:
Compounding Value (future value) = P x FVIF i, n
Where,
P = Principal amount
FVIF = Future value interest factor or compounding factor for given values of ‘i’
and ‘n’ taken from future

CONTINUED:
Let us now solve the above example by using the compounding
value table:
Future value to be received after 1st year:
FV = 5,000 x 1.08 = 5400
Future value to be received after 2nd year:
FV = 5,000 x 1.166 = 5830
Future value to be received after 3rd year:
FV = 5,000 x 1.260 = 6,300
Future value to be received after 4th year:
FV = 5,000 x 1.360 = 6,800
FV = 5,000 x 1.469 = 7,345
FV = 5,000 x 1.587 = 7,935

2. The Future Value of a Series of Unequal Cash Flows over a
Period of Time
When an investor has invested his money in installments over a period of time,
he or she may want to know the value of his or her investments after a certain
period. This can be calculated as illustrated below:
Illustration: Mrs. Meena Matta invested Rs. 20,000, Rs. 10,000 and Rs. 5,000
at the starting of 1st , 2nd and 3rd year. Calculate the compound value of her
investment at the end of 3rd year when interest is provided at the rate of 10%
compounded annually.
Solution:
Compounded value or FV of Rs. 20,000 invested for 3 years
FV = 20,000 (1 + 0.10) 3 = Rs. 26,620
FV = 10,000 (1 + 0.10) 2 = Rs. 12,100
FV = 5,000 (1 + 0.10) = Rs. 5,500
Hence, total compounded value of Mrs. Meena Matta investments will be:
= Rs. 26620 + Rs. 12,100 + Rs. 5,500 = Rs. 44,220

CONTINUED:
Alternatively, this illustration can be solved by
using future value interest factor table as
follows:
Amount of Mrs. Meena Matta at the end of 3rd
year will be:
= 20,000 x 1.331 + 10,000 x 1.210 + 5,000 x 1.10
= 26,620 + 12,100 + 5,500 = 44,220
Where, 1.331, 1.21 and 1.10 are the compounding
values of Re 1 at 10% rate of interest after 3,2
and 1 year respectively.

The Future Value of a Series of Equal Cash
Flows over a Period of Time (FV of an
Annuity):
A series of equal cash flows (either inflow or
outflow) occurring over a period of equal time
intervals is known as annuity. Suppose in the
above illustration if Mrs. Meena Matta invests
Rs. 20,000 an equal amount at the end of 1st year,
2nd year and 3rd year for 3 years at a certain rate of
interest. This outflow of equal amount at equal
time intervals can be termed as annuity.

CONTINUED:
Illustration: Mrs. Geeta Damir invested Rs. 20,000, at the end of 1st, 2nd and
3rd year. Calculate the compound value of her investment at the end of 3rd
year when interest is provided at the rate of 10% compounded annually.
Solution:
Amount of Mrs. Geeta Damir at the end of 3rd year will be:
= 20,000 x 1.210 + 20,000 x 1.110 + 20,000 x 1.00
= 24,200 + 22,000 + 20,000 = 66,200
However, compounding value of this annuity can also be determined by
using the future value interest factor for an annuity of Re 1 Table.
Compound value (Future Value) of an annuity = Annuity Amount x FVIFA
i, n
Where FVIFA i, n = 20,000 x 3.310 = Rs. 66,200.
Here, 3.310 is the compounding factor of an annuity of Re 1 at an
interest rate of 10% for 3 years taken from the future value interest
factor for an annuity of Re. 1 Table.

4. The Future Value of a Cash Flow when
Compounding is done More Than once in a Year
In all of the above illustrations, compounding of interest has
been done on annual basis. However, in many cases interest is
compounded more than once in a year, say semi-annually,
quarterly or even monthly.
When interest is payable half - yearly
I 2 * n
FV = P 1 + -----
2
When interest is payable quarterly
I 4 * n
FV = P 1 + ----
4

Continued:
When interest is payable monthly
I 12 * n
FV = P 1 + ----
12
When interest is payable daily
I 365 * n
FV = P 1 + ------
365

Continued:
Find the compound interest on Rs.2,500 for 15 months at 8%
compounded quarterly.
Solution
I 4 * n
FV = P 1 + ------
4
0.08 4 * 1.25
FV = 2500 1 + ---------
4
5
FV = 2500 1.02
FV = 2500 X 1.104 = 2,760
Compound Interest = 2,760 - 2,500 = Rs.260

Continued:
Illustration: Mrs. Kanta Rani Damir has invested Rs. 1,00,000 for
3 years at the interest rate of 12% per annum compounded
quarterly. Find the amount she will get after 3 years.
Solution
We know, FV = (1 + i) n
Where, P = Principal = Rs. 1,00,000
12
i = Effective rate of interest per quarter = ------ = 3%
4
n = No. of quarters = 3x4 = 12
Hence,
FV = 1,00,000 (1 + 0.03) 12 = 1,00,000 x 1.426 = 1,42,600
Where, 1.426 is the compounding factor of Re. 1 at 3% per
quarter interest for 12 periods (quarters).

PRESENT VALUE OR DISCOUNTING CONCEPT
“Deposit Rs. 1,000 and take back Rs. 1,100 after
one year”, stated in another way means that Rs.
1,000 is the present value of Rs. 1,100 to be
received a year hence. The present value concept
is exact opposite of the compounding technique
concept. In case of compounding we calculate the
future value of a sum of money or series of
payments, while in case of Present Value
Concept, we estimate the present worth of a
future payment / installment or series of
payments adjusted for the time value of money.

Concepts in Valuation
The basis of Present Value approach is that
opportunity cost exists for money lying idle. This
return is termed as ‘discounting rate’.
Given a positive rate of interest, the present value of
future rupee will always be lower. The technique for
finding the present value is termed as ‘discounting’.
Discounting concept can be explained for calculating:
1. Present value of a future sum.
2.Present value of a series of unequal cash flows.
3. Present value of a series of equal cash flows.

