1 2
Capital Budgeting Decisions FEATURES WHICH DISTINGUISH CAPITAL
A capital budgeting decision is also called a capital
expenditure decision. A capital expenditure is an outlay of cash
or commitment of firm’s funds for a project or long term asset
that is expected to produce a cash inflow over a period of time
exceeding one year.. For example, a machinery worth Rs. 1
crore purchased today might help make cash flows of
Rs.1,00,000 , Rs, 2,00,000 , Rs. 3,00,000 etc., in the first,
second, third year and so on respectively. . By this decision, a
firm decides to invest its current funds most efficiently in the
long term assets and the benefit from these assets are expected
to flow over a series of years.
The firm’s investment decisions generally include
expansion, acquisition, modernization, replacement of long
term assets besides it also includes divestment (sale of a
division or business), undertaking a huge advertisement
campaign, research and development etc having long term
effects or any other project that requires a capital expenditure
and generates a future cash flow.
Because capital expenditures can be very large and have
a significant impact on the financial performance of the firm,
great importance is placed on project selection. This process is
called capital budgeting.
Definitions:
CHARLES T. HORNGREN," Capital budgeting is
long-term planning for making and financing proposed
capital outlays".
G.C PHILIPPATOS," Capital budgeting is concerned
with the allocation of the firm's scarce financial resources
among the available market opportunities".
BUDGETING DECISIONS FROM ORDINARY DAY
TO DAY BUSINESS :-
Importance of Investment decisions
1. Calculation is based on cash flow as it is the cash in hand
that is important for immediate investment and not the
profit which may not be entirely in cash (Cash flow =
Accounting profit before depreciation, interest and tax –
depreciation – interest – tax + depreciation)
2. It involves the exchange of current funds for the benefits to
be achieved in future.
3. The future benefits are expected to be realized over a
series of years.
4. A significant period of time (more than one year) elapses
between the investment outlay and the receipt of the
benefits..
5. They influence the firm’s growth in the long run as the
effects of investment decision extend into the future.
6. They affect the risk of the firm as the investment is made
now but the benefits occur in future and the future is
uncertain.
7. The funds are invested in non-flexible and long-term
activities
8. They involve commitment of large amount of funds and
therefore requires a careful planning to the taken
beforehand.
9. It involves a long term and significant effect on the
profitability of the concern
10. They are irreversible, or reversible at substantial loss.
Long term assets such as machinery once acquired are not
easy to resell (dispose off) them unless otherwise at heavy
loses.
 - 2 -Page 2 of 29
11. They are among the firm’s most difficult decisions. They
are based on cash flows occurring in future which are very
difficult to predict correctly.
NEED AND IMPORTANCE OF
CAPITAL BUDGETING:-
Capital budgeting decisions are vital to any organisation.
The importance of capital budgeting may be well
understood from the fact that an unsound investment
decisions may prove to be fatal to the very existence of
concern. The following are:-
Growth:- The effects of investment decisions extend into
the future and have to be endured for a longer period than
wrong decisions can prove disastrous for the continued
survival of the firm; unwanted or unprofitable expansion
of assets will result in heavy operating cost to the firm.
On the other hand, inadequate investment in asset would
make it difficult for the firm to compete successfully and
maintain its market share.
Risk:- A long term commitment of funds may also
change the risk complexity of the firm. If the adoption of
an investment increases average gain but causes frequent
fluctuations in its earnings, the firm will become more
risky. Thus, investment decisions shape the basic
character of a firm.
Funding:-Investment decisions generally involve large
amount of funds which make it imperative for the firm to
plan its investment programmes very carefully and make
an advance arrangement for procuring finances internally
or externally.
Irreversibility:- Most investment decisions are
irreversible. It is difficult to find a market for such capital
items once they have been acquired. The firm will incur
heavy losses if such assets are scrapped.
Complexity:- Investment decisions are among the firm's
most difficult decisions. They are an assessment of future
events which are difficult to predict. It is really a complex
problem to correctly estimate the future cash flow of an
investment. The uncertainty in cash flow is caused by
economic, political, social, and technological factors.
TYPES OF INVESTMENT
DECISIONS:-
There are many ways to classify the investment. One
classification is as follows:-
a.)Expansion of existing business.
b.)Expansion of new business.
c.)Replacement and modernisation.
Expansion and Diversification:-A company may add
capacity to its existing product lines to expand existing
operations. For example:- a fertilizer company may
increase its plant capacity to manufacture more urea.
Expansion of a new business requires investment in new
product and a new kind of production activity within the
firm is called diversification.
Replacement and modernization:- Assets become
outdated and obsolete with technological changes. The
firm must decide to replace those assets with new assets
 - 3 -Page 3 of 29
that operate more economically. If a cement company
changes from semi-automatically drying equipment to
fully automatic drying equipment, it is an example of
modernization and replacement.
Another way to classify investments
is as follows:-
1.)Mutually Exclusive investments.
2.)Independent investments.
3.)Contingent investments.
MUTUALLY EXCLUSIVE INVESTMENTS:- It
serves the same purpose and competes with each other. If
one investment is undertaken, others will have to be
excluded. A company may for example-either use a more
labour-intensive, semi-automatic machine or employ a
more capital-intensive.
INDEPENDENT INVESTMENTS:-It serves different
purposes and do not compete with each other. For
example-a heavy engineering company may be
considering expansion of its plant capacity to
manufacture additional excavators and addition of new
production facilities to manufacture new product-light
commercial vehicles. Depending on their profitability and
availability of fund, the company can undertake both
investments.
CONTINGENT INVESTMENTS:-These are dependent
projects; the choice of one investment necessitates under
taking one or more other investments. For example ,if a
company decides to build a factory in a remote, backward
area, it may have to invest in house, roads, hospitals,
schools, etc. for employees to attract the work force.
INVESTMENT EVALUATION
CRITERIA:-
Three steps are involved in the evaluation criteria of an
investment:
a.)Estimation of cash flows.
b.)Estimation of the required rate of return.
c.)Application of a decision rule for making the choice
for
I) accepting or
II) rejecting
Of investment
projects
There is a wide array of criteria for selecting projects.
Some shareholders may want the firm to select projects
that will show immediate cash inflow, others may want
long-term growth with little importance on short-term
performance. Ultimately, the goal of the firm is to
maximize present shareholder value.
A number of capital budgeting techniques are in use in
practice. They are grouped in the following two
categories:-
1.)Discounted Cash Flow (DCF) criteria.
a.)Net Present Value.(NPV)
b.)Internal Rate of Return(IRR)
c.)Profitability Index (PI)
d.)Discounted Payback Period
 - 4 -Page 4 of 29
2.)Non-Discounted Cash Flow Criteria
a.)Payback-Period(PB)
b.)Accounting Rate of Return(ARR)
DISCOUNTED CASH FLOW(DCF):-Sound decision
making requires that the cash flows which a firm is
expected to give up over period should be logically
comparable.In fact, the absolute cash flows which differ
in timing, and risk are not directly comparable. Cash
flows become logically comparable when they are
appropriately adjusted for their differences in timing and
risk.
The recognition of the time value of money and risk is
extremely vital in financial decision making. If the timing
and risk of cash flow is not considered, the firm may
make decisions which may allow it to miss its objective
of maximizing the owner's welfare.
The welfare of owners would be maximized when net
wealth or net present value is created from making
financial decisions.
Time preference of money:-If an individual behaves
rationally. He would not value the opportunity to receive
a specific amount of money now equally with opportunity
to have the same amount at some future date. Thus an
individual's preference for possession of a given amount
of cash now, rather than the same amount at some future
time, is called 'time preference money'.
Time preference for money and valuation of cash flows
The time preference for money concept puts more value to the
cash flow occurring now than later. To measure profitability
arising a project, its cash in flows occurring at different time
interval need to be added up against cash outflows to
determine net gain. Since the cash flows have different
preferences attached to them, all are brought to the current
preference level. This process of bringing all future cash flows
to the current level is known as discounting of cash flows.
Three reasons may be attributed to the individual's time
preference for money:
a.)Risk
b.)Preference for consumption
c.)Investment opportunities
Finding Present value by discounting:-It is the method
by which future cash flows are translated into their
present value. The process of determining present value
of a future payment(or receipts) or a series of future
payments(or receipts) is called discounting. The
compound interest rate used for discounting cash flows is
called the discount rate. It is also known as
OPPORTUNITY COST OF CAPITAL as it is
minimum required rate of return expected from a project
otherwise investment will flow into the next best
alternative left for selecting this very alternative.
I. Discounted cash flow criteria takes into consideration
the time value of money ie., a rupee earned today is
worth more than the same rupee earned borrow. Further,
the decision is based on cash flows accuring during the
entire life of the project.
(a) Net Present Value method (NPV method)
It is the modern method of evaluating investment
proposals.
Investment involve cash flows. Profitability of an
investment project is determined by evaluating its cash
 - 5 -Page 5 of 29