Present Value of Future Cash
The present value of money received in future will be less than
the value of same money in hand today. This is because the
money in hand can be invested and its absolute value can be
increased at a future date. Whereas money received in future
has to be discounted to find its present value. This can be
calculated as per the following formula:
A
PV = ----------
(1 + i) n
Where,
PV = Present Value
A = Amount or future cash flows
i = Rate of interest per annum or per period
n = No. of years or periods

Continued:
Mrs. Rani Damir of Kota is supposed to get Rs. 1,00,000 after 3 years.
Let existing rate is 10%. Find the present value of this sum which Mrs.
Rani will get after 3 years.
A
PV = ----------
(1 + i) n
Where,
A = Rs. 1,00,000, i = 10 % p.a., n = 3 years
1,00,000 1,00,000
PV = -------------- = -------------------- = Rs. 75,130
(1 + 0.10) 3 1.1 x 1.1 x 1.1
However, this problem can be solved with the help of readymade table
showing the present value of one rupee for various values of i and n
with help of Present Value Interest Factor Table.
Hence, PV = A x discounting factor or present value interest factor
= 1,00,000 x 0.7513 = Rs. 75,130

Present Value of Series of Unequal Cash Flows
In a business situation, it is very natural that returns received by a firm are
spread over a number of years. An investment made now may fetch returns for
a period after some time. Any businessman will like to know whether it is
worth to invest or forego a certain sum now, in anticipation of returns he will
earn over a number of year(s). In order to take this decision he will need to
equate the total anticipated future returns, to the present sum he is going to
sacrifice. To estimate the present value of future series of returns, the present
value of each expected inflows will be calculated. (In case of compounding,
the expected future value of series of cash flows was calculated).
The present value of series of cash flows can be represented by the following
formula:
A1 A 2 A 3 A n
PV = ---------- + ------------- + ------------- + ……………
(1 + i) (1 + i) 2 (1 + i) 3 (1 + i) n
Where:
PV = Sum of present values of each future cash flow
A1, A2, A3 = Cash flows after period 1, 2, 3, etc.
i = Discounting rate
n = No. of years or periods

Continued:
Given the time value money as 10% (i.e. the
discounting factor), you are required to find out
the present value of future cash inflows that will
be received over next four years.
Year Cash flows (Rs.)
1 10,000
2 20,000
3 30,000
4 40,000
Present value factors or discount rate at 10% is
0.909, 0.826, 0.751 and 0.683.

Present Value of an Annuity or Present
Value of Equal Cash flow
In the above case there was a mixed stream of cash
inflows. An individual or depositor may receive
only constant returns over a number of years. For
example returns on debentures / fixed deposits etc.,
is fixed in its nature. This implies that the cash
flows are equal in amount. To find out the present
value of annuity either we can find the present value
of each cash flow or use the annuity table. The
annuity table gives the present value for an annuity
of Re. 1 for interest rate ‘r’ over number of years
‘n’.

Continued:
Calculate the Present Value of Annuity of Rs. 5,000
received annually for four years, when discounting factor
is 10%.
Alternatively, formula for calculation of the present value
of an annuity can be derived from the formula for
calculating the Present Value of a series of cash flows.
PV = A x PVIFA i, n
Where, PV = PVIFA i, n is the present value interest factor
for an annuity of Re. 1 at the rate of interest for n periods
or simply discounting factor for an annuity of Re. 1.
The PV in the above example can be calculated as:
5000 × 3.170 = Rs. 15,850.

Present Value of a Perpetual Annuity
A person may like to find out the present value of his
investment in case, he is going to get a constant
return year after year. An annuity of this kind which
goes on forever is called perpetuity. A practical
example is the way in which scholarships are given
to the students in schools / colleges. An individual
invests a certain sum of money, on which a constant
interest is received year after year. This return is
given in the form of award, to students achieving
academic excellence. This type of annuity continues
forever.

Continued:
The present value of perpetuity of an amount A can
be ascertained by simply dividing A by interest rate
as discount i, symbolically represented as:
A
PVp = ------
i
Where,
PV p = Present value of perpetuity
A = amount of an equal cash flow
i = Rate of interest

Continued:
Mr. Ramesh Naruala, principal wishes to institute a
scholarship of Rs. 5000 for an outstanding student
every year. He wants to know the present value of
investment which would yield Rs. 5,000 in
perpetuity, discounted at 10%.
Solution: The present value can be simply calculated
by:
A 5,000
PVp = ------ = ---------- = Rs. 50,000
i 0.10
This is quite convincing since an initial sum of Rs.
50,000 would be invested at a rate of 10% and it
would provide a constant return of Rs. 5,000 for
ever without any loss of initial capital.

CALCULATION OF DOUBLING PERIOD
Generally, investor may be interested to know
the period in which their investment becomes
double. There is a thumb rule for this purpose
which avoids the use of future value interest
factor table. This rule is known as rule of 72.
According to this rule the doubling period is
obtained by dividing 72 by the interest rate.
Hence,
72
Doubling Period = ------
r

Continued:
There is another more accurate rule of thumb (where r = rate of interest)
known as rule of 69 for calculating doubling period. According to this
rule, doubling period can be calculated as follows:
69
Doubling Period = 0.35 + -------
r
For example, if the rate of interest is 10 %, then doubling period
through these rules can be calculated as follows:
72 72
Doubling Period = ------ = ---------- = 7 years and 2 months
r 10
69 69
Doubling Period = 0.35 + ------- = 0.35 + -------- = 0.35 + 6.9 =
r 10
7.25 = 7 Years and 3 Months.

SOURCES OF SHORT-TERM AND
LONG-TERM FINANCE
One of the important constituents of financial
system is the financial market instruments,
popularly known as financial products. As on date,
wide range of financial products are available in the
Indian Financial Market. As more variety of
financial products are available in the market, it
suits the need of variety of investors, and as a
consequence more and more investors are attracted
towards the financial market.
The main criteria for the success of a financial
product is that investor gets a reasonable return on
his investment and issuer gets credit on reasonable
terms.

KINDS OF FINANCIAL MARKET
INSTRUMENTS
1. SHARES
Section 2(46) of the Companies Act, 1956 defines the
term “share”. As per this share means share is the share
capital of a company; and includes stock, except where a
distinction between stock and share is expressed or
implied.
By its nature, a share is not a sum of money but a bundle
of rights and liabilities. From investor point of view a
share is a right to participate in the profits of a company,
while it is a going concern and declares dividend; and
right to participate in the assets of the company, when it
is wound up. On the other hand from company point of
view, a share is a liability as it is to be returned at the time
of winding up.

Continued:
There are two types of shares:
1. Preference shares
2.Equity shares
Preference Shares: A preference share is a share
which fulfills the following two conditions:
(a)It carries preferential right in respect of payment of
dividend; and
(b)It also carries preferential right in regard to
repayment of capital.
In simple words, preference share capital must
have priority both regards to dividend as well as
capital.

TYPES OF PREFERENCE SHARES
1. Redeemable and Irredeemable Preference
Shares (Sec. 80): Redeemable with in 20 years
from the date of its issue. As per Companies
(Amendment) Act, 1996, with effect from 1st
March, 1997, a company cannot issue
irredeemable preference shares.
2. Participating and Non-Participating
Preference Shares: Preference shares are
always non-participating, unless expressly
stated to be participating.

Continued:
3.Cumulative and Non-Cumulative Preference
Shares: Preference shares are always cumulative,
unless expressly stated to be non-cumulative.
4. Convertible Preference Shares: This instrument is
in two parts i.e., part A and part B. Part A is
convertible into equity shares automatically and
compulsory on the date of allotment without any
application by the allottee. Part B is redeemed at par
or converted into equity share after the lock-in-period,
at the option of the investor, at a price 30%
lower than average market price.