flows. The NPV method is a process of calculating the more projects can be added
present value of project’s cash flows, using the
It leads to wealth
opportunity cost of capital as the discount rate, and
maximization of shareholders
finding out the net present value by subtracting initial
truly
investment from present value of cash flows.
It takes into account the
earning over the entire life
of project and true
profitability evaluated
Illustration: Cash flows of a certain project are as follows
where C1, C2, C3 ----- Cn represent cash flows occuring in year 1,
given that no project would to accepted if the return is less
2, 3 ---- n respectively than 10%.
K = opportunity cost of capital assumed to be known Mears Outflows(Rs) Inflows(Rs) (At 10%
(given) and contant. discount)
Co = initial investment Present value
n = expected life of investment. factor
Acceptance rule : 0 1,50,000 - 1
- Accept if NPV>O (i.e., NPV is positive) ; It is going to 1 30,000 20,000 .909
increase the wealth. 2 30,000 .826
- Reject is NPV<O (i.e., NPV is negative) it is going to 3 60,000 .751
decrease wealth. 4 80,000 .683
- Project may be accepted if NPV = O : zero profits. 5 30,000 .620

Merits Demerits The savage value (scrap value) at the end of 5th year is Rs
Considers all cash flows Requires estimates of cash 40,000.
flows which is a tedious task Calculation of Present value of cash flows
Year PV Outflows PV of Inflows Present
True measure of profitability Requires computation of
factor cash (c) Value of
(as it considers all cash flows) opportunity cost of capital 10% inflows cash
which is difficult to calculate inflows
in practice. (a) (b) (axb) (axc)
Based on the concept of time The result of NPV changes 0 1 1,50,000 1,50,000 -
value of money with change in discounted 1 .909 30,000 27,270 20,000 18,180
rates 2 .826 30,000 24,780
3 .751 60,000 45,060
It also allows value addivity
4 .683 80,000 54,640
principle i.e NPV’s of two or 5 .620 30,000 18,600
 - 6 -Page 6 of 29

5 .620 40,000 24,800

Total 1,77,270 Total PV 1,86,060
PVP of Cash
Cash inflows It involves two methods:-
outflow
Ist method:-When net cashflow are equal over the life of
(Salvage value occurs in 5th year hence the Present value of 5th
year is used) the asset than two steps have to be followed:-
NPV = Rs. 186,060 – Rs. 1,77,270 a.)Find present value factor where
= Rs 8790. PVF= initial outflow /annual cash inflow.
Since NPV is more than zero hence the investment should be b.)Consult present value annuity table at the
accepted as it will add Rs 8790 to Shareholders wealth (Profits row is equal to life of investment .
accruing to Shareholders) c) The Vertical column will show the desired
IRR.
b) Internal Rate of Return (IRR) method:
It is also known as Time-adjusted rate of return, IInd method:-Where annual cashflows are unequal over
discounted cash flow, discounted rate of return, the life of the asset. IRR is found by the trial and error
Yield method, and Trial and error yield method. method.

It is discounted at a suitable rate of hit and trial Required NPV XXXXXX

method , which equals the NPV so calculated to the C1
amount of investment. NPV at Lower rate XXXXXX C2
The IRR is that discount rate at which project’s NPV is
zero. In other words, It is the discount rate at which NPV at higher rate XXXXXX
present value of an investments cash inflows is equal to
the present value of its cash outflows. IRR = Lower rate +(higher – lower rate)C1/C2

The method is at variously known as yield on investment,

marginal efficiency to capital, rate of return over cost, time
adjusted rate of internal return and so on.
Merits Demerits
Considers all cash flows Requires estimates of cash flows
; where r= rate of return on the investment
True measure of profitability Does not hold the value
Acceptance rule: additivity principle (i.e. IRR = of
> Accept if IRR > k two or more projects do not add)
> Reject if IRR < k Based on concept of time value At times fails to indicate correct
> Project may be accepted if IRR = k ; k=opportunity cost of of money choice between mutually
capital exclusive projects.
 - 7 -Page 7 of 29

Consistent with wealth At times yields multiple rates evaluate,PI method is most suitable. The other merits and
maximization principle demerits are same as NPV method.
Difficult to compute Non Discounted Cash flow Criteria
It may be noted that in IRR method ‘r’ has to calculated by
trial and error method taking help of extrapolation method. These are traditional method of investment evaluation in
which the timing of cash flows is ignored (that some cash
flows occur earlier some cash flows occur later, i.e. it ignores
c)Profitability Index: (Benefit cost ratio) time value of money. Though these methods do not help in
The ratio of the present value of the cash flows to the correctly estimating shareholders wealth creation yet they or
initial outlay is profitability index. popular with business executives
(a) Pay back period method : Pay back is the number of
years required to recover the initial cash outlay of an
investment project. Thus it measures the period of time for
In this method, k is assumed be known (given) It is also the original cost of a project to be recovered from the
manipulation of NPV method in which instead of subtracting additional earnings of a project itself.
Co from cash inflows, the cash inflows are divided by Cash
Outflows. In case of evaluation of a single project, it is adopted if it
pays back for itself within a period specified by the
management and if the project does not pay back itself
Acceptance rule:- within the period then it is rejected.
Accept if PI > 1.0
Reject if PI < 1.0 In case of multiple projects: that project is accepted that
Project may be accepted if PI = 1.0 has the lowest payback period if it is also less than
Merits Demerits
• Considers all cash flows • Requires estimates of the
standard payback period.
• Recognises the time value of cash flows which is a
money tedious task Formula:-PAY BACK PERIOD (PB) =
• It is a relative measure of • At times, fails to indicate cash outlay or original cost of asset
profitability (as it relates choice between mutually annual cash inflows
cash inflows to cash exclusive projects.
outflows) Acceptance rule:
• Consistent with the wealth Accept if PB<standard payback period of an investment.
maximization principle Reject if PB>Std payback
Project may be accepted if PB=Std payback period
This method is a slight modification of NPV method. The
NPV has one major drawback, it is not easy to rank
projects when the costs are differing significantly. To
 - 8 -Page 8 of 29