EQUITY SHARE
Equity share means share which is not a preference share.
There are three kinds of equity shares: Equity shares with
equal rights, Equity shares with differential rights and
Sweat Equity share.
1. Equity Shares with Equal Rights: Here all the
shareholders have equal rights in respect of dividend,
voting or otherwise.
2. Equity Shares with Differential Rights: The Companies
(Amendment) Act, 2000 has enabled the companies to
issue equity share capital with differential rights as to
dividend, voting or otherwise in accordance with such
rules and conditions as may be prescribed. The Central
Government has since notified the Companies (Issue of
share capital with differential right) Rules, 2001.

Continued:
3. Sweat Equity Shares: The concept of sweat
equity shares has been introduced to Companies
(Amendment) Act, 1999 by inserting a new
section 79 A in the Companies Act, 1956.
‘Sweat Equity Share’ means equity shares issued
by the company to its employees or directors at a
discount or for consideration other than cash, for
providing know how, making available rights in
the nature of intellectual property rights or value
creation or by whatever name called.

2. DEBENTURES
Section 2 (12) of the Companies Act, 1956
defines debentures as: “ Debenture includes
debenture stock, bonds and any other securities of
a company, whether constituting a charge on the
company’s or not”
In simple words, a debenture may be defined as
an instrument acknowledging a debt to a
company by some person or persons.

TYPES OF DEBENTURES
1. Redeemable and Perpetual or Irredeemable
Debentures.
2. Registered and Bearer Debentures
3. Secured and Unsecured Debentures
4. Convertible and Non-Convertible Debentures
5. Third Party Convertible Debentures
6. Fully Convertible Debentures with Interest
(optional).

PUBLIC DEPOSITS
Public deposits is a kind of borrowing made by
companies. It may be noted that public deposits
are always unsecured borrowings.
‘Deposit’ means any deposit of money with, and
includes any amount borrowed by a company
but shall not include such categories of amount
as may be prescribed in consultation with the
Reserve Bank of India.

BONDS
Bond is a negotiable certificate evidencing indebtedness. It is normally
secured. A debt is generally issued by a company, municipality or
Government. A bond investor lends money to the issuer and in
exchange, the issuer promises to repay the bond amount on a specified
date. The issuer usually pays the bond holder periodic payments over
the life of the bond.
TYPES OF BONDS
1. Zero Coupon Bond 2.Deep Discount Bond
3. Convertible Bond 4. Dual Convertible Bond
5. Stepped Coupon Bond 6. Floating Rate Bonds and Notes
7. Commodity Bonds 8. Capital Index Bonds
9.. Disaster Bonds 10. Easy Exit Bonds
11. Clip and Strip Bonds 12.Industrial Revenue Bonds
13. Carrot and Stick Bonds

Continued:
1. Zero Coupon Bond : This bond is issued at a discount
and repaid at a face value. No periodic interest is paid.
The difference between the issue price and redemption
price represents the return to holder. The buyer of these
bonds receives only one payment at the time of maturity
of the bond.
2. Deep Discount Bond: This bond is issued at a very high
discount on its face value and face value is paid at the
time of maturity. IDBI (Industrial Development Bank of
India) and SIDBI (Small Industries Development Bank
of India) had issued this instrument. IDBI had issued
deep discount bond of face value of Rs. 1,00,000 at a
price of Rs. 2,700, with a maturity period of 25 years.
Alternatively investor can withdraw from the investment
periodically after five years.

Continued:
3. Convertible Bond: A bond giving the investor the
option to convert the bond into equity at a fixed
conversion price.
4. Dual Convertible Bond: A dual convertible bond is
convertible into either equity share or
debentures/preference shares, at the option of the
investor.
5. Stepped Coupon Bond: Under stepped coupon
bonds, the interest rate is stepped up or down during
the tenure of the bond. The main advantage to the
investor is the attraction of higher rate of interest in
case of general rise in interest.

Continued
6. Floating Rate Bonds or Notes: In this case, interest is not
fixed and is allowed to float depending upon market
conditions. The instrument is used by the issuer to hedge
themselves against the volatility in interest rates.
7. Commodity Bonds: commodity bonds are bonds issued to
share the risk and profitability of future commodity prices
with the investors. For example, Petro bonds, Silver
Bonds, Gold Bonds, Coal bonds etc.
8. Capital Index Bonds: Capital Index bonds are inflation
protection securities. Such bonds, therefore provide good
hedge against inflation risk. The return to the investors in
these bonds is connected with the wholesale price index.
9. Disaster Bonds: These are issued by companies and
institutions to share the risk and expand the capital to link
investor returns with the size of insurer losses. The bigger
the losses, the smaller the return and vice-versa.

Continued
10. Easy Exit Bonds: Easy exit bonds are bonds
which provides liquidity and easy exit route to
the investor by way of redemption where investor
can get ready encashment in case of need to
withdraw before maturity.
11. Clip and Strip Bonds: In clip and strip bonds,
two separate coupon instrument are sold to the
investors. The streams of coupon payments are
stripped away and the principal amount of the
bond is sold as a deep discount bond. The gain to
investor is difference between the purchase price
and the par value.

Continued
12. Industrial Revenue Bonds: Industrial revenue
bonds are issued by financial institutions in
connection with the development of the industrial
facilities. These may become attractive if certain
income tax and wealth tax concessions are offered.
13. Carrot and Stick Bonds: Carrot and Stick bonds
are the variations of convertible debentures
redeemable at premium. The carrot (incentive) is the
lower than the normal conversion premium. The
stick is the issuer’s right to call the issue at a
specified premium if the price of equity shares is
traded above a specified percentage of the
conversion price.

MONEY MARKET
Money market refers to the market where borrowers
and lenders exchange short-term funds to solve their
liquidity needs.
The money market is a market which uses
overnight or short-term funds. It also uses financial
assets that are close substitute for money i.e., those
which can easily be converted into money with
minimum transaction cost and without a loss in
value. It refers to the segment of financial system
which enables the raising of short-term funds for
meeting the temporary shortages of cash and
obligations as well as temporary deployment of
excess funds for earnings returns.

Continued:
The money market operates as a whole sale market
and has a number of inter-related sub-markets such
as the call market, the bill market, the treasury bill
market, the commercial paper market, the certificate
of deposit market etc. The volume of transaction in
money market is very large and varied and skilled
professional operators are required to ensure
successful operations. Due to its flexibility, money
market trading is mostly done on telephone with
written confirmation from both borrowers and
lenders being sent immediately thereafter. The
transaction are required to be on ‘same day
settlement’ basis.

CHARACTERSTICS OF MONEY MARKET
• Short duration i.e., intra-day to one year.
• Large size of instruments.
• High liquidity due to existence of secondary
market.
• High safety because only persons of high
standing are selectively permitted by the RBI
to enter this market.
• Market determined interest rates.

OBJECTIVES OF MONEY MARKET
The broad objectives of money market are to
provide the following:
• A balancing mechanism for short-term
surpluses and deficiencies.
• A focal point of RBI intervention for
influencing liquidity in the economy.
• A reasonable access to the users of short-term
funds to meet their requirements at realistic /
reasonable price or cost.