Intial cash outlay Rs 50,000

Annual cash Rs 10,000, Rs 20,000, Rs 15,000, Rs
inflow 10,000 Rs 10,000 respectively in
Merits Demerits 1,2,3,4,5th year.
• Easy to understand and • Ignores the time value of Payback Period = Period required to recover Rs 50,000
10,000 – 1st Year
compute and inexpensive money
20,000 – 2nd Year
to use • Ignores cash flows 30,000
• Stresses on liquidity occurring after the 15,000 – 3rd Year
• Easy and crude way to payback period. 45,000
cope with risk • Not a measure of 5,000 to recover from 4th year to make .
Rs 10,000
• Uses cash flows profitability
50,000
information (not the • No objective way to
accounting profit for determining standard Payback Period = 3 complete years + 5000
decision making as it is payback 10,000
the cash in hand that is • No relation with the 3½ years
important not the profit wealth maximization
which may not be entirely principle. b) Discounted Payback: The number of years required to
in cash) recover the cash outlay on the present value basis is the
• It does not take into
• It reduces the loss discounted payable period. It has our advantage over
consideration the cost
through obsolescence payback period method that it recognizes time value of
of capital. money by using discounted cash flows. But it has all the
and is more suited to
• It is usually a subjective demerits of payback period.
the developing
decision ba) Post Payback profitability method: One of the serious
countries like India.
limitations of paybacks period method is that it does not
• Due to its short term take into account cash inflows earned after pay back
approach, it is period and hence the true profitability of the project
particularly suited to a cannot be assessed.
firm which has shortage
Post payback profitability index helps to select two or
of cash
more projects having same payback period (mutually
exclusive projects)
Illustration Even cash inflows
1 Initial cash outlay Rs 50,000 Post Payback Profits x 100
Post payback profitability index =
Life of an asset 5 years Investment
Estimated Annual Rs 12,500
cash flow Accept the project whose post payback profitability
Payback Period = Investment = 50,000 = 4 yrs index is more in case of mutually exclusive projects
Annual Cash flow 12500 having same payback period.
& Uneven cash inflows
 - 9 -Page 9 of 29

c) Accounting rate of return: This method takes Total profits (after depreciation before tax) * 100
into account the earnings expected from the net investments
investment over their whole life. The accounting
concept of profit is used rather than cash inflows. c.)Return on average investment=
The project with higher rate of return is selected as
compared to the one with lower rate of return. Total profits * 100
average investment

Average Profit Average investment=net investment/2

ARR =
Average Investment
d.)Average Return on Average investment method:-
Acceptance rate: (Average annual profits/average net investment)*100.
Accept if ARR>minimum rate (decided by management)
Reject if ARR< minimum rate
May Accept if ARR = minimum rate

Merits Demerits Discounting of Cash flows:

• Uses accounting data with • Ignore the time value of The time preference for money can be shown quantitatively
which executives are money with the help of compound rate of interest.
families • Does not use cash flows
• Easy to understand and • Hence, Simply.
No objective way to Future Value = Principal + Interest Taking Principal
calculate determine minimum (P) (J) as 100 and
• Give more weightage to acceptable rate of return = 100+.10 x 100 interest rate 10%
future receipts = 100 (1+.10) for one year the
= 100(1.10) = Rs 110 future value will
Conclusion: NPV is most superior investment criterion as it is be
always Juggling the above figures
110 = 100 (1.10)
The return on investment method can be used in several fv = P (1+I)
ways:- V =P
a) Average rate of return:- 1+I
Average annual profits *100 Principal is alternatively called as present value while dealing
net investment with cash flows and ‘I’ as required rate of interest.

Required rate of Interest = Risk Free rate+ risk prepium

b.)Return per unit of investment method:-
 - 10 -Page 10 of 29

This, required rate is the opportunity cost if capital. Which is 1000 1500 1100 400
PV = + + +
called so because, the investor would invest money in (1+.08)1 (1+.08)2 (1+.08)3 (1+.08)4
securities of equivalent risk.
Compounding for
for 1 year
Risk Premium is the return over and above the risk free rate for 2 years
which the investor should receive in order to make him forego for 3 years
his principal now. for 4 years
Risk free rate :- Compensates him for foregoing the
amount now in anticipation of future Financial Management, Risk and Return and value of the firm
Figure (1)
Risk premium :- Compensates him for undertaking risk of
uncertainty of income.

Thus, in the above example, the investor would accept Rs 110

after a year and would readily give Rs 100 now for it.
Thus, we can say that he is indifferent between Rs 100 now
and Rs 110 after a year. This means – Rs 110 after 1 year is
equal to Rs 100 now

If FV = Rs 110
Then, PV = Rs 100
If both are equal 110 = (1+1.10)
110 = 100
1.10
FV = PV
1+I
(hence, the equation earlier gets
formed)

Similarly P.V can be found of Multiple cash flows occurring at

different thre Intervals taking the discounting rate into
consideration.
Consider an investor with an investment opportunity of
receiving Rs 1000, Rs 1500, Rs 1100, Rs 400 respectively at
the end of one through four year. The Present value of this cash
inflows stream taking required interest rate at 81. is:-
Operating & Financial Leverage
When a lever is used, a force applied at one point is
transformed into larger force or motion at some other point. In
business context. However, leverage refers to the use of fixed costs in
an attempt to increase (lever up) profitability.
Leverage appears in two forms, in business, as operating
leverage and financial leverage.
 - 11 -Page 11 of 29

Operating Leverage (EBITt – EBITt-1)

400% 100%
In the short run, the costs are of two types, namely, fixed EBIT t-1
operating cost and variable operating cost. Fixed operating cost do
not vary as volume changes. It includes depreciation of building, From the table, it is clear that 50% change in sales lead to 400%
equipment, insurance etc. variable operating cost vary directly with change in profits (EBIT) in case of firm A which employed 78%
the level of output. It includes raw material, direct labour costs etc. fixed operating costs us compared to 100% change in profits in firms
Fixed operating costs are incurred with the hope that sales B which employed 22% fixed operating costs.
volume will produce revenues more than fixed and variable costs. Degree of Operating Leverage
Presence of fixed operating cost is referred to as operating It measures the sensitivity of a firm’s operating profit to a change in
leverage. Due to its presence, a change in volume of sales results in firm’s sales.
more than proportional change in operating profit (loss). Degree of operating leverage % change in operating profit (EBIT)
Thus, like a lever, the presence of fixed operating costs causes at Q units (DOL = % change in output (or Sales)
a % change in sales volume to produce a magnified percentage The degree is measured at a units because the sensitivity of the firms
change in operating profit (or loss). to a change in sales as measured by DOC will be different at each
However, leverage is a double edged sword-just as company level of output (or sales).
profits can be magnified, so too can the company’s losses. Equation:-
Table showing the effect of operating leverage an operating Q (P-V)
profit (EBIT). DOL Q units =
Q (O-V)-FC
OR
Panel A : Two firms before changes in sales DOL S Rs of Sales =
EBIT +FC
EBIT

Firm A Firms B Where Q is quantity, P is Sales Price, V is variable cost, Fc is fixed

Sales 10,000 11,000 cost, EBIT is Earning before interest and tax.
Operating Costs DOL & Business Risk
Fixed cost (Fc) 7,000 2,000 DOL is just one component of business Risk whose principle
Variable Cost (VC) 2,000 7,000 contributing factors are variability in sales and production cost. What
Operating Profit (EBIT) 1,000 2,000 it does, is, magnifies their impact on profits.
Operating Leverage ratios Financial Leverage (or Trading on Equity)
Fc/ Total costs .78 .22 Financial leverage involves the use of fixed cost financial. Financial
Fc/ Sales .70 .18 leverage is acquired by choice, but operating leverage may not. It
may be dictated by physical requirements of firm’s operations. For
Panel B : Two firms after 50% increase in sales example, a steel mill by way of its heavy investment in plant and
equipment will have large fixed operating cost component consisting
Firm A Firms B of depreciation. Financial leverage is always a choice item, no firms
Sales 15,000 16,500 is required to have only long term debt or preferred stock financing.
Operating Costs Firms can, instead, finance operations and capital expenditures from
Fixed cost (Fc) 7,000 2,000 internal sources and issues of common stocks.
Variable Cost (VC) 3,000 10,500 Degree of financial leverage (DFL)
Operating Profit (EBIT) 5,000 4,000
Percentage change in EBIT
 - 12 -Page 12 of 29

It measures the sensitivity of a firm’s earnings per share to a change A company can raise additional funds from various sources such as
in firm’s operating profit. (a) all common stock (b) all debt or (c) all preferred stock.
DFL = % change in earnings per share (EPS) The indifference analysis is used to determine EBIT level which EPS
% change in operating profit (EBIT) is same for two (or more) alternatives. This analysis is also referred
to as Break Even analysis. Following formula is used:-
Effect of financial leverage on level and variability of earnings per
shares EPS = (EBIT – I) (I – t) – PD
(fig in Rs) NS
Firm A Firm A
(100% (50% equity where I = annual interest paid
equity PD = annual preferred dividend paid
Panel A: EBIT 80,000 80,000 t= corporate tax rate
Interest (I) — 30,000 NS = Number of shares of common stock
Profit before tax (PBT) 80,000 50,000 outstanding
Expected taxes (t) @ 40% 32,000 20,000 for example : indifference point between the common stock
PAT 48,000 30,000 and all debt financing alternatives given t=40% Interest rate is
Number of shares of common stock 4,000 2,000 12% additional finance required is Rs 50,00,000. Given 20,000
outstanding (NS)
shares outstanding. Share price is Rs 50. Which translates into
Expected earnings per share (EPS)
additional 1,00,000 shares

Firm A Firm A Common Stocks All debts

(100% (50% equity
equity (EBIT – 0) (1-.40) – 0 = (EBIT – 6,00,000) (1-.40) – 0
Panel B: Risk Components
3,00,000 2,00,000
Degree of financial leverage
EBIT 1.00 1.60
[ EBIT – I – PD/ (I0T) ] NS is case of common stocks is 3,00,000 shares (i.e. 200000 +
PD = Preferred dividend 1,00,000) 2,00,000 an already outstanding and 1,00,000 shares are
t = tax rate additionally raised)
I = Interest amount NS in case of all financing is 200000 Shares Since no additional
shares are issued only debt is raised to finance additional
Mence, it is clear than EPS is more in case of firm B which also requirement.
earns same EBIT as firm A due to the use of financial leverage. I in case of common stock is zero since no interest arises due to non
Total Leverage: usage of debt.
When financial leverage is combined with operating leverage the I in case of all debt financing is calculated as
result is referred to as total or combined leverage. The result of t = 40% in both the cases
combined leverage is that a small change in firms sales leads to a PD = 0 Since no preferred stocks is used for financing
much greater change in EPS due to Play of both the leverages. Solving the equation further by cross multiplication:
% Change in EPS (EBIT) (.60) (2,00,000) = (3,00,000) (EBIT) – 6,00,000) (.60)
Degree of total leverage =
% change in output (sale) = EBIT (1,20,000) = (1,80,000) (EBIT – 600000)
DTC = DOL x DFL = EBIT (1,20,000) = (1,80,000) (EBIT)) – (1,80,000) (6,00,000)
Indifference Analysis: bringing EBIT from RHS to Left hand side
 - 13 -Page 13 of 29
EBIT (1,20,000) – (1,80,000) (EBIT) = - (1,08,00,00,00,000)
EBIT (1,20,000 – 1,80,000) = - 1,08,00,00,00,000
60,000 (EBIT) = 1,08,00,00,00,000
1,08,00,00,00,000
EBIT = = 18,00,000
60,000
At EBIT = Rs 18,00,000 whether the firm uses all debt or all
common stock. EPS will remain same (or indifferent to EBIT)
The indifference point can also be found out graphically
The higher the EBIT than indifference point, the use of debt would
result in higher EPS and lower the EBIT than indifference point the
valuable is the use of common stock for greater EPS to occur.
Nature and Scope of Financial
Management
Finance is as important to a business as the blood for life.
Every enterprise, whether big, medium or small needs
finance to carry on its operations. Without adequate
finance, no business can achieve its objective.
Financial management refers to that part of the
management activity which is concerned with the
planning and centrolling of firm’s financial resources.
Evolution of Corporate finance/financial management
The evolutionary stages of corporate finance are
studied as follow:
1. Traditional approach: the traditional approach
relates to the initial stages of its evolution during
1920s and 1930s. Financial management was
known as ‘Corporate finance’ then; According to
this approach the scope of finance function was
limited to only procurement of funds needed by a
business on most suitable terms. It completely
ignored the efficient use of funds in the business
and day to day financial problems of an
organization.
2. Modern Approach: According to this view, finance
function deals with not only finding out sources of
raising funds, but also their proper utilization.
Finance is treated as on integral part of management
and the finance function covers financial planning,
raising of funds, financial control etc. The
techniques of simulation, mathematical
programming, financial engineering are used in
financial management to solve day to day financial
problems.
Chronology of evolution
1. In the initial stages of evolution of corporate
finance, emphasis was placed on the study of
sources and forms of financing the large sized
business.
 - 14 -Page 14 of 29
2. The grave ECONOMIC RECESSION of 1930’s
rendered difficulties in raising finance from banks
and other financial institutions. Thus, emphasis
was on improved methods of planning and
control, sound financial structure of the firm and
concern for liquidity - Thus, ways and means of
evaluating the CREDIT WORTHINESS of firm
were developed.
3. Late 1950’s, the Post world war era – saw
reorganization of industries and need for selecting
sound financial structure. Emphasis shifted from
profitability to liquidity and from institutional
finance to day to day operations . Techniques of
analyzing capital investment in the form of
CAPITAL BUDGETING were also developed.
Scope of financial management widened to
include the process of DECISION MAKING
WITHIN THE FIRM.
4. Modern Phase began in mid-fifties, the discipline
of CORPORATE FINANCE OR FINANCIAL
MANAGEMENT became more ANALYTICAL
AND QUANTITATIVE
5. 1960’s saw advances in the thory of
‘PORTFOLIO ANALYSIS’ by Markowitz,
Sharpe, Litner etc., Modern concept like CAPM,
OPTION PRICING THEORY, BINOMIAL
MODEL were developed.
6. In 1980’s , role of taxation in personal and
corporate finance was emphasized. Further, newer
avenues of raising finance with the introduction of
new capital market instruments such PCD’s,
FCD’s PSB’s and CPP’s were introduced.
7. Globalisation of markets has witnessed the
emergence of FINANCIAL ENGINEERING,
which involves the design, development and
implementation of innovative financial
instruments and the formulation of creative
optimal solution. The techniques of models,
mathematical programming and simulations were
used.
Thus, we can say that Financial Management has evolved
from a branch of economics to a distinct subject of
detailed study of its own.
Traditional approach Modern approach
1. It relates to initial stages It relates to late 1950’s
of evolution during 1920’s were the concept of
and 1930’s when the term MANAGEMENT OF
CORPORATE FINANCE WORKING CAPITAL was
was used used.
2. The scope was confined It views finance function in
to only procurement of broader sense
funds on most suitable term
3. Utilisation of funds was It includes both raising of
considered beyond its funds as well as their
purview utilization
4.It was felt that decisions Finance function does not
regarding applications of only stop at finding out
funds are taken somewhere sources but also their
else in organization proper utilization ( of
funds)
5. Institutions and Finance function involved
instruments for raising decision making relating to
funds were considered to utlisation of funds so that
be a part of finance returns generated should be
function more than costs of
procuring them
6. Scope fo finance Scope covered financial
function, evolved around planning, raising of funds,
the study of capital market allocation of funds and
 - 15 -Page 15 of 29
institutions, instruments of financial control
raising external funds
Using techniques of
mathematical
programming, simulation ,
financial engineering etc
Limitations of traditional approach
1. It is outsider looking in approach that completely
ignores internal decision making as to the proper
utilization of funds.
2. The focus of traditional approach was on
procurement of long term funds. Thus it ignores
the important issue of working capital fiancé and
management.
3. the issue of allocation of funds , which is so
important this approach ignores it completely
4. It does not lay focus on day to day financial
problems of an organization.
Financial Decision
The modern approach considers four basic management
decision -
(i) Investment decision/ capital budgeting decision
(ii) financing decision/ capital structure decision
(iii) Liquidity decision/ working capital decision
(iv) dividend decision/ distribution decision
1. Investment decision: Investment denotes
expenditure made now whose benefits will be
received over a number of y ears in the future. In
simple terms, it refers to determination of total
amount of assets to be held in the firm. The
profitability of various investments is assessed by
finance manager in term of expected return, costs
involved and risk associated with future. These
decisions relate to setting up of new unit, expansion,
replacement, research and development projects,
mergers, acquisitions and also spin offs etc.
2. Financing Decision: Once a firm decides to make
an investment, it must decide on the best source of
financing that investment. It can raise funds from
various sources such as debentures, preference
capital, equity capital etc. The financing decision is
concerned with how best to finance new assets that
would reduce the overall cost of raising the funds
and would also minimize risk associated with
financing.
3. Liquidity decision: The amount of current assets to
be held in the business is known as liquidity
decision. Such as decision is influenced by trade off
between liquidity and profitability.
The higher the amount of liquid assets such as
stock, debtors, cash etc the higher the liquidity i.e.
ability to pay off short term debts but lower would
be profitability as the amount keep in the form of
current assets gets blocked in the business and thus
fails to earn any return that would have been
possible had it been invested somewhere else.
4. Dividend Decision: It is another important financial
decision. The financial manager must decide
whether the firm should distribute all profits, or
retain them fully a part of it. The higher rate of
dividend may raise the market price of shares and
thus, maximize the wealth of shareholders. The firm
should also consider the question of dividend
stability, stock dividend and cash dividend.
Financial Goal
 - 16 -Page 16 of 29
The decision that a finance manager makes must be
guided by a goal. The goal can be:
(i) Profit Maximization goal: Profit earning is the
main aim of every business. No business can
survive and grow without earning profit, besides,
profit is a measure of efficiency of a business
enterprise. The arguments favouring this objective
are as follows:
(a) when profit earning is the main aim of
business then profit maximisation should be
obvious objective.
(b) Profitability measures efficiency of a business.
(c) Profit enables a firm to survive adverse
conditions.
(d) Profits are main source of financing the firm’s
growth
(e) Profits are essential for fulfilling social goals
also.
Arguments against profit maximization goal:
(i) The term ‘profit’ is ambiguous. Does it mean
profit before tax & after tax? Does it mean
operating profit or profit available for share
holders is not clearly defined.
(ii) This objective ignores time value of money is
it does not recognize that a rupee earned today
is worth more than a rupee earned after a year.
(c) It ignores the risk element associates with
projects. A project may involve more risk than
another project to make it unacceptable due to
inadequate risk bearing capacity of the firm.
(d) It also does not take into account the effect of
dividend policy on the market price of shares
II. Wealth Maximisation Objective:
Shareholder’s wealth is measured by the product of
no. of shares owned, multiplied with the current
market price per share theoretically, wealth
maximisation objective s claimed superior to profit
maximisation objective on the following grounds:
(i) It provides on urambiguous objective to seek
when making investment and financing
decisions.
(ii) It takes into account the time value of money
as the cash flows occurring later are
adequately reduced to bring them to present
level.
(iii) It also provides for adjustment of risk factor
during cost - benefit analysis in decision
making.
(iv) It saves the interests of suppliers of funds,
employees, management and society as all of
them desire an increase in the market price of
shares hold in their hands.
Limitation of this objective :
(i) It is a prescriptive idea and does not describe
what firms should actually to.
(ii) The objective of wealth maximisation may not
necessarily be socially desirable.
(iii) There is some controversy as to whether the
objective is to maximise shareholder’s wealth
or the wealth of the firm which include
debenture holders, preferred shareholders etc.,
(iv) The objective may not be realizable when
there is a separation of ownership and
management in company from of
 - 17 -Page 17 of 29