CONSTITUENTS OF MONEY MARKET
Commercial banks, financial institutions, large
companies and the Reserve Bank of India are
the major constituents of Indian money
market. RBI as the residual source of funds in
the country plays a key role and holds a
strategic importance in the money market. RBI
is able to expand or contract the liquidity in
the market through different instruments as
Statutory Liquidity Ratio (SLR), Current
Liquidity Ratio (CLR), etc. Thus, RBI policy
controls the availability and the cost of credit
in the economy.

MONEY MARKET INSTRUMENTS
1. MONEY AT CALL AND MONEY AT SHORT
NOTICE: Money at call is outright money. Money at short
notice is for a maturity of or upto 14 days. The participants are
bank and All India Financial Institutions as permitted by RBI.
Corporate with minimum lendable resources of Rs. 20 crores
for transaction have also been permitted to lend in the market
through Discount and Finance House of India Limited (DFHI).
DFHI is an organization which was set up to develop an active
secondary market for money market instruments and integrate
various segments of the market in order to facilitate the
smoothening of short-term liquidity imbalances.
The market is over the telephone market. Non-bank participants
act as lenders only. Banks borrow for a variety of reasons to
maintain their Cash Reserve Ratio, to meet heavy withdrawals,
to adjust their maturity mismatch etc.

Continued:
2. Commercial Bills: Commercial bills are
basically negotiable instruments accepted by
buyers for goods or services obtained by them on
credit. Such bills, being bills of exchange, can be
kept up to due date and encashed by seller or
may be endorsed to a third party in payment of
dues to the latter. But the most common method
is that the seller who gets the accepted bills of
exchange discounts it with the banks or Financial
Institutions or Bill Discounting Houses and
collects money, less the interest charged for the
discounting.

Continued
3. Certificate of Deposits: Certificate of Deposits
are similar to the traditional term deposit but are
negotiable and can be traded in the secondary
market. A Certificate of deposit is a document of
title at a time of deposit.
Certificate of deposit are issued in multiple of
Rs. 1 lakh, subject to minimum investment of
Rs. 1 lakh per investor. The maturity of
certificate of deposit varies between 15 days and
1 year.

Continued
4. Commercial Paper: The Commercial Papers refers to the unsecured
promissory notes issued by credit worthy companies to borrow funds on
a short-term basis. In India, this instrument has been introduced to
enable high rate borrowers to have new avenues for short-term
borrowing and also providing an additional instrument to investors.
Commercial paper can be issued in multiples of Rs. 5 lakhs but the
amount to be invested should not be less than Rs. 5 lakhs face value.
The commercial papers are issued for maturities between 7 days and
365 days from the date of issue.
All India Financial Institutions and Corporates can raise the funds by
issue of commercial papers. However corporates can raise the funds
subject to the satisfaction of the following conditions:
1. It should have a tangible net-worth of at-least Rs. 4 crore.
2. It must have availed the working capital facility from some banks or
financial institutions.
3. Commercial papers proposed to be issued should have minimum
specified credit rating from any of the approved credit rating agency.

Continued
5. Term Money: The term money will be for 14 days to 90 days,
with highly elastic interest rates fixed by market farces on
demand and supply. The short-term money market in the
formal market (consisting of RBI. SBI, Banks, LIC, UTI, GIC)
relate to term money market, commercial bill market and inter-deposit
market.
6. Bills Rediscounting: Bill-financing seller drawing a bill of
exchange and the buyer accepting it, thereafter seller
discounting it with, say a bank, is an important device for fund
raising in advanced countries. The bills are liquidated on
maturities. Hundies (an indigenous form of bill of exchange)
have been popular in India, too. But there is a general
reluctance on the part of buyers to commit themselves to
payments on maturity. In addition, banks have a facility to
rediscount the bills with the RBI and other approved
institutions like LIC, GIC, UTI, IFCI, DFHI etc.

Continued
6. Bills Rediscounting: Bill-financing seller drawing
a bill of exchange and the buyer accepting it,
thereafter seller discounting it with, say a bank, is
an important device for fund raising in advanced
countries. The bills are liquidated on maturities.
Hundies (an indigenous form of bill of exchange)
have been popular in India, too. But there is a
general reluctance on the part of buyers to commit
themselves to payments on maturity. In addition,
banks have a facility to rediscount the bills with the
RBI and other approved institutions like LIC, GIC,
UTI, IFCI, DFHI etc.

Continued
7. Government Securities / Gilt – Edged Securities:
Government Securities (G-Sec) are sovereign securities
which are issued by the Reserve Bank of India on behalf
of the Government. The term ‘Government Securities’
includes Central Government Securities, State
Government Securities and Treasury Bills. The Central
Government borrows funds to finance it fiscal deficit.
Benefits of Investing in Government Securities
1. No tax deducted at source.
2. Additional Income Tax Benefit u/s 80L.
3. Zero default risk.
4. Highly liquid.
5. Qualifies for Statutory Liquidity Ratio (SLR) purpose.

Continued
8. Treasury Bills: Treasury bills are claims against
the government. They are negotiable securities
and since they can be rediscounted with the RBI.
They are highly liquid. As a result, RBI holds the
major portion of outstanding treasury bills. The
other feature of treasury bills are absence of
default risk, easy availability, assured yield, low
transaction cost, etc.
The treasury bills are issued are for 14 days, 91
days, 182 days and 364 days. Bids for Treasury
Bills are to be made for a minimum amount of
Rs. 25,000 only and in multiple therof.

Internal Source of Finance
An existing company earning a good amount of
profit has the option of not distributing dividend
to it its shareholders. The company realizing
profitable investment opportunities can plough
back its undistributed profit to pursue its growth
expansion strategies. This way company is
financing its investment from the internal
sources.
1.Depreciation as a source of internal financing.
2.Retained earnings as a source of internal
financing.

FOREIGN CAPITAL AS A SOURCE OF FINANCE
Foreign capital has become an important source of finance
for Indian industries in different ways. It refers to the funds
provided by foreign investors. These investors may be
foreign governments, institutions, banks, business
corporations or individual investors. Till 1990, quantum of
foreign capital investment was quite low. However, with
the introduction of economic reforms in 1991 and starting
of the process of liberalization and globalization,
government has encouraged the inflow of foreign
investments in India. Government has taken a number of
policy initiatives since then to attract foreign investment in
various sectors of economy. There have been different
ways in which the foreign investment is coming to the
India namely (i) Foreign direct investment (FDI) (ii)
Foreign portfolio investment (iii) Foreign commercial
borrowings.