organisation. Shareholders interest
conflict with manages interest.
In spite of the conflicts, shareholders wealth
maximisation objective is more logical and operationally
feasible than the profit maximisation objective.
Organisation of Finance function
Board of director
Managing Director
many directors or a highly placed official. All important
financial decisions are taken by the committee or
executive but routine decisions are left to the lower level
of management.
In still larger concerns, two more officer — controller and
treasure - may be appointed under the direct superrison of
chief financial officer (CFO). the controller is concerned
with planning and controlling the finance, preparing
reports, estimating the requirement of funds, capital
budgeting etc whereas treasure deals in raising of long
term finds, working capital (short term firms), protection
of funds etc.

In India, controller is generally termed as finance

controller or the management accountant. But the
Vice President Vice President Vice President
Production Finance Marketing
designation of treasure is not very popular as some of his
functions are performed by company secretaries,
chartered accountants etc.
Controller Treasurer
Planning & Control Provision of both Long term &
short term capital Functional Areas of Financial Management
Accounting Relations with banks &
financial institute are The scope of financial management is getting enlarged
Preparation financial reports Cash Management
Reporting and Interpreting Receivables management day by day spanning from routine function of record
Internal audit Protection of funds & securities keeping to giving strategic direction to the organisation
Tax administration Investor relations for outdoing the competitors. Some of the functional
Economic appraisal & reporting Audit
to Government areas are stated as follows:

Organisation of finance function varies from
enterprises, enterprise, depending upon is nature, size and
other requirements. In small concerns, the owner himself
handles finance function. In medium and large scale
concerns, a separate department looks after all the finance
functions. This department is headed by a committee or
executive under the direct supervision of board of
1. Preparing books of accounts : The basic functions
of the finance function is to record daily
transactions properly with documentary evidence
and enable the preparation of Trading account,
profit and loss account and balance sheet.
2. Financial analysis Y Interpretation: Finance
manager tries to draw of out critical information
 - 18 -Page 18 of 29
about liquidity, profitability and efficiency of the
concern by analysis of the financial statements.
3. Financial forecasting: Determining the financial
needs of a concern in advance is another important
function of the finance manager. The requirement of
funds for long term and short term needs varies
from industry to industry, scale of operations,
economic conditions etc.
4. Selecting the source of funds: Estimated needs of
funds are then to be fulfilled by raising of adequate
funds. The finance manager has to evaluate various
sources of funds so that the cost of raising them is
minimised.
5. Profit planning & Control: Profit is a function of
cost and volume. Given the amount of profits
should be earned, the finance manager calculates
the volume of sales to achieve the said profitability.
Cost-Volume-Profit analysis tool devised to help the
finance manager in profit planning and control.
6. Capital Budgeting: Investment of procured funds
among various projects that would yield maximum
profits and maximise the market price of firms share
is another important functional area of finance.
7. Working Capital Management: Working Capital is
the portion of total funds lying with the business
that are kept as cash, debtors, stocks for carrying on
daily operations smoothly. Adequate amount of
working capital should be kept in the business as its
scarcity such as mad-equate cash to pay for
purchases or loans in time may tarnish the image of
concern and in most situation may lead to
bankreptsy also whereas WC is also bad as it does
not earn any return.
8. Devising Dividend Policy: Dividend is the portion
of profits distributed to the shareholders. This profit
can be kept (retained) in the business also if it needs
cash for growth. Shareholders desire dividends
whereas the concern wants to keep profits with
itself to finance its needs. The finance manager
should decide how much to keep and now much to
distribute to keep both the parties satisfied.
9. Valuation decision: Financial management is also
concerned with evaluation of sale/purchase value of
a firm in case of mergers, acquisitions, spin offs,
demurrers etc.
10. Corporate risk Management: Every business
decision involves risk whether it is a merger or
outsourcing and so on. The finance function aims to
effectively assess the riskiness of every project, and
looks for strategies to manage or mitigate the risk
associated with it.
11. International financial management: The business
now a days are transcending boundaries making the
finance function more complex. The funds can now
be raised from any country and invested at different
places. The tax laws relating to different countries
have to be complied with, there is problem of
consolidation of books of accounts, risk of
operating in different countries also critically
influences the financial decision making.
Capital Structure
Theories and factors
A firm uses different sources to raise funds for its long
term needs. These sources are debt, preference capital and
equity capital. On debt fixed rate of interest in payable and on
preference capital a fixed rate of dividend (not legally
obligatory); if declared, is payable whereas equity
Shareholders receive their share from profits after paying all
 - 19 -Page 19 of 29
the above and further it is also not obligatory; sources that of
preference dividend.
A mix of debt and equity capital used in the business is
referred to as its capital structure.
Why Debt is used
The interest amount payable on debt is fixed say interest
payable on 10% debentures of Rs 10,00,000 is Rs 1,00,000
every year till the debt is repaid. If the
firm is able to earn more than 10% (say 15%) from the use of
these funds, the difference will increase in profits:-
Income earned = Rs 15/100x10,00,000 = Rs 1,50,00
Interest payment = Rs 1,00,000
Addition to profits made by the use of debt 50,000
At the same time, own funds may be used anywhere else more
profitably.
This use of debt and preference capital can which only a
fixed amount is payable) as a source of finance, along with
equity capital is known as FINANCIAL LEVERAGE or
TRADING ON EQUITY.
Optimum Capital Structure:
A firm may use debt in different proportion debt and equity
parts to the total funds raised. Say, if total funds are 100; may
be;’ 50 debt, equity 50 equity or debt 60 and equity 40 and 50
on there can be different mixes of both the sources.
That mix of debt and equity that minimises the total cost of
capital is known as OPTIMUM CAPITAL STRUCTURE. An
optimum Capital Structure thereby increase the market value
of the firm by decreasing the cost of capital.
Controversy Regarding Optimum Capital Structure
There are different views on whether an optimum capital
structure exists or not these views are given in the following
approaches:
1. Net Income Approach : (NI) approach:
According to this approach, overall cost of capital
(CWACC) declines with the increase in the use of debt
(or ___ leverage). As a result, value of the firm rises
with leverage. And Optimum Capital Structure exist at
100% debt usage and no equity usage.
2. Net Operating Income Approach: Not approach:
According to this approach, overall cost of capital
remains unchanged by the use of leverage. Reason
being; whatever benefit or addition to profit is gained by
the use of leverage the same is eaten away by the
increase in the cost of equity which now feel the
existence of increased risk than before.
As a result, no optimum capital structure is said to exist
and therefore 100% equity is as good as 100% debt or
any combination of them.
3. Traditional Approach
As per this approach, the cost of capital falls initially
with the increase in use of debt upto a certain level and
after reaching the optimum capital structure it begins to
rise with the increase in the use of debt. It is a
combination of NI approach and NOI approach.
Hence, According to this approach, Optimum capital Structure
exists.
4. Modigliani and Miller (Mm) Approach:
If can be studied under two situations:-
(a) In the absence of taxes; it supports NOI approach
and denies the existence of optimum capital
structure.
(b) In the presence of corporate taxes; the use of debt
ads to the value of firm (this addition is known as
interest tax shield). This advantage is however
reduced with the inclusion of personal income
 - 20 -Page 20 of 29

taxes payable on dividends and the financial : where = Proportion of debt in total funds
distress costs.
I. Net Income Approach: = Proportion of equity in total of funds
OPTIMUM CAPITAL STRUCTURE = 100% debt.
It is based on the following assumptions:
(*) The use of debt does not change the risk illustration,
perception of investors as such Ke and Kd remains
constant with change in Leverage. Assume a firm has an expected annual net operating income of
* Kd < Ke (i.e. debt capitalisation rate is loss than Rs 1,00,000, an equity rate, Ke, of 10% and Rs 5,00,000 of 6%
equity capitalisation rate) debt. The value of the firm and overall cost of capital change
* Corporate income taxes do not exists. Graphically, can be studied as :
it can be shown as
Kd = Cost of debt is Case I Case II Change
interest rate is taken (using 5,00,000 debt (using 12,00,000
as 6% 7,00,000 debt increase in
Net operating Rs Rs debt
Ke = dividend and Income X 1,00,000 1,00,000
growth expectations Total cost of
by equity share debt i.e., Interest
holders is taken as = Rs.
10% representing
30,000 —
cost of equity.

— 42,000

Net income (NI) 70,000 58,000 NOI

Ko = overall cost of capital measured as V
available to
equity
NOI= X = net operating income before interest and taxes shareholders
(i.e.; EBIT)
V = value of firm which is sum of value of equity ‘S’ Market value of Equity(s)
and value of debt ‘D’ NI/ke = 70,00/10 , 58,000/10 7,00,000 5,80,000
i.e., V = S+D Market value of Debt 5,00,000 7,00,000
Ko can also be measured as : IWT/Ko Value of firm v=SID 12,00,000 12,80,000
Rs. 80,000 increase in value of firm
Case I Case I Change
(using 5,00,000 debt) (Using Rs 7,00,000 debt)
Rs. 2,00,000 increase in debt
 - 21 -Page 21 of 29

X 1,00,000 1,00,000 Fall in the overall

Ko = 12,00,00 x 100 12,80,00 x 100 cost of Capital
V
0 0 (i.e. ko) from
8.33% to 7.81%
= 8.33% = 7.81%

II. NET OPERATING INCOME APPROACH

(No optimum capital structure exists a firm’s market
value is not affected by capital structure)

Assumptions of NOI approach are as follow:

- The market value of the firm is found by the following
equation; V=D+S = NOI/Ko = X/Ko . This equation is
stated as capitalising the net operating income of the
firm (ie. X or NOI) at overall or weighted overage cost
of capital (i.e Ko) where Ko is not affected by the
amount of debt used.
- Ko depends on the business risk i.e. risk of not able to
the same NOI as before from the investment due to
market conditions.
- The use of less costly debt increases the risk of
shareholders. This causes cost of equity to risk and as a
result the advantage given by use of debt is taken away
by the increase in cost of equity. (Equity shareholders
demand higher return compensation for bearing higher
risk)
- Cost of debt i.e. kd is constant
- The corporate income tax as do not exist.
It can be graphically represented as :-
If is clearly visible from the graph that with increase in
leverage Ke rises and this makes Ko to remain constant at all
levels.
Degree of leverage
III. TRADITIONAL APPROACH or INTERMEDIATE
APPROACH - Existence of Optimum Capital
Structure
It is a compromise between not Income approach and net
operating income approach. According to this approach,
The value of the firm can be increased or the cost of
capital can be reduced by the correct mix of debt and
equity.
According to this approach, the overall capital structure
movements due to change in capital structure can be
divided into three stages shown graphically as under :
 - 22 -Page 22 of 29

Third Stage : Declining Value

Beyond the acuptable limit of leverage, the value of the

firm decreases or cost of capital increases with leverage.
As is indicated by rising Ko in the third stage.