FOREIGN DIRECT INVESTMENT
Foreign Direct Investment refers to the investment made by foreign
companies by setting up their branches, subsidiaries in another country.
FDI, helps the foreign companies by setting up their companies to invest
heavily in establishing their manufacturing branches, setting up
marketing facilities, service centers etc. The foreign companies not only
invest their funds but also bring scarce materials, professional know-how
and superior technologies. Under the FDI mechanism, foreign companies
are allowed to take back the profits earned on such investments, to their
respective home countries. Indian government after the post reforms era,
has been encouraging flow of FDI from Non-Resident Indians (NRIs)
and Overseas Corporate Bodies (OCB). Government has created an
institutional set-up like setting up of Foreign Investment Promotion
Board (FIBB) in 1996, Foreign Investment Implementations Authority
(FIIA), Secretariat for Industrial Assistance (SIA), Investment Promotion
and Infrastructure Development cell to encourage FDI in India in a big
way. Various tax concessions have been allowed to 100% Export
oriented units or units set up in various economic zones or backward
areas by overseas bodies. India has now become one of the favourite
countries for such investment by foreign corporate bodies.

FOREIGN PORTFOILIO INVESTMENT
Besides FDI, the Reserve Bank of India and the government
have allowed Indian companies with a proven track record
to raise long term finance in foreign currencies through the
issue of debt investments and ordinary shares from foreign
capital markets. In 1993, government allowed Indian
companies through a scheme known as “Issue of Foreign
Currency Convertible Bonds and ordinary shares (through
Depository Mechanism) scheme, 1993” to raise foreign
capital. The scheme since then has been amended from time
to time to encourage more and more foreign capital.
Through this scheme Indian companies are allowed to raise
long term loans or capital in foreign currency by way of
issuing (a) Foreign currency convertible bonds, and (b)
Ordinary shares through depository mechanism.

EURO ISSUES
After the announcement of the above mentioned scheme in 1993, the Indian companies have started
raising long term finance from foreign investors and NRIs by way of Euro Issues. Euro Issue refers to
the issue of a security listed in European Stock Exchanges, though the subscription from such issue
can come from any country in the world. Indian companies have raised foreign currency funds by
issuing various financial instruments like:
Foreign Currency Convertible Bonds (FCCBS): FCCBS are bonds issued according to the relevant
scheme and subscribed by a non-resident investors in foreign currency and convertible into depository
receipts or ordinary shares of the issuing company at a specified fixed price. Important features of
these bonds are as follows:
• These bonds are unsecure in nature.
• They carry a fixed rate of interest which is quite low from Indian standard.
• Have a definite maturity date.
• An option for conversion into fixed number of ordinary shares of issuing company at a specified
price.
• Denominated in a freely convertible foreign currency like U.S. dollars, Euros etc. Interest and
redemption value is also paid in foreign currency.
• Can be freely traded in listed foreign stock exchanges. For example, Euro convertible bonds can be
freely traded on European stock exchanges like London Stock Exchange, Luxemburg Stock
Exchange.
Many Indian companies like Essar Gujrat, Jindal Strips, Reliance Industries, ICICI, TISCO etc. have
raised foreign currency capital by issuing FCCBS.

Continued:
European Deposit Receipts (EDRs): An EDR is a
depository receipt/certificate issued by an overseas
depository bank outside India and issued to non-resident
investors represented by the ordinary shares of the issuing
company. Hence, like depository receipt, an EDR is also a
negotiable instrument representing fixed number of
ordinary shares of issuing company. EDR is tradable again
in European stock exchanges.
Global Depository Receipts (GDRs): A GDR is a
depository receipt which is listed on stock exchanges in
U.S.A or Europe or in both. A GDR represents a certain
number of ordinary shares of the issuing company. These
ordinary shares are denominated in Indian currency i.e.
rupee, though GDR is traded in dollars. Indian companies
issue these shares to an overseas depository who in term
issues these GDRs to the investors.

Continued:
American Depository Receipts (ADRs): ADRs are used when funds are to be raised
through retail investors in U.S.A. ADR is again a depository receipt denominated in U.S.
dollars issuing by a depository bank representing ordinary shares in non-U.S. companies.
Through ADRs, an American investor can invest his funds in the ordinary shares of a non-
U.S. company. This investment will be in the form of depository receipts offered for issue
by a foreign company either is U.S. A or in international market. Advantages of raising
long term finance through FCCBS, DRS (EDRs, GDRS. ADRs) are as follows:
• The cost of funds raised from foreign market is lower than the cost in the domestic
market.
• Through the issue of FCCBs, EDRs, GDRs, and ADRs Indian companies collect the issue
proceeds in the foreign currency. The foreign currency can be utilized for imports,
repayment of foreign currency loans, acquisitions in foreign country etc.
• The issue of depository receipts does not involve any foreign exchange risk to the issuing
company because shares are represented in rupees.
• There is no dilution of management control of the company as these issues do not give
any voting rights to the holders.
• Depository receipts give their holders an option to convert them into ordinary shares of
the company.
• The issue of these instruments in the international market enhances the reputation and
goodwill of the issuing company worldwide. This gives strategic advantages to the
company in dealing with bankers, customers, authorities etc.
• Because of the enhancement in the reputation of the company worldwide, its products find
easy acceptability internationally.

LEVERAGE ANALYSIS
A general dictionary meaning of the term ‘Leverage’ refers to “an
increased means of accomplishing some purpose”. Leverage allows us to
accomplish certain things which are otherwise not possible, viz; lifting of
heavy objects with the help of lever. This concept of leverage is valid in
business also. In financial management, the term ‘leverage’ is used to
describe the firm’s ability to use fixed cost assets or funds to increase the
return to its owners; i.e. equity shareholders. James Horne has defined
leverage as “the employment of an asset or sources of funds for which the
firm has to pay a fixed cost or fixed return”. The
fixed cost (also called fixed operating cost) and fixed return (called
financial cost) remains constant irrespective of the change in volume of
output or sales. Thus, the employment of an asset or source of funds for
which the firm has to pay a fixed cost or return has a considerable
influence on the earnings available for equity shareholders. The fixed
cost/return acts as the fulcrum and the leverage magnifies the influence. It
must, however, be noted that higher is the degree of leverage, higher is
the risk as well as return to the owners. It should also be remembered that
leverage can have negative or reversible effect also. It may be favourable
or unfavourable.

Continued:
There are basically two types of leverages, (i)
operating leverage, and (ii) financial leverage. The
leverage associated with the employment of fixed
cost assets is referred to as operating leverage, while
the leverage resulting from the use of fixed
cost/return source of funds is known as financial
leverage. In addition to these two kinds of leverages,
one could always compute 'composite leverage' to
determine the combined effect of the leverages. In the
present days, the term leverage is also used in relation
to working capital so as to measure the sensitivity of
return on investment to changes in the level of
current assets.

1. FINANCIAL LEVERAGE OR TRADING ON EQUITY
A firm needs funds so run and manage its activities.
The funds are first needed to set up an enterprise and
then to implement expansion, diversification and
other plans. A decision has to be made regarding the
composition of funds. The funds may be raised
through two sources : owners, called owners equity,
and outsiders, called creditors’ equity . When a firm
issues capital these are owners' funds, when it raises,
funds by raising long-term and short-term loans it is
called creditors’ or outsiders’ equity. Various means
used to raise funds represent the financial structure of
a firm. So the financial structure is represented by
the left side of the balance sheet i.e. liabilities side.

Continued:
Traditionally, the short-term finances are excluded from the
methods of financing capital budgeting decisions, so, only
long term sources are taken as a part of capital structure.
The term capital structure refers to the relationship between
various long-term forms of financing such as debentures,
preference share capital, equity share capital, etc. Financing
the firm’s assets is a very crucial problem in very business
and as a general rule there should be proper-mix of debt
and equity capital. The use of long-term fixed interest
bearing debt and preference share capital along with equity
share capital is called financial leverage or trading on
equity. The long-term fixed interest bearing debt is
employed by a firm to earn more from the use of these
resources than their cost so as to increase the return on
owner’s equity. It is true that the capital structure cannot
affect the total earnings of a firm but it can affect the share
of earnings for equity shareholders.

Continued:
The fixed cost funds are employed in such a way that the
earnings available for common stockholders (equity
shareholders) are increased. A fixed rate of interest is paid on
such long-term debts (debentures, etc.). The interest is a liability
and must be paid irrespective of revenue earnings. The
preference share capital also bears a fixed rate of dividend. But,
the dividend is paid only when the company has surplus profits.
The equity shareholders are entitled to residual income after
paying interest and preference dividend. The aim of financial
leverage is to increase the revenue available for equity
shareholders using the fixed cost funds. If the revenue earned by
employing fixed cost funds is more than their cost (interest
and/or preference dividend) then it will be to the benefit of
equity shareholders to use such a capital structure. A firm is
known to have a favorable leverage if its earnings are more
than what debt would cost. On the contrary, if it does not
earn as much as the debt costs then it will be known as an
unfavorable leverage.

Continued:
Every firms has to make its own decision
regarding the quantum of funds to be borrowed.
When the amount of debt is relatively large in
relation to capital stock, a company is said to
be trading on their equity. On the other hand if
the amount of debt is comparatively low in
relation to capital stock, the company is said to
be trading on thick equity.

IMPACT OF FINANCIAL LEVERAGE
The financial leverage is used to expand the shareholders
earnings. It is based on the assumption that the fixed
charges/costs funds can be obtained at a cost lower than
the firm’s rate of return on its assets. When the difference
between the earnings from assets financed by fixed cost
funds and the costs of these funds are distributed to the
equity stockholders, they will get additional earnings
without increasing their own investment. Consequently,
the earnings per share and the rate of return on equity share
capital will go up. On the contrary, if the firm acquires
fixed cost funds at a higher cost than the earnings from
those assets then the earnings per share and return on
equity capital will decrease. The impact of financial
leverage can be analyzed while looking at earnings per
share and return on equity capital.

Continued:
A firm is considering two financial plans with a
view to examining their impact on Earnings per
Share (EPS). The total funds required for
investment in assets are Rs. 5,00,000.
Plan 1 Plan 2
Debt (Interest @ 10% p.a.) 4,00,000 1,00,000
Equity shares (Rs. 10 each) 1,00,000 4,00,000
Total Funds required 5,00,000 5,00,000
The earnings before interest and tax are assumed
to Rs. 50,000, Rs. 75,000 and Rs. 1,25,000. the
rate of tax be taken 50%. Comment.

Comments
(1) Plan I is a leveraged financial plan because it has 80% debt financing
and has only 20% equity financing. Plan II is a conservative financial
plan or thick trading on equity where fixed cost funds are only 20% of
total funds and the rest is financed through equity capital.
(2) The EPS is increasing in Plan I with the increase in profits (EBIT).
In situation (1) the earnings per share is same in both the plans i.e., Re.
0.50. As the EBIT has increased from Rs. 50,000 to Rs. 75,000
(situation 2) the EPS in plan I is Rs. 1.75 while it is Rs. 0.81 in plan II.
EPS is Rs. 4.25 in Plan I and Rs. 1.438 in Plan II when EBIT increases
to Rs. 1,25,000
(3) It is a clear from the analysis that EPS is increasing with the increase
in profits in Plan I as compared to that of Plan II. This is possible with
the use of more fixed cost funds in plan I as compared to Plan II.
(4) The increase in EPS in Plan I is due to the financial leverage because
earnings before interest and tax are same in all the situation.

Illustration 2
G & H Ltd. Company has equity share capital of Rs. 5,00,000
divided into shares of Rs. 100 each. It wishes to raise further Rs.
3,00,000 for expansion cum modernization plans. The company
plans the following financing schemes.
(a) All common stock
(b)Rs. one lakh in common stock and Rs. two lakh in 10%
debentures.
(c)All debt at 10% p.a.
(d) Rs. one lakh in common stock and Rs. two lakhs in preference
capital with the rate of dividend at 8%.
The company's existing earnings before interest and tax (EBIT)
are Rs. 1,50,000. The corporate rate of tax is 50%. . .
You are required to determine the earnings per share (EPS) in
each plan and comment on the implications of financial
leverage.

Comments
In the four plans of fresh financing, Plan III is the most
leveraged of all. In this case additional financing is done by
raising loans @ 10% interest. Plan II has fresh capital stock of
Rs. one lakh while Rs. two lakhs are raised from loans. Plan IV
does not have fresh loans but preference capital has been raised
for Rs. two lakhs.
The earnings per share is highest in Plan III i.e. Rs. 12. This plan
depends upon fixed cost funds and thus has benefited the
common stockholders by increasing their share in profits. Plan II
is next best scheme where EPS is Rs. 10.83. In this case too Rs.
2 lakhs are raised through fixed cost funds. Even in Plan IV,
where preference capital of Rs. 2 lakhs is issued, it is better than
Plan I where common stock of Rs. 3 lakh is raised.
The analysis of this information shows that financial leverage
has helped in improving earnings per share for equity
shareholders. It helps to conclude that higher the ratio of debt to
equity the greater the return for equity stockholders.

Impact of Leverage on loss
If a firm suffers losses then the highly leveraged
scheme will increase the losses per share. This impact
is clear from the following illustration.
Illustration 3. Taking the figures in Illustration 2, a
concern suffers a loss of Rs. 70,000. Discuss the
impact of leverage under all the four plans.
Comments
The loss per share is highest in Plan III because it has
the higher debt-equity ratio while it is lowest in Plan I
because all additional funds are raised through equity
capital. The leverage will have an adverse impact on
earnings if the firm suffers losses because fixed cost
securities will enlarge the losses.

Continued:
Illustration 4. Calculate EPS (earning per share) of
SKM Ltd. and G & H Ltd. assuming (a) 20% before
tax rate of return on assets (b) 10% before tax rate of
return on assets based on the following data :
SKM Ltd. G & H Ltd.
Rs. Rs.
Assets 2,00,00,000 2,00,00,000
Debt (12%) ---- 1,00,00,000
Equity (Rs. 10 each) 2,00,00,000 1,00,00,000
Assume a 50% income tax in both cases. Also give
your comments on the financial leverage.