After L2 mix at any addition of debt in the capital debt

holders also start feeling the risk and this leads to increase
in their cost in the form of agency cost (interference of
debt holders in decision making, asking for more stricter
contract stipulations and so on) along w\with further
increase in the risk perception of equity shareholders.

Both these costs together pull up the overall cost of capital.

IV MM hypothesis :
1. Absence of Corporate Taxes: Irrelevance of Capital
First Stage: Increasing Value
Structure
In the first stage, Ke remains constant as equity share
Assumptions:-
holders do not perceive increase in risk due to increase in
- Perfect capital market exists i.e
the use of debt. This causes an addition to profits because
i) securities are freely bought & sold
of the use of debt which adds to the value of the firm and
ii) investors can freely borrow at the same terms as firms
reduces the overall cost of capital as indicated in the graph
can
when Ko falls with increases in Leverage.
iii) they are rational.
iv) Transaction costs do not exist i.e. the cost of buying &
Second stage: Constant Value: Optimum Capital Structure
selling securities
- Homogeneous risk classes: Firms within same industry
The fall in Ko continues fill a particular limit the mix of
will have more or loss same risk about the earnings to
debt and equity) after that the equity share holders start
occur as per expectation.
fearing more risk due to debt obligations (i.e. bankruptry
- Risk: The risk of investors is defined as the variability (i.e.
due to default in payment of interest) and ask for more
changes) of the not operating income the greater the
returns (i.e. Ke, rises) for their investment. This offsets the
variability from the previous record the greater the risk.
debt advantage. As such Ko remains constant.
- No corporate taxes exist
- Full payout: firms distribute their entire earnings to the
Any mix of debt and equity in stage II (between L1 & L2)
investors.
optimum capital structure.
 - 23 -Page 23 of 29

Preportion I : Under prepositino I value of firm is Independent Ke = Cost of equity or equity capitalisation rate (i.e. it is the
of the debt equity mix and the value of the firm is computed rate by which we divide Net Income available to
as: shareholders to find out market value of equity)
Value of the firm = Market Value of + Market Value of
Equity Debt According to Preposition I, Since total market value of the firm
is unaffected by financing mix, it follows that the cost of
Expected overall cost of capital capital will not change with change in the degree of leverage
= and the WACC will be equal to cost of equity (ke)
Expected overall cost of capital

Arbitrage Process or Switching Process :

MM hypothesis staes that two firms identical in all respects

According to preposition I it is the NOI, that is look upon by
investors in calculating the risk associated with the firm and
not separately the earnings available to equity shareholders as
the interest expenses.
It is the variability or flluctuations in NOI that affects the
investors not the amount of debt used.
(i.e. in the same risk class) exept for capital structures cannot
have different market values of their firms. If they have
different market values, arbitrage or switching will take place.
In arbitrage, investors use personal or home-make leverage
(i.e. undertake personal loans is the purpose of investments) as
against corporate leverage to restore the equilibrium.

The Preposition I can be expressed as: Illustration :- Suppose 2 firms: unlevered firm U and levered
firm L - have identical NOI at Rs 10,000.

Unlevered Levered
firm firm
U L
NOI = X Expected Rs, 10,000 Rs. 10,000
S=Value of Equity Rs 1,00,000 Rs. 60,000
Share
D=Value of debt Rs. 50,000 [ 6% debt]
V=S+D Rs1,00,000 Rs 1,10,000

Ko = WACC = weighted average cost of capital Suppose a person sums = 10% of the levered firm L.
D = Debt Return on investment = .10 (X-INT)
V = S+D = Value of the firm = .10 (10,000 - 6/00x50,000)
S = Equity capital = .10 (10,000-3000) = Rs 700
Value of Investment = .10 (S) .10 (60,000)
= Rs 6000
 - 24 -Page 24 of 29

The person can earn the same return of Rs700 through an With decrease in demand for L’s shares its value would
alternative strategy by following the following steps: decrease; and increase in demand for firm ‘U’s shares its value
would increase. Till they become equal. Hence, Preposition 1
Step 1: Sell your investment in firm L for Rs 6,000 is proved.
Step 2: Borrow on your personal account an amount equal to
your share of firm L’s following @ 6% of 10% share, Preposition II:- Preposition II states that cost of equity, Ke,
.10 (50,000) = Rs 5000 would increase with increase in leverage, that would exactly
Your have 6000+5000 = Rs 11000 with your offset any increase in earnings per share consequently firm’s
Step 3: Buy 10% of un_____ firm ‘U’s shares market value would remain unchanged. It can be newed
Investment = .10 (v) graphically as:
=.10 (1,00,000) = Rs 10,000
Return = .10 (NOI) = .10 (10,000)
= Rs 1000
However, you have borrowed Rs 5000 at 6% therefore
you will have to pay Rs 300 as interest.
Interest = 6/100 x 5000 = Rs 300
Your net return is Rs 700 as shown below:

Rs
Equity return firm U 1000
Less : Interest on personal borrowing 300
Net return 700 This graph follows NOI approach upto stage I. IN stage II
when Kd increase due to increase in risk perception of debt
holders Ke start falling down as a part of their risk has been
Note: that you are also left with cash Rs 1000 as follows :- transferred to debt holders. Consequently, any increase in Ko
by increase in Kd is brought down by fall in Ke by same extent
Rs keeping Ko again constant as before. Hence, them is no
Equity return firm U 6000 Optimum capital structure
Less : Interest on personal borrowing 5000
Net return 11000 Criticism of M-M hypothesis :
Less investment in firm U = .10 (1,00,000) 10,000
Remain in a Cash 1,000 The shortcomings of MM hypothesis are as follow :
1. The assumption that individuals (i.e. common investors)
Due to this advantage of alternative investment strategy, a and firms can borrow and lend at the same rate of interest
number of investors will sell their shares in firm L and buy the does not hold good in practice.
shares of firm ‘U’. 2. It is incorrect to assume that corporate leverage (i.e. debt
raised by firms) and home made leverage (i.e. personal
 - 25 -Page 25 of 29

loans taken by individuals) are exact substitutes firms have Amount 5000 4400
limited liability whereas individuals have unlimited available to
equity share
liability. holders
3. The transaction of buying and selling of securities involves Total returns 5000 1,200 as interest
costs as such non existence of transaction cost cannot be available to income for
said to be practically applicable. debt holders as 4,400 debt holders
4. Working of orbitrage in also influenced by institutional well as equity
share holders earnings
restrictions. At times institutional investors may not able to available to
use personal leverage in place of corporate leverage simply equity show
because they are not allowed to do so. holders
Total 5000 5,600
Existence of corporate taxes & MM hypothesis
Evidence of corporate taxes (i.e. the taxes firms pay on their
profits) further strengthans the MM hypothesis. Earning increase due to the USE OF DEBT & EXISTENCE
OF CORPORATE TAXES.
The existence of corporate tax gives a tax advantage to the
firm on its interest payments which is an expenses allowed to Note that income tax liability of firm L is Rs 44000 where as
be deducted from profits and on the remaining profits taxes are that of firm U is Rs 5,000. The difference of Rs 600 which
computed. firm ‘L’ is saving or paying less by way of income tax is
known as “Interest tax Shield”. If Interesting to watch out that
This yields greater income for its investors for example:- the total return available to firm ‘L’ is Rs 5600 & firm ‘U’ is
X = NOI = Rs 10,000 Rs 5000 i.e.Rs 600 less (Rs 5600 - Rs 5000). This difference is
Kd = 0.06 or 6% same as saved by way of taxes of Rs 600. This savings has
D = Rs 20,000 increased the total returns of the firm by Rs 600.
Corporate tax = 50%
It can be computed following method also:
Unlevered firm will have Rs 5000 [ 10,000 - 50/100x10,000]
for distribution to its equity share holders worked out as Interest tax shield = Tax rate X Interest
follows for both L & U firms. INTS = .50 x Kd D
= .50 x (.06x20,000)
Unlevered Levered = .50 x 1200
firm (U) firm (L) = Rs 600
Rs Rs
NOI 10,000 10,000
Thus, the value of a Levered firm is equal to value of
– Interest – ( x20,000) 1,200
unlevered firm plus the present value of interest tax shield :
Profit before 10,000 8,800
tax
Less taxes @ 5000 4400 (Income tax
VL = VU+TD ; [5600 = 5000 (Vu) +600(Interest tax shield)]
50% liability)
 - 26 -Page 26 of 29