Comments
G & H Ltd. has used debt in its financing, as such
when the rate of return is 20% (higher than the
cost of debt), its EPS is higher than that of SKM
Ltd. which does not use any debt. But when the
financial leverage is unfavorable at 10% rate of
return (the cost of debt is higher), there is a
negative impact of leverage and the EPS has
decreased.

DEGREE OF FINANCIAL LEVERAGE
The degree of financial leverage measures the impact
of a change in operating income (EBIT) on change in
earning on equity capital or on equity share. Degree
of financial leverage DFL can be calculated as:
Percentage change in EPS
DFL = -------------------------------------
Percentage change in EBIT
or
EBIT
DFL= ---------------------
EBT (or, EBIT-I)

Illustration 5
XYZ Company has currently an equity share capital of Rs. 40
lakhs consisting of 40,000 equity shares of Rs. 100 each. The
management is planning to raise another Rs. 30 lakhs to finance
a major program of expansion through one of the four possible
financing plans. The options are :
(i) Entirely through equity shares.
(ii) Rs. 15 lakhs in equity shares of Rs. 100 each and the
balance in 8% Debentures.
(iii) Rs. 10 lakhs in equity shares of Rs. 100 each and the balance
through long-term borrowing at 9% interest p.a.
(iv) Rs. 15 lakhs in equity shares of Rs. 100 each and the balance
through preference shares with 5% dividend.
The company’s expected EBIT will be Rs. 15,00,000. Assuming
corporate rate of tax 50%, you are required to determine the EPS
and comment on the financial leverage that will be authorized
under each of the above scheme of financing.

SIGNIFICANCE OF FINANCIAL LEVERAGE
Financial leverage is employed to plan the ratio between debt and
equity so that earning per share is improved. Following is the
significance of financial leverage :
(1) Planning of Capital Structure: The capital structure is
concerned with the raising of long-term funds, both from
shareholders and long-term creditors. A financial manager has to
decide about the ratio between fixed cost funds and equity share
capital.
(2)Profit Planning: The earning per share is affected by the degree of
financial leverage. If the profitability of the concern is increasing
then fixed cost funds will help in increasing the availability of
profits for equity stockholders. Therefore, financial leverage is
important for profit planning. The level of sales and resultant
profitability is helpful in profit planning. An important tool of
profit planning is break-even analysis. The concept of break-even
analysis is used to understand financial leverage. So, financial
leverage is very important for profit planning.

LIMITATIONS OF FINANCIAL
LEVERAGE/TRADING ON EQUITY
The financial leverage or trading on equity suffers from the following limitations :
1. Double-edged weapon: Trading on equity is a double-edged weapon. It can be
successfully employed to increase the earnings of the shareholders only when the rate of
earnings of the company is more than the fixed rate of interest/dividend on
debentures/preference shares. On the other hand, if it does not earn as much as the cost of
interest bearing securities, then it will work adversely and hence cannot be employed.
2. Beneficial only to companies having stability of earnings: Trading on equity is
beneficial only to the companies having stable and regular earnings. This is so because
interest on debentures is a recurring burden on the company and a company having
irregular income cannot pay interest on its borrowings during lean years.
3. Increases risk and rate of interest: Another limitation of trading on equity is on account
of the fact that every rupee of extra debt increases the risk and hence the rate of interest
on subsequent loans also goes on increasing. It becomes difficult for the company to
obtain further debts without offering extra securities and higher rates of interest reducing
their earnings.
4. Restrictions from financial institutions: The financial institutions also impose restrictions
on companies which resort to excessive trading on equity because of the risk factor and to
maintain a balance in the capital structure of the company.

2. OPERATING LEVERAGE
Operating leverage arises due to the presence of fixed
operating expenses in the firm’s income flow. A company’s
operating costs can be categorized into three main sections:
• Fixed Costs;
• Variable Costs;
• Semi-variable Costs.
The operating leverage is the firm’s ability to use fixed
operating costs to increase the effects of changes in sales
on its earnings before interest and taxes. Operating leverage
occurs any time a firm has fixed costs. The percentage
change in profits with a change in volume of sales is more
than the percentage change in volume.The degree of
leverage will be calculated as :

Continued:
Contribution
Operating Leverage = ----------------------
Operating Profit (EBIT)
Contribution = Sales – Variable Cost
or
= Fixed Cost + Profit
Operating Profit = Sales – Variable Cost – Fixed Cost
or
= Contribution – Fixed Cost
Contribution
Profit Volume (P/V) Ratio = -----------------
Sales
Fixed Cost
Break Even Point = ----------------
P/V Ratio
% Change in Profits
Degree of Operating Leverage = ---------------------------
% Change in Sales

Continued:
When production and sales move above the break
even point, the firm enters highly profitable range of
activities. At break even point the fixed costs are
fully recovered, any increase in sales beyond this
level will increase profits equal to contribution. A
firm operating with a high degree of leverage and
above break even point earns good amount of profits.
If a firm does not have fixed costs then there will be
no operating leverage. The percentage change in sales
will be equal to the percentage change in profits.
When fixed costs are there, the percentage change in
profits will be more than percentage change in sales
volume.

Continued:
Illustration 6: Following is the cost information of
Kanchan Enterprises:
Fixed Cost = Rs. 50,000
Variable Cost = 70% of Sales
Sales = Rs. 2,00,000 in the previous year and
Rs. 2,50,000 in the current year.
Find out percentage change in Sales and
Operating profits when:
(i)Fixed costs are not there (no leverage).
(ii)Fixed costs are there (leverage situation).

Solution
(i) P.Y. C.Y. %
Change
Sales 2,00,000 2,50,000 25
Less: Variable Cost 1,40,000 1,75,000 25
Profit from operations 60,000 75,000 25
(ii)
Sales 2,00,000 2,50,000 25
Less: Var. cost 1,40,000 1,75,000 25
Contribution 60,000 75,000 25
Less: Fixed Cost 50,000 50,000
Profit form operations 10,000 25,000 150

Comments:
1. In situation (i) where there are no fixed costs or
absence of leverage the percentage change in
sales and percentage change in operating profit is
the same as 25%.
2. In situation (ii) where there are fixed costs, the
leverage being occurring, the percentage change
in profits (150%) is much more than the
percentage change in sales (25%).
3. The fixed cost element has helped in increasing
the percentage increase in profits.

Illustration 7
A firm sells a product for Rs. 10 per unit, its
variable costs are Rs. 5 per unit and fixed costs
amount to Rs. 5000 p.a. Show the various levels
of operating profit that result from sales of 1000
units, 2000 units and 3000 units.

3. COMPOSITE LEVERAGE
Both financial leverage and operating leverage
increase the revenue of firm. Operating leverage
affects the income which is the result of
production. On the other hand, the financial
leverage is the result of financial decisions. The
composite leverage focuses attention on the entire
income of the concern.
Composite Leverage = Operating Leverage x
Financial Leverage

Illustration 8
A company has sales of Rs. 5,00,000, variable
cost of Rs. 3,00,000, fixed costs of Rs.
1,00,000 and long term loans of Rs. 4,00,000
at 10% rate of interest. Calculate the
composite leverage.