Vi = Value of levered firm VU = Value of Unlevered firm

VU = Value of Unlevered firm T = Corporate tax rate
T = Tax rate Tpe = Personal tax rate on equity
D = Value of debt Tpb = Personal tax rate of debt
TD = Interest Tax shield
The objective of a firm would be to minimise the total taxes
The above discussion imphes that when corporate tax rate i.e. (both corprate and personal) while deciding on how much to
T is positive i.e. T>o, the value of levered firm will increase borrow as the existence of personal taxes reduce the interest
continuously with debt. Thus, theorefically the value of the tax shield advantage available to the firm.
firm will be maximum when it employs 100% debt. This is
shows as follows : Suppose in the previous illustration both the debtholders and
equity shareholders may personal income tax of 40% on their
income

Unlevered Levered
firm (U) firm (L)
Rs Rs
Earning available to Equity 5000 4400
share holder before personal
taxes
Less Personal tax @ 40% = 2000 1760
Tpe
After tax earning available 3000 2640
to equity share holder
Earning Interest Income of – 1200
debt holder personal taxes
Less personal taxes @ 40% – 480
= Tpb
Existence of Personal taxes: Interest income after 720 =D
personal taxes
Investors pay personal taxes on the income earned by them.
Total returns 3000 2640
Therefore, from investors point of view, taxes will include both available after Equity
corporate and personal taxes corporate & Debt – 720
personal taxes
Hence, the value of levered and unlevered firms would now Total 3000 3360 Difference in
equate as follow : Levered firm is
3360-3000=Rs
360

Interest tax shield has reduced from earlier Rs 600 to Rs 360

Where, VL = Value of levered firm due to the existence of personal taxes.
 - 27 -Page 27 of 29
Putting the values in egn (1) the get
Vc = 3000 +
= 3000 + [ 1-(1-(1-.50) 720
= 3000 + .50 x 720
= 3000 + 360
= Rs 3360 as calculated above
firms save their taxes by having interest as part of their
expenses. But this interest income is taxed in the hands of debt
providers even if they receive it or not. Whereas, equity
shareholders are taxed on their dividend income only when
they receive it in their hands or sell their shares and get cpaital
gains (selling shares at a price higher than their purchase price)
The above fact, induces companies to go for debt but
demotivates debt holders. Hence, the firms have to induce debt
holders to provide more debt by paying them higher rate of
interest.
Firms will keep increasing the rate of interest until the
corporate tax savings are greater than personal tax 1oss.
Thereafter they will stop.
This impolies :-
1. There exists an optimum capital structure
2. There is no optimum capital structure for a single firm but
for the whole economy.
Limitations :-
1. If implies that investors would keep on investing in
securities and debt holders in debt. But in p;ractice,
investors hold a mix of debt and quity securities (shares)
known as portfolio
2. The personal tax rate on equity cannot be zero as firms pay
dividends
3. Investors in high tax bracket may indirectly invest in debt
securities by investing in those institutions wherefrom
income is tax exempt.
These institutions, in turn, invest in corporate bonds.
Financial Distress & MM Hypothesis
If a firm can have an optimum capital structure at 100% debt
then why don’t firms in practice borrow 100%?
The answer lies in the fact that as the amount of debt is
increased, certain disadvantages due to the use of debt also
increase simultaneously. These disadvantages are grouped
under the term FINANCIAL DISTRESS.
Financial distress occurs when a firm is unable to pay its
interest and principal repayment obligations as and when they
became due. This may, in extreme cases, push a firm into
banks uptry which involve distress sale of its assets at
throwaway prices to settle the claims of creditors, incuring
legal costs etc. It may involve many indirect costs as well.
Management may avoid investment in profitable projects if
they are risky under insolvency or financial distress.
Financial distress reduces the value of the firm. The value of a
levered firm is given as:
VL = Vu+TD-PVFD
VL = Value of levered firm
VU = Value of unlevered firm
TD = TAX shield on Interest
PVFD = Present value of financial distress
PVINTS = Present value of interest tax shield
Graphically it can be shown as:
 - 28 -Page 28 of 29
The figure shows that present value of Interest tax shield
increases with increase in borrowing but 50 does the present
value of financial distress.
However, the cost of financial distress are quite insignificant at
moderate level of debt, therefore the value of the firm increase
with debt.
With more an dmore debt, the cost of financial distress
increases and therefore, tax benefit shrinks. The optimum point
is reached when the Present Value of the tax benefit becames
equal to the present value of the costs of financial distress. The
Value of the firm is Maximum at this point.
Short Notes
Capital budgeting (or investment appraisal) is the
planning process used to determine whether a firm's long
term investments such as new machinery, replacement
machinery, new plants, new products, and research
development projects are worth pursuing. It is budget for
major capital, or investment, expenditures
Cash Flow Vs Accounting Profit
Acounting profit would be the reported amount of
"Profit" after calculating books against sales and
operational expenses. Once you have figured in all
associated cost to a service or product, paid the overhead
bills, insurances and such; the remainding revenue would
be reported as profit
ACCOUNTING RATE OF RETURN METHOD:-
ADVANTAGE:-
i.)It is very simple to understand and easy to operate.
ii.)It uses the entire earnings of a project in calculating
rate of return and not only the earnings upto payback
period and hence gives a better view of profitability as
compared to pay back period method.
iii.)As this method is based upon accounting concepts of
profits, it can be readily calculated from the financial
data.
DISADVANTAGE:-
 - 29 -Page 29 of 29

i.)This method also like pay back method ignores the
time value of money as profits earned at different points
of time are given equal weight by arranging the profits.
ii.)It does not take into consideration the cash flows
which are important than the accounting profits.
Is Equity Capital without Cost:
Equity shareholders are the real risk bearers of a firm. They are
the residual holders of all the profits of a firm and they have
got voting rights still distributing dividends to them is at the
discretion of the company management.
But it does not mean that they need not be given dividend. The
reason being, if they are not given dividend or regularity is not
maintained in distributing dividend to them, they may not be
interested in their investment in the company and may shift
their investment to other companies.
Company form of organization involves separation of
ownership and control. Shareholders are scattered at distant
places far and wide and the actual management is entrusted to
the managers of the firm.
This becomes the cause of conflict between both the parties.
Due to distance from the managerial activities shareholders
lack trust on the managers regarding their truthfulness in
managing the affairs of the firm and feel that they might be
using resources to their own benefit.
Debtholders also feel the same way.
This distrust causes repeated checking on the affairs of the
company which involves cost titled as agency costs. The term
agency is used since managers act as agent of the shareholders
and debtholders of the firm in managing the affairs of the firm.

Hence, it is in the interest of maintaining the wealth of the

company shareholders intact that they are distributed dividends
at least equal to opportunity cost of capital. This becomes a
cost to the company.

There are various measures of cost:

Earnings model
Dividend model at normal growth
Supernormal growth model
Average residual income model
CAPM model

Also the value of retained earnings should be calculated as it is

the undistributed income which actually belongs to equity
shareholders.

AGENCY COSTS