CAPITAL BUDGETING
The most important function of corporate finance
is not only the procurement of external funds for
business but also to make efficient and wise
allocation of these funds. The allocation of funds
means the investment of funds in various assets
and other activities. It is also known as
‘Investment Decision’, because a choice is to be
made regarding the assets in which funds will be
invested. These funds which can be acquired fall
into two broad categories:
1.short-term or Current Assets;
2.Long-term or Fixed Assets.

MEANING OF CAPITAL BUDGETING
Capital budgeting is the technique of making decisions for
investment in long-term assets. It is a process of deciding
whether or not to invest the funds in a particular asset, the
benefit of which will be available over a period of time
longer than one year.
“Capital budgeting consists in planning the deployment of
available capital for the purpose of maximizing the long-term
profitability of the firm”. R.M.Lynch
“Capital budgeting involves the planning of expenditures
for assets, the returns from which will be realized in
future time periods”. Milton H. Spencer

FEATURES OF CAPITAL BUDGETING DECISIONS
1. Funds are invested in long-term assets.
2. Funds are invested in present times in
anticipation of future profits.
3. The future profit will occur to the firm over a
series of years.
4. Capital budgeting decisions involve a high
degree of risk because future benefits are not
certain.

IMPORTANCE OF CAPITAL BUDGETING
1. Such decisions affect the profitability of the
firm.
2. Long term periods.
3. Irreversible decisions.
4. Involvement of large amount of funds.
5. Risk
6. Most difficult to make.

KINDS OF CAPITAL BUDGETING DECISIONS
1. Accept – Reject Decisions;
2. Mutually Competitive Decisions;
3. Priority Order Decisions.

TECHNIQUES/METHODS/CRITERION FOR
CAPITAL BUDGETING DECISIONS
1. Accounting Profit Criteria – Average Rate of
Return Method
2. Cash Flow Criteria
(a) Pay Back Method
(b)Method based on Discounted Cash Flows:
(i) Net Present Value Method (NPV)
(ii) Profitability Index Method (PI)
(iii) Internal Rate of Return Method (IRR)

Average/Accounting Rate of Return
Average Annual Profits after Taxes
ARR = ---------------------------------------------
Average Investment
Total Profit after
Tax of All
years
Av. Annual Profits after Taxes = ---------------------
No. of Years
Original Investment + Salvage
Value
Av. Investment =
----------------------------------------

ILLUSTRATION 1
A project having a life of 5 years will cost Rs.
4,00,000. its stream of income before
depreciation and taxes is expected to be Rs.
1,00,000; Rs. 1,20,000; Rs. 1,60,000; Rs.
1,70,000 and Rs. 2,00,000 during the life of
the project. Depreciation is charged on straight
line basis and the rate of tax applicable to the
firm is 40 per cent. Calculate ARR.

ILLUSTRATION 2
Geet Ltd., is considering the purchase of a machine. Two
machine are available , E and F. The cost of each machine is
Rs. 60,000 each. Each machine has an expected life of 5
years. Net profit before tax during the expected life of
machine are given below:
Year E F
1 15,000 5,000
2 20,000 15,000
3 25,000 20,000
4 15,000 30,000
5 20,000 10.000
Total 85,000 90,000
Following the method of return on investment, ascertain
which of the following alternatives will be more profitable.
The average rate of tax may be taken at 50%.

ILLUSTRATION 3
Determine the average rate of return from the following date of
Machines A and B:
Machine A Machine B
Rs. Rs.
Cost 56,125 56,125
Annual estimated
Earnings after dep.
And tax 1st Year 3,375 11,375
2nd year 5,375 9,375
3rd year 7,375 7,375
4th year 9,375 5,375
5th year 11,375 3,375
Estimated life of machines 5 years 5 years
Estimated Salvage Value 3,000 3000
Average Tax Rate 50% 50%

ADVANTAGES OF ARR
1. Simple;
2. Entire life time of the project is considered.
Disadvantages:
1. It uses accounting income rather than cash flows.
2. Time value of money is not considered.
3. Difficult to fix a pre-determined rate.
4. Size of investment not taken into consideration.

Pay Back Method
This method calculates the number of years required to
payback the original investment in project. In other
words, payback period is the period which is required to
recover the original investment in a project.
Actual payback period calculated according to this method
is compared with the pre-determined payback period
fixed by the management in terms of maximum period
during the original investment must be recouped. If the
actual payback period is less than the pre determined
payback period, the project would be accepted; if not, it
would be rejected. Alternatively when many projects are
under consideration, they may be ranked according to the
length of the payback period. Obviously, projects having
the shorter payback period will be selected.

Methods of calculating Payback Period
1st Method
This method is adopted when the project is generates
equal cash inflow each year. In such case, the initial cost
of the investment is divided by the constant annual cash
flow:
Investment
PB = ----------------------------------------
Constant Annual Cash Flow
2nd Method
This method is adopted when the project generates unequal
cash inflow each year. . Under this method, payback
period is calculated by adding up the cash inflows till the
time they become equal to the original investment.

ILLUSTRATION 4
A project requires initial outlay of Rs. 80000 and
is expected to generate cash flow after tax but
before depreciation of Rs. 8000; Rs. 20000; Rs.
14000; Rs. 30000; Rs. 32000 and Rs. 45000
during its 6 years life. Calculate the payback
period.

ILLUSTRATION 5
ABC Ltd. Is considering the purchase of a machine. Two machines A and B
are available. Machine A will cost Rs. 60000 and has a life of 5 years.
Machine B will cost Rs. 98000 and has a life of 7 years. There will be no
salvage value from any machine.
The estimated cash flow before depreciation and tax from the two
machines are as follow:
Year Machine A Machine B
Rs. Rs.
1 30000 42800
2 24000 35600
3 22000 28400
4 20000 21200
5 14000 18000
6 ---- 17000
7 ----- 16400
The company uses straight line depreciation method and tax rate is 50 %.
Which machine should be selected on the basis of payback period.

Advantages of Payback Method
1. Simple
2. Appropriate in case of uncertain conditions
3. Importance to short-term earning
4. Superior to ARR method
Disadvantages
1. It ignores the cash flow after the pay back
method.
2. It ignores time value of money
3. It ignores the profitability of the project.

Net Present Value Method
Net Present Value (NPV) method is one of the Discounted
Cash Flow technique. Under this method present value of
cash outflows and cash inflows is calculated and the
present value of cash outflow is subtracted from the
present value of cash inflows. This difference is called the
Net Present Value (NPV)
Thus, NPV = PV of Inflow – PV of Outflow
In other words, NPV =Present value of cash inflows of no of
years – present value of cash outflow.
If PVF is not given:
1 1
NPV = Cash inflow x --------- + Cash inflow of 2nd year x ----------
(1 + r) (1 +r)2

